Part 1: Permitted Investments and Compliance

The self-directed individual retirement account (IRA) is an increasingly popular option for an IRA account owner, especially those owners who have significant net worth and are sophisticated investors. A self-directed IRA is like any other IRA in most respects. The difference is in the type of investments available.

In a standard IRA, the account will be invested in publicly traded products like stocks, bonds, and mutual funds. With a self-directed IRA, the account owner can choose many types of alternative assets. The danger with self-directed IRAs, however, is that they are advertised as allowing “almost any type of alternative investment” without much stated about the myriad of rules that apply. Self-directed IRAs are in fact regulated and subject to a wide variety of limitations. These limitations do not so much restrict types of investments, but rather impose sometimes burdensome reporting requirements and restrictions on the types of transactions that can take place with the account owner or related parties. It can be easy to violate some of the rules, and the consequence can be disqualification of the tax-favored status of the IRA or a deemed taxable distribution from it.

Investment Related Requirements. An account will fail to qualify as an IRA, or can lose it status as one, by making a prohibited investment. To maintain tax-favored status, an IRA cannot:

• Invest in life insurance. IRC § 408(a)(3).
• Invest in collectibles. IRC § 408(m). Under Code Section 408(m)(2), a collectible includes any work of art; any rug or antique; any metal or gem; any stamp or coin; any alcoholic beverage; or “any other tangible personal property specified by the Secretary for purposes of this subsection.”
  • An IRA can invest in certain US gold coins and silver coins minted by the Treasury Department. It cannot invest in Krugerrands.
  • It also can invest in certain gold, silver, palladium and platinum bullion.
• Engage in a loan to the account owner or pledge the account as security. IRC § 408(e)(2), (4).

The list of prohibited investments for an IRA is extremely short. An IRA owner is not prohibited from investing in any of the following:

• Privately held corporations, partnerships or LLCs
• Real estate
• Venture capital, private equity, or hedge funds
• Private debt obligations
• Options or other derivative financial products

However, an investment in any of the assets can raise a host of additional problems that may make the investment undesirable or not cost effective. The investment also can lead to inherent self-dealing problems, which will be discussed in Part 2 of this topic next month. Any self-dealing transaction prohibited under Code Section 4975 can clause the IRA to lose its tax-exempt status. IRC § 408(e)(2). In general, the use of an IRA to make a private investment requires careful administration at every step.

Prohibitions Because of Investment Itself. Certain investments are not prohibited under the rules governing IRAs but cannot be made because of limitations imposed on ownership of the investment. The most important prohibition is that an IRA cannot invest in an S corporation under the S corporation shareholder rules. The corporation will lose its S status if an IRA becomes an owner.

In addition, an investment sponsor may prohibit an IRA from being an owner of an investment. This could be for any number of reasons and will depend on the sponsor. Any owner considering the use of an IRA for an investment should check with the investment sponsor, issuer, or underwriter. As discussed below, an IRA owner should never attempt to circumvent this problem by not telling the sponsor that the funds being used are IRA funds.

Valuation and Reporting. Even though a particular IRA investment is self-directed, the IRA custodian or trustee (the IRA provider) is responsible for valuing the investment and for reporting the value of the IRA to the IRS. The IRA provider must file a Form 5498 annually with the IRS to report the account value. It is due May 31 and reports the value as of December 31 of the prior year. The instructions to Form 5498 state:

“[t]rustees and custodians are responsible for ensuring that all IRA assets (including those not traded on established markets or with otherwise readily determinable market value) are valued annually at their fair market value.”

If the investment is not readily tradeable, the IRA provider will need information on the investment from the IRA owner (e.g., annual financial statements) and in many cases will require an annual appraisal. The cost of the appraisal will be paid from the IRA or by the IRA owner. A provider typically will require that an independent party serve as the appraiser. There is a risk of violating the self-dealing rules if the IRA owner or a related party acts as appraiser (even if qualified). For a hedge fund or private equity investment, the provider may be willing to rely on an annual valuation provided by the general partner.

An IRA owner should review carefully the provider’s custodial agreement regarding the valuation requirements. The provider may reserve the right to distribute the asset if the owner fails to provide timely valuation information. The distribution would result in taxable income and possibly early withdrawal penalties.

Valuation becomes an even greater issue when annual required minimum distributions start. At that point, accurate valuation also is necessary to have the correct distribution amount determined. Once reaching the RMD, the illiquidity of the investment also will present a challenge. If possible, the owner should have enough cash and/or marketable assets in the IRA, or in another IRA, to satisfy the required distribution. If not, part of the non-marketable asset will have to be distributed. If it is not readily divisible, then the owner will have to make a larger distribution than is necessary.

Asset Titling. The IRA provider must hold title to the IRA assets. With a non-traditional asset, it is common to make mistakes in titling and in using the correct tax identification information. If the assets is mistakenly titled in the name of the owner, the investment is treated as a distribution. The correct title for the asset is [Name of provider], as [custodian or trustee] of [Name of participant] IRA.

The sponsor of the investment may not be aware of the proper protocol for titling the asset. There is usually little that can be done to correct a titling error. The IRA provider may have no idea that an investment was incorrectly titled until it receives a statement or K-1 from the investment entity. In at least one case, an IRA owner used the word IRA in the account title (i.e., John Doe IRA) and was able to correct the title without having the investment treated as a distribution. See Ancira v. Comm’r., 119 T.C. 135 (2002) (investment not deemed a distribution from IRA). But see Dabney v. Comm’r., T.C. Memo 2014-108 (investment was deemed a distribution). In order to correct an error, the IRA owner will need the provider to cooperate and possibly make amended filings.

Unrelated Business Taxable Income. Under Sections 511 to 514 of the Code, the IRS will tax business income received by a tax-exempt entity that is unrelated to its original purposes. See IRC § 512(a)(1). These rules apply to IRAs. IRC § 408(e)(1). Income from debt-financed property receives the same treatment. See IRC § 514. A direct investment in a business that is organized as a limited partnership or LLC will produce UBTI. If the IRA owner plans to invest in an operating business, it is much better to invest in a C corporation. Many private investment funds, hedge funds and real estate investment funds will produce business income and/or debt financed income. Many larger funds also will offer a version of the fund for tax-exempt entities, which uses a blocker entity to prevent UBTI from flowing through to the investors.

Contributions. Noncash contributions to an IRA are prohibited. An IRA owner cannot purchase a business interest, real estate or investment fund and then contribute it to the IRA. The IRA must make the investment directly.

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