Equity Trust, a well know IRA custodian and marketer of self-directed IRAs at events across the country, was recently served with a cease and desist order by the US Securities and Exchange Commission (SEC). The order is based on Equity Trust’s tacit involvement in a Ponzi Scheme wherein 100 Equity Trust account holders directed funds to be invested with two unscrupulous individuals (download here). Equity Trust has argued the injunction is unjust given they do not offer investment advice and each account holder signs a buy-direction letter confirming Equity Trust did not offer any advice and agrees to hold Equity Trust harmless for any negative outcome. The SEC was not persuaded by this argument. (Equity Trust SEC Cease and Desist) This is first of such actions by the SEC against an IRA custodian; however, it comes on the heels of two separate actions, in different courts, finding prohibited transactions on the part of self-directed IRA account holders.
A few weeks ago in Terry L. Ellis et ux. v. Commissioner; No. 14-1310, the Appellate Court agreed with the IRS and disqualified an IRA when the account holder entered into a partnership transaction with his self-directed IRA and an unrelated party. On its face this type of transactions is permissible but, with most advanced strategies, the details are an extremely important component when such a transaction is scrutinized. The record is not clear as to whether or not Mr. Ellis received poor advice from his IRA custodian or attempted to go it alone. I assume a bit of both, but the crux of the problem for Mr. Ellis was three-fold:
- The LLC agreement listed Mr. Ellis’s self-directed IRA as a member more than 30 days prior to the IRA actual creation;
- The LLC agreement provided for payment of a management fee to Mr. Ellis; and
- The IRA was engaged in an active trade or business (selling cars) via the LLC (this is not a prohibited transaction but a taxable event. The Court did not need to address this issue because it invalidated Mr. Ellis’s IRA.)
The Court found the poorly drafted operating agreement providing for the payment of a management fee to Mr. Ellis coupled with its actual payment, was a prohibited transaction. The payment alone was enough to revoke his IRA’s tax-exempt status, and the Court did not need to consider the other issues.
In a separate, unrelated case, this one a bankruptcy, the Court revoked a debtor’s IRA exemption upon a finding the debtor engaged in a prohibited transaction. In re: Barry K. Kellerman et ux.; No. 4:09-bk-13935, the debtor entered into a transaction similar to Ellis wherein an LLC was created between the debtor’s self-directed IRA, set up by Entrust, (I believe the Court’s reference to Entrust is significant for other reasons referenced below) and the debtor’s closely held corporation. The Court found several aspects of this arrangement constituted a prohibited transaction:
- The debtor’s corporation and his self-directed IRA made both cash and noncash contributions to the LLC;
- The LLC’s purchase of specific real estate was necessary for debtor’s development of property held outside of the LLC;
- The debtor could not have purchased the property held in the LLC without the use of his IRA funds, i.e., he could not obtain financing to purchase the property; and
- The LLC loaned the debtor money.
What is particularly interesting in this case who sought to defeat the IRA’s exemption – the bankruptcy trustee and not the IRS. Under most state laws, IRAs are an exempt asset in a bankruptcy. If the Trustee could show, which he did, Mr. Barry committed a prohibited transaction, his IRA would lose its exemption protection. Mr. Barry lost his IRA.
You might be wondering why would either of these individuals enter into a transaction with an LLC that was not wholly owned by their self-directed IRA. The answer is simple, the investment of a self-directed IRA into an LLC partially owned by the IRA account holder, or an independent third party is not a per-se prohibited transaction. In fact, the Ellis court recognized as much in its opinion stating: “The tax court also found that the IRA’s purchase of an interest in CST was not a prohibited transaction because the company did not have any membership interests when the investment was made. See Swanson v. Comm’r, 106 T.C. 76, 88 (1996) (explaining that a “corporation without shares or shareholders does not fit within the definition of a disqualified person”).” However, these transactions run awry when the taxpayer proceeds without competent legal advice. Most real estate investors rely upon their IRA custodians for advice who later disavow any liability by hiding behind disclaimer language in their buy-direction agreements.
Thus, we are brought back to the Entrust reference in the Kellerman bankruptcy decision. The Court specifically referenced the following provision from Entrust’s buy-direction letter signed by Mr. Kellerman:
I understand that my account is self-directed and that Entrust . . . will not review the merits, legitimacy, appropriateness and/or suitability of any investment in general, including, but not limited to, any investigation and/or due diligence prior to selling any investment, or in connection with my account in particular. . . . I understand that neither the Administrator nor the Custodian determine whether this investment is acceptable under the Employment Retirement Income Securities Act (ERISA), the Internal Revenue Code (IRC), or any applicable federal, state, or local laws, including securities laws. I understand that it is my responsibility to review any investments to ensure compliance with these requirements.
I am directing you to complete this transaction as specified above. I confirm that the decision to sell this asset is in accordance with the rules of my account, and I agree to hold harmless and without liability the Administrator and/or Custodian of my account under the foregoing hold harmless provision.
The Court found it important to reference this language because Mr. Kellerman asserted an Entrust representative sanctioned the investment into an LLC he partially owned. Having dealt with a number of individuals in similar situations, i.e., engaging in minor to severe prohibited transactions with their self-directed IRAs, one answer remains consistent when asked who advised them on their course of action – a representative with their self-directed IRA custodian. Amazingly, some of these individuals have provided me emails with structure diagrams, prepared by their IRA custodians, sanctioning prohibited transactions.
Thus, we consider the Equity Trust injunction. The SEC in their request for an injunction specifically stated Equity Trust engaged in a pattern of behavior wherein they advised and facilitated their account holders to engage in certain transactions then sought to hide behind disclaimer language in their buy-direction letters. This type of behavior will undoubtedly result in considerable future litigation as the IRS’s examination of self-directed IRAs gains momentum. One would think active, self-directed IRA investors would prefer to seek security over instability. However, it often comes down to the knowledge of the present situation. Like Edward John Smith, who failed to realize the magnitude of the damage his ship suffered on the fateful night of April 15, 1912, so have many self-directed IRA account holders. For an unlucky few, their IRAs have struck an iceberg, and their exemption will not hold if prompt rescue action is not taken.
All is not lost if you are one of the unlucky few who received bad advice or would like to partner with your qualified funds for a specific investment. The first step toward rescue or alternative investing begins with the creation of a qualified plan, i.e., Solo 401k or profit sharing plan. Savvy real estate investors, aware of the IRS’s attacks and now the SEC’s concern with self-directed IRAs, have strategically moved their funds out of the crosshairs by rolling their self-directed IRAs into one of the aforementioned plans. This tax-free rollover, not available for ROTH IRAs, gives the account holder full control over his roll over funds as the plan trustee. (Other benefits include the ability to borrow up to 50k, pool accounts for even greater investing opportunities, tax-free leveraged investing inside of the plan, and greater control.)
Once your funds are in a qualified self trusteed account, you can make any number of permissible investments one of which can be a partnership between your qualified plan and you individually via an LLC. Should you elect to make this type of investment here are the rules of the road:
- Do not set it up on your own – use an experienced attorney (contact my firm for assistance at 800-706-4741 or email me)
- Ownership in the LLC must be proportional to the contributions, i.e., if your plan invests 70k and you invest 30k the ownership must be split 70/30;
- Only contribute cash to the LLC;
- One shot is all you get, i.e., you and your plan can only make one contribution to the LLC. After its initial funding, any further contributions will be considered a prohibited transaction; and
- Do not receive any benefit direct or indirect from the transaction.
If you are careful and take appropriate steps, tax-deferred investing without the impending chaos is possible. The key is in knowing its coming and the time for action is now.