Last week, the Department of Labor issued Advisory Opinion 2011-04A finding that it would be a “prohibited transaction” (“PT”) for an IRA to purchase a promissory note and deed of trust from a bank where the IRA owner and his spouse were indebted under the note, and where the IRA owner’s family trust held title to the real property at issue.
This ruling is important because the Department of Labor concluded that the proposed arrangement would be an impermissible extension of credit from the IRA to the IRA owners, even though the owners simply intended to move the existing loan over from a bank to the IRA without thereafter refinancing or otherwise taking any action that would constitute a new loan from the IRA. Also significant is that the Department of Labor classified the proposed transaction as prohibited self dealing, for reasons explained below.
The Advisory Opinion involved an IRA that the owner opened over twenty years ago. The owner was the sole account holder and his wife was the sole beneficiary. In 1993 the owners bought an eight-unit apartment building in San Diego for $200,000, financed with a loan from Chase Bank that was secured by a first deed of trust on the property, and evidenced in the form of a promissory note. Title to the property was held in the name of the owners’ family trust. The owners were the trustees and sole beneficiaries of the family trust.
What the owners proposed to do was to have the IRA purchase the promissory note and deed of trust from Chase Bank. Chase Bank would assign the note and deed over to the IRA, or more precisely to another bank serving as IRA custodian, and the owners would make all subsequent payments on the note to the IRA custodian, which in addition to receiving payments would otherwise enforce the promissory note.
The owners’ request for an advisory opinion specifically pointed out that “the transaction [was] structured to avoid any new loan or other extension of credit between the IRA and the [owners], as would occur if they refinanced the loan under different terms using the IRA as a new lender.”
This language refers to one type of prohibited “party in interest” transaction – the direct or indirect lending of money or other extension of credit between a plan (here, the IRA) and a disqualified person or persons (here, the IRA owners). ERISA and the Internal Revenue Code (“Code”) describe four other types of specific prohibited transactions as well as several general categories of prohibited “self dealing” with IRA/plan assets by a fiduciary. Of relevance here are (a) the transfer of plan assets or income to, or use of them by or for the benefit of, a disqualified person; and (b) dealing with plan assets or income for the fiduciary’s own personal account. These are set forth in Code Section 4975(c)(1)(D) and (E), respectively.
The Department of Labor analysis first identified the IRA owner as a fiduciary with regard to the IRA due to his sole discretion over IRA investments. As a fiduciary he was a “disqualified person” as that term is defined in Code Section 4975(e)(2), as were his family members (including his wife) and his family trust, as he and his wife (now both fiduciaries and disqualified persons) together owned more than 50% of the trust. (The DOL has express authority to interpret Section 4975 of the Code and also interprets parallel provisions of ERISA governing prohibited transactions.)
Then, the Department of Labor rejected the notion that simply “moving” the loan over from Chase Bank to the IRA was not a prohibited extension of credit from the IRA to the IRA owners. First, it cited Department policy that a loan is a transaction that “continued from the time it is made until all amounts due are paid,” and that the parties must be examined throughout that time for indicia of a prohibited relationship. On that basis the Department found that a prohibited extension of credit would occur as soon as the IRA acquired the note from Chase Bank, and that the IRA’s holding of the note would constitute another prohibited extension of credit so long as the IRA owners or any other disqualified persons made payments on the note.
The Department of Labor went on to determine that the transfer to and holding of the loan by the IRA would also constitute prohibited self dealing if the transaction was part of an agreement, arrangement or understanding by the IRA owner, as the IRA’s fiduciary, “to benefit himself or persons in which he has an interest that affects his best judgment as a fiduciary (e.g., the Family Trust.)” Noting that this was “generally an inherently factual question,” the Department observed that the proposed purchase of the note by the IRA from Chase Bank would be one in which the IRA owner “would have an understanding, as a fiduciary, that the assets of the IRA are being used to create a prohibited transaction (i.e., an ongoing debtor-creditor relationship between the IRA and disqualified persons) once the IRA acquires the Note.” It therefore concluded that, under those circumstances, the IRA’s purchase of the note would be a separate, self-dealing prohibited transaction under Code Section 4975(c)(1)(D) and (E).
This Advisory Opinion is a good example of how a proposed IRA investment that had been structured with an attorney’s advice and approved by a very reputable bank custodian could still be found to be three different types of prohibited transaction, once under the scrutiny of a government agency. Simply put, this is an area of the law where even the cautious can come to grief. Seeking a tax advisor’s opinion, if not agency approval, is advised before proceeding with any unorthodox IRA investment.