(To be Stored in Master File with Copies of Amendments with List of Recipients in Master File)
Date Amendment
Sent
Type of IRA Amended
Form Number/
Revision Date
(Attach Copy with list of Customers who Received)
Purpose (e.g., “GUST” (law change) or “Merger”
(internal change))
In a true reading of the term “Self-Directed” IRA, almost all IRAs are self-directed, meaning the IRA Holder/Beneficiary directs the investments of the IRA. If a certain financial institution does not have or admin-ister the type of investment the IRA Holder/Beneficiary wants, he or she is free to go to another financial insti-tution.
However, the IRA Industry has given the term “self-directed” a different meaning. For IRAs, “self-directed”
means the IRA Custodian/Trustee allows the IRA Holder/Beneficiary to invest in non-cash assets, not just sav-ings accounts and CDs that the financial institution offers.
Investment transactions associated with self-directed IRAs can be quite diverse and are often complex. The pur-pose of this section is to address some of the general concerns associated with self-directed IRAs, including a brief introduction to prohibited transactions, real estate investments, and unrelated business taxable income.
Prohibited Transactions
The tax code addresses prohibited transactions in terms of what an IRA Holder, Beneficiary or a “disqualified per-son” can or cannot do with regard to an IRA. A person or entity is considered “disqualified” if they are any of the following:
• A fiduciary of the plan
• A person or entity providing services to the plan
• An employer, any of whose employees are covered by the plan
• An employee organization, any of whose members are covered by the plan.
• Any direct or indirect owner of 50% or more1of any of the following (if an employer or employee organization described above):
• Combined voting power of all classes of stock of a corporation
• Capital or profits interest of a partnership
• Beneficial interest of a trust or unincorporated enterprise
• A member of the family of any of the individuals listed above, including:
• Spouse
• Ancestor
• Lineal descendent
• Spouse of a lineal descendent
1The IRS has the authority to use any percentage they deem applicable, even less than 50%.
Although the preceding list may be helpful in identifying individuals who are obviously “disqualified” to partake in certain IRA transactions, it is not exhaustive or complete. One area of particular concern is the area of indi-rect prohibited transactions, whereby a person who is not normally considered a disqualified person may become one if an IRA Holder/Beneficiary or other fiduciary influences that person to engage in a transaction that they would not engage in the absence of said influence.
Examples of transactions that are considered prohibited include the following acts between an IRA and a disqual-ified person:
• Borrowing or lending money
• Receiving unreasonable compensation for services
• Purchasing life insurance
• Pledging of IRA assets
• Buying and selling property
• The acquisition of collectibles
The tax consequences associated with prohibited transactions are serious. Generally, if an IRA Holder or his or her beneficiary engages in a prohibited transaction, the IRA ceases to be treated as an IRA on the first day of the year in which the prohibited transaction occurs. Not only does the IRA become fully taxable, it also becomes sub-ject to prohibited transaction penalties ranging from 15% up to 100% if steps are not taken to timely correct the transaction.
Example: A PT was made in 2001 when the IRA Holder was age 55. It was not discovered/determined until 2014 when the IRA Holder is now age 68. How is it reported concerning tax and penalty?
Solution: The IRA ceases to be an IRA on January 1 of the year the PT occurred, even if the PT had occurred on December 31 of that year. So in this example a distribution is reported as of January 1, 2001. The distribution, IRS Code 5, would be taxed and penalized in 2001. All IRA entries since January 1, 2001 must be corrected with all reports and statements also corrected so that no IRA transaction is reported after January 1, 2001.
Then too, the Internal Revenue Code and Regulations further confuse the issue by stating that a prohibited trans-action can be caused “directly or indirectly.” The “indirectly” opens up a wide area for interpretation by the IRS.
And although it is generally not the responsibility of the IRA Custodian/Trustee/Administrator to determine whether an investment or transaction is a prohibited transaction, the IRA Custodian/Trustee/Administrator CAN NOT KNOWINGLY ALLOW A PROHIBITED TRANSACTION TO OCCUR without also subjecting itself to IRS penalties.
Special Concerns Regarding Real Estate Investments
Because prohibited transactions can be indirect, as well as direct, it is impossible to provide a list that covers every conceivable situation that might result in a prohibited transaction. However, the following list provides some common prohibited transaction concerns and guidelines relating to real estate transactions in an IRA.
1. Real estate must be for investment purposes only.
2. The IRA Holder (or any other disqualified person) cannot live on the real estate or use it for any pur-pose, for any period of time…not even one day.
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b. In-Laws c. Children d. Spouses
e. Related Businesses
4. The IRA may not be used as collateral to purchase the property.
5. Vesting must be as tenants in common (undivided interest).
6. Any loans to an IRA must be non-recourse loans. These may be provided by hard-money lenders as non-conforming portfolio loans, although community banks that specialize in real estate construction also sometimes make such loans.
a. The IRA custodian/trustee can NOT lend money to the IRA
7. All rental income and expenses must flow through the IRA. They must either go directly to the IRA Custodian/Trustee, a third-party administrator, or a property manager for deposit into the IRA.
8. An IRA Holder may act as property manager if:
a. All rent checks are made out to the IRA, not the IRA Holder directly.
b. Repairs may be arranged by the IRA Holder, but not performed by the IRA Holder.
i. The client cannot be compensated for managing the property.
ii. All expenses must be paid through the IRA, not by the IRA Holder directly. and reimbursed 9. An IRA Holder cannot purchase real estate from his or her IRA. If they want to have the property for
their own personal use, they must take a distribution of the property, which must be valued at fair market value. Therefore, before any distribution of real estate occurs from an IRA, a full appraisal should be performed for distribution reporting purposes.
10. An IRA Holder can not sell any property to his or her IRA. No exception!
Fees
Fees are another area of concern with respect to prohibited transactions. Typically, there are three types of fees associated with IRA operations: administrative, commission or sales, or a combination of both. A description of each of these fees and special prohibited transaction concerns associated with them follow.
Administrative Fees
Administrative fees are fees associated with maintaining an IRA. Some examples of administrative fees include transaction fees (e.g., rollover, transfer, distribution, account closing, etc.), as well as investment management. Administrative fees may be paid from outside of the IRA, or they may be debited from the IRA directly. If an IRA Holder pays an administrative fee with non-IRA assets, they may be eligible for a deduction for the fee on their income tax return. However, if they take a distribution from the IRA to reimburse themselves for paying the fee out-of-pocket, the withdrawal will be treated like a distribution from the IRA for all tax purposes (i.e., penalties and taxes may apply).
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If the fee is paid from IRA assets, there will be no taxes on the amount paid as a fee. An IRA Holder may not reimburse the account for any fees paid directly by the IRA and any attempt to do so will be treated as a reportable contribution to the IRA subject to statutory, annual limits.
Sales Fees and Commissions
Fees associated with the purchase or sale of an investment are not considered administrative fees and must be paid directly from an IRA and may neither be deducted on an IRA Holder’s income tax return, nor reimbursed to the IRA. They are part of the purchase cost or sales proceeds.
Combination Fees
Sometimes administrative and sales fees are bundled together. Such combined fees are sometimes referred to as “wrap fees”. Although the IRS has reviewed these fees for Qualified Retirement Plans, they have not provided any guidance for IRAs. For Qualified Retirement Plans, the IRS has indicated that if the component of a combined fee that is associated with administrative services can be identified, that portion may be treated as an administrative fee for the purpose of determining payment options. In cases of uncertainty as to whether to treat a fee as an administrative or a sales fee, a Private Letter Ruling may be requested from the IRS.
Fees are never a reportable transaction.
Unrelated Business Taxable Income (UBTI)
The purpose of an IRA is to generate income for retirement, and when that is the primary purpose of the invest-ment it is generally not subject to income taxation while it is held in the IRA. However, when an IRA invests in certain businesses, the net income generated by the normal operation of the business not considered to have the primary purpose of generated income for retirement (even though it does generate income for retirement). Such income is considered unrelated business taxable income (UBTI) rather than investment income for reporting and taxation purposes. UBTI is subject to taxation at the trust income tax rate. An IRA, when holding such assets, must pay income tax on UBTI.
A related taxation and reporting issue concerns debt-financed real estate within an IRA. This usually becomes an issue in cases where the income from cash flows on an office building or an apartment building is used to get a nonrecourse loan from a commercial lender to purchase property for an IRA. Because some of the financing for this investment is coming from outside the IRA, a portion of the profits on such an investment will be taxable as income, sometimes referred to as debt financed income (DFI).
When an IRA holds investments that are subject to UBTI or DFI, the IRA Custodian/Trustee is responsible for filing a Form 990-T for the investments to report the UBTI. They can pass that into the IRA Holder, however the IRA Custodian/Trustee remains responsible for it.
ment that applies to all IRAs. This is not a problem when the assets held in an IRA are commodities that are trad-ed on an open market and the value of the asset is readily available. When a self-directtrad-ed IRA includes assets such as limited liability companies or partnerships, businesses, real estate, special expertise is required to prop-erly value these assets and a good faith effort should be made to find someone with valuation expertise to value them because proper valuation plays an important role in the taxation of distributions of assets that are taken in kind, as well as in calculating RMDs, since the prior year-end value of an IRA is used in calculating how much must be taken by an IRA Holder each year.
Although it is the financial organization’s responsibility to properly report FMV, it is not mandatory that they absorb the cost of hiring individuals to make such special valuations, and it is highly recommended that finan-cial organizations that allow difficult to value assets stipulate to IRA Holders that any such costs associated with these required valuations be paid from IRA assets. They can NOT be paid with funds from outside the IRA.
Please note additional earlier comments concerning the 2014 Forms 1099-R and 5498.
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Do you need an Internal IRA Audit?
There are many reasons why a financial organization should consider doing an internal IRA audit including:
• Changes in personnel
• Mergers and acquisitions
• General quality assurance checking
Generally, you can safely assume that if you’ve never performed an internal IRA audit, or it’s been a long time since you performed one, you will benefit from one.
What should you expect from an Internal IRA Audit?
If you are like most financial organizations, you will probably find a number of issues, including:
• Reporting errors
• Incorrect completion of forms
• Missing amendments
• Misapplication of IRA rules
• Missing documentation
However, it is far better to find these problems as early as possible, because many of them are correctable, and the sooner you correct them and educate personnel regarding the common problems that are found, the fewer problems there will be in future audits.
Are you ready for an internal audit?
The three forms contained in this chapter are provided to help you check whether your IRA operations are in compliance.
• The “Compliance Checklist” documents the forms you currently use, as well as investments, and com-pliance procedures.
• The “Master File Audit” documents compliance with major IRA requirements such as CIP, reporting, and document amendments.
• The “Individual File Audit” documents findings in individual customer files, particularly with regard to opening documents and transactions. In preparation for an official audit, it is highly recommended that an internal audit randomly spot check at least 10 percent of each type IRA held by the organiza-tion. Check the larger IRAs and the owners with the most recent transactions. Check all Financial Institution Owners, Officers, Directors and Employees.
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NOTE: This should be done whether your files are hard copy or electronic.
Record Retention
The IRS requires that records be retained as long as the IRS has a legal right to request them which is technical-ly forever. Any decision to destroy tax documentation should be made in consultation with your organization’s tax and legal departments. Recent guidance from the IRS indicates that electronic information returns such as Form 1099-R and Form 5498 should be kept for at least five years either in a paper format or in an electronic format that can be used to reproduce what was sent to the IRS. However, your organization’s tax department should consult the IRS District Director in your location regarding any questions related to the retention of tax-related returns (both paper and electronic) and a written record retention policy should be maintained. Please note that the length of time a specific tax document should be maintained will vary, and some records should be main-tained indefinitely, such as records of plan amendments, and any documents relating to a potential criminal inves-tigation.
As pointed out earlier in this manual, the IRS has given no direct specifications for IRA Custodians/Trustees.
Consequently it is imperative that IRA Custodians/Trustees rely on their own legal, tax and compliance counsel.
Preparation for an Outside Audit
Generally, an outside auditor will tell you the records to which they need to have access at least a week before arriving on location. Since independent auditors generally have a limited time on location, it is important to have these records available or readily accessible when they arrive. Therefore, it is useful to have all Form 1099-Rs and Form 5498s submitted during the last two years. These should be printed and ready for the auditor’s review when they arrive. Taking care to have the materials they request ready will help to maximize the time the audi-tor can spend finding potential compliance problems and will help your organization get the most value out of its audit.
Please note, also, that audits may be customized to your financial organization’s particular needs, but the more areas you would like reviewed, the more time it will take to perform an in-depth audit. The following forms show the key compliance areas that an auditor may review. Depending on what sort of an audit you request, the audi-tor should evaluate all of the areas you’ve requested they look at and provide a report explaining what the com-pliance requirements are for those areas of concern, any comcom-pliance concerns that were found in your files or your procedures, and possible means for correcting those issues.
Note: Information on the audit services performed by JM Consultants is available upon request.
way possible.
• Unbiased so they are less likely to overlook “small” errors
• Most familiar with current rules, regulations and procedures
• Best able to offer ways to correct errors
• Best able to offer ways to correct procedures
• Able to perform the audit with as little disruption of your personnel as possible
• Discreet and Confidential .
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Transaction Type (Contribution) Internal System Code Traditional current year