Could Mitt Romney’s IRA be disqualified?: An adventure into the muddy waters of the prohibited transaction rules.May 15, 2012
Copyright © 2012 by Warren L. Baker – Amicus Law Group, PC
While much of the scrutiny over Mitt Romney’s IRA has been centered on whether the IRA invested offshore in order to avoid current IRA tax consequences, very little focus has been on whether Mr. Romney’s IRA could be legally unsound at its core. Does Mr. Romney benefit, directly or indirectly, on a personal level from the investments made by his IRA? Was Mr. Romney’s IRA allowed to purchase assets on a preferred basis, which could constitute an invalid constructive contribution to his IRA? Admittedly, whether Mr. Romney’s IRA has committed a prohibited transaction will forever be between him, his advisors, and the federal government. However, I can tell you from experience that the prohibited transaction issues described in this article can cause significant problems regardless of whether you are an investor with $40,000 in your self-directed IRA or you are Mitt Romney and have multiple millions.
For my readers that might be wondering “why are you writing about Mitt Romney’s IRA”, let me provide some background. As the Republican Presidential nomination race heated up in January of 2012, Mr. Romney began receiving some criticism that he was not “relatable”, due in part to his vast wealth, which he accumulated as a result of his success at the private equity firm he helped co-found, Bain Capital. The heat was turned up even further by two events: (1) Mr. Romney stated on the campaign trail that his overall tax rate is “around 15-percent”; and (2) fellow Republican Presidential nominee candidate Newt Gingrich released his personal tax return showing that he pays around 35-percent. The end result of these politically-charged events is that Mr. Romney was pressured to disclose more detailed personal financial information, in the form of his 2010 federal tax return and estimated figures for 2011.
One piece of information that caught the attention of many news agencies and legal commentators was Mr. Romney’s very large IRA, reported to be worth anywhere between $20 million and $100 million. The media jumped on the idea that Mr. Romney’s IRA could not possibly be this large, based on the inherent contribution limits imposed on IRA accounts. However, several explanations exist that could help to justify the value of Mr. Romney’s IRA, including: (1) large annual contributions were made to a different type of retirement plan (e.g. a defined benefit plan and/or a 401(k) plan – which, depending on the plan, allow tens-to-hundreds of thousands of dollars of contributions per year) and later “rolled over” or transferred to the IRA; and (2) very successful investing on a tax-deferred basis within the IRA.
For purposes of illustration, assume Mr. Romney was able to accumulate $2 million in retirement savings by the time he was 44 years of age (which, given his almost instant success in the business world, is not out of the question). If we then assume that this $2 million was very successfully invested into mostly risky, yet lucrative private equity investments, which resulted in an average 20-percent annual return over the next 20 years, Mr. Romney’s IRA would be worth over $75 million today.
All of this is fine and good as long as Mr. Romney’s IRA investments were always handled in a legal manner. In my role as a tax attorney and advisor to hundreds of self-directed IRA investors, I always alert my clients to two major legal/tax problems that can arise within “self-directed IRAs” (side note: Because Mr. Romney’s IRA was likely invested into “non-traditional” types of investments, e.g. private equity funds that are not available on the public securities market, I would generically categorize Mr. Romney’s IRA as a self-directed IRA). First, the income resulting from the IRA’s investments can result in current tax consequences to the IRA itself. This generally occurs when the IRA either: (1) receives income from a trade or business “regularly carried on” by the IRA (or by a flow-through tax entity in which the IRA holds equity), which is not otherwise exempt from current tax under the unrelated business taxable income (UBTI) rules;1 or (2) receives income that would normally be exempt from tax under the UBTI rules, but the income results from “debt-financed property”.
Several articles have been written recently regarding the appropriateness of Mr. Romney’s IRA investing into offshore Cayman Islands companies (sometimes called “blocker corporations”), which could then be used to invest into private equity funds run by Bain Capital – all without triggering UBTI tax consequences to Mr. Romney’s IRA (the reason why this works is that dividends from corporations are exempt from UBTI; as opposed to certain “flow-through” income from LLCs and partnerships). Although this issue is significant due to the fact that UBTI is taxed at trust rates (35-percent), I will assume, for purposes of this article, that Mr. Romney’s IRA legitimately avoided UBTI, and thus, has always grown entirely tax-deferred.
The second major legal/tax problem that self-directed IRA investors must be aware of is avoiding the complete invalidation of the IRA’s tax-exempt status. The Internal Revenue Code (“IRC”) and the Employee Retirement Income Security Act (“ERISA”) both describe certain transactions that are not allowed within a retirement account.2 These so-called prohibited transactions include various types of financial interactions between a “disqualified person”3 and “a plan” (which includes an IRA), including:
(1) a sale or exchange, or leasing, of any property between a plan and a disqualified person;
(2) lending of money or other extension of credit between a plan and a disqualified person;
(3) furnishing of goods, services or facilities between a plan and a disqualified person;
(4) transfer to, or use by or for the benefit of a disqualified person, of any assets or income of a plan;
(5) a fiduciary dealing with the assets or income of a plan in the fiduciary’s own interest or for the fiduciary’s own account (i.e., self-dealing); or
(6) the receipt of consideration by a fiduciary for the fiduciary’s own account from any party dealing with a plan in connection with a transaction involving the assets or income of the plan (i.e., a kickback).
A “disqualified person” includes the IRA account owner4, his or her spouse, and certain other family members, business entities, and business partners.
Prohibited transactions occurring as a result of items (1) through (4) above are normally fairly easy to detect because they involved direct interactions between the IRA and a disqualified person (or entity). For example, if Mr. Romney’s IRA purchased a vacation home from (or was used by) Mr. Romney’s children, a prohibited transaction would definitely occur. For purposes of this article, I will assume that Mr. Romney’s IRA has not committed this type of blatant prohibited transaction. However, that assumption does not close the door on potential prohibited transaction problems.
One of the key characteristics of a self-directed IRA is that the IRA owner has discretionary authority over the IRA’s investments. This is important because it results in the IRA owner being characterized as a “fiduciary”, and thus, brings into play what is commonly referred to as “fiduciary prohibited transactions” (see items (5) and (6) above). Both the Department of Labor (DOL) and the Internal Revenue Services (IRS) have ruled that the fiduciary prohibited transaction rules are applicable regardless of whether there is a disqualified person on the other side of the transaction.5 For example, the DOL has reviewed scenarios in which the investments made by the IRA affected the IRA owner’s exercise of his “best judgment” as a fiduciary (despite the fact that no disqualified person was involved), and ruled that a prohibited transaction could occur as a result of a conflict of interest.6 In addition, Tax courts,7 the DOL,8 and the IRS9 have all stated that if a fiduciary or another disqualified person (e.g. the IRA owner) benefits, directly or indirectly, as a result of the use of tax-deferred retirement assets, a prohibited transaction could occur, regardless of whether the retirement plan directly interacted with a disqualified person.
In summary, a self-directed IRA owner cannot execute investments that result in a conflict between his/her loyalty to the IRA and his/her loyalty to another person (whether a disqualified person or not). Also, a disqualified person cannot receive a direct or indirect personal benefit from the IRA’s investments. This is where I believe Mr. Romney’s IRA could have a legal problem. According the Wall Street Journal10, Mr. Romney’s IRA is currently invested into numerous investment entities run by Bain Capital. Presumably, the IRA is a limited partner in these venture funds or is invested as a limited partner via an offshore corporation. Bain Capital, on the other hand, serves as a general partner, which likely results in management fees (currently) and “carried interest” payments (down the road).
In general, carried interest is earned by investment managers who actively work at a firm. Mr. Romney left Bain Capital in 1999, but as part of his departure agreement retained profit sharing rights as a retired partner. In fact, Mr. Romney has earned $13 million of carried interest income over the past two years alone. There lies the ultimate problem. If the on-going investments being made by Mr. Romney’s IRA are resulting in a direct or indirect benefit to him personally, a prohibited transaction argument exists. It is likely that Mr. Romney would argue that he is not a fiduciary because his investments are controlled by a “blind trust” or third-party fiduciary. However, if he is not in control of his IRA’s investments (either directly or indirectly), why is his IRA still invested into so many funds run by Bain Capital? Would an independent fiduciary continue investing into these funds? If Mr. Romney is not controlling the IRA, but is simply directing the IRA trustee, he still has a fiduciary prohibited transaction problem.11
Although the federal legal framework governing IRAs is in desperate need of clarification, I believe that both of the following scenarios, if they exist in Mr. Romney’s situation, either directly violate the IRA legal principles or, at the very least, are in conflict with the intent of the IRA rules:
(1) The IRA’s investment results in direct or indirect personal compensation or benefit to a disqualified person. Allowing a disqualified person to currently benefit from the IRA’s investments conflicts with the idea that tax-deffered funds are not truly “owned” by the IRA account holder until they are withdrawn during “retirement years” and taxes are paid.
(2) The IRA is granted a special investment right that would not be available without a disqualified person’s interest in the underlying entity and/or investment structure. For example, if the IRA is allowed to purchase an asset at an artificially decreased price and/or earns income at a preferred rate based on the fact that a disqualified person in involved, at a minimum, an “excess IRA contribution” could result.12
If Mr. Romney’s IRA did indeed commit a prohibited transaction (perhaps many years ago), the IRA’s tax-exempt status could be revoked and the entire value of the IRA could be deemed to be distributed to Mr. Romney, effective January 1st of the year in which the prohibited transaction occurred.13 The result of this rather harsh rule can lead to absolutely disastrous tax consequences! For purposes of illustration, assume the combined value of Mr. Romney’s retirement accounts was $20 million in 1999 (when he left Bain Capital) and his IRA is worth $75 million today. Assume further that Mr. Romney rolled all of his retirement plans into one IRA in 1999, an event that is not uncommon when someone changes careers. Finally, assume that Mr. Romney’s IRA committed a prohibited transaction in early 2000, which would automatically revoke the IRA’s tax-exempt status as of January 1, 2000. In simplified terms, the tax result would be:
(1) $20 million of additional income to Mr. Romney in 2000 – i.e. a constructive distribution of the entire IRA. Because this income is coming from an IRA, the income would be taxed at ordinary income rates (top rate was 39.6% in 2000). Tax due: $9.9 million.
(2) In 2000, Mr. Romney was 52 years old, which means that the constructive distribution of $20 million would also be subject to the 10-percent early distribution penalty. Penalty amount: $2 million.
(3) Because the prohibited transaction was not acknowledged at the time, this $9.9 million would be subject to interest and underpayment penalties from 2000 until 2012. Although the IRS will occasionally agree to reduce penalties (assuming no fraudulent transaction is found), interest cannot be waived. Additional amount due: $8.1 million (assuming interest at a 5-percent average rate and no penalties are applied).
(4) Because the IRA would have lost its tax-exempt status in 2000, all earnings within the IRA after that time would be treated as being earned by Mr. Romney individually. Assuming the assets grew another $55 million since 2000 and Mr. Romney would be taxed on these earnings at 35% (assuming this income would be ordinary in nature), the additional tax due by Mr. Romney would be $19.25 million.
(5) Finally, because the earnings in #4 were not recognized by Mr. Romney, penalties and interest could apply to this tax liability as well, resulting in an additional amount due of $15.75 million (again, assuming interest at a 5-percent average rate and no penalties).
(6) Total owed to IRS: $55 million (i.e., 73% of IRA’s value would be lost; if penalties were imposed under #3 or #5 above, almost the entire IRA could be wiped out!)
As you can see from the discussion above, the rules that govern self-directed IRAs are not always crystal clear. However, the consequences of ignoring these legal and tax principles can be extremely detrimental to any IRA investor, including, but certainly not limited to, Mitt Romney.
1 Internal Revenue Code (“IRC”) Section 408(e)(1). The UBTI provisions are found at § § 511 through 514. Conforming amendments were not made to § § 511(a)(2)(A) and 501(a) to include IRAs when the IRA Code provisions were enacted, but IRC § 408(e)(1) clearly indicates the UBTI provisions apply to IRAs.
2 IRC § 4975(c)(1); ERISA § 406(a).
3 IRC § 4975(e)(2).
4 The language is not as clear as it should be, but the intent to include such persons is seen at IRC § 408(e)(2), describing IRA owners as the “creators” of the accounts. The House approach during the drafting of ERISA would have applied the Code’s prohibited transactions rules of IRC § 503 (applicable to “creators” of certain types of entities subject to those prohibited transaction rules). See H.R. Rep. No. 1280, 93d Cong., 2d Sess. 340 (1974). The definitions found in IRC § 4975(e)(2) were adopted instead, but the IRA provisions never were cleaned up before being enacted.
5 See also IRS Employee Plans Technical Guidance, Prohibited Transactions, IRM 220.127.116.11.5 (June 14, 2002).
6 See DOL Op. Ltr. 93-33A (IRA investment benefited IRA owner’s brother and sister).
7 See Rollins v. Commissioner, T.C. Memo 2004-260 (401(k) made loans to companies that were not automatically disqualified, but minority shares were owned by the disqualified parties. Tax Court held that a § 4975(c)(1)(D) prohibition did not require an actual transfer of money or property between the plan and the disqualified person. The fact that a disqualified person could have benefited as a result of the use of plan assets was sufficient).
8 While there is nothing per se wrong with the IRA owner and the IRA investing in the same investment, several DOL advisory opinion letters illustrate that not all investments may be proper. See DOL Adv. Op. 2000-10A (Although fiduciary prohibited transactions are very fact-specific, DOL listed examples in which certain actions, if they occurred, could trigger such a prohibited transaction, including: (1) A prohibited transaction would occur if an IRA transaction is part of an agreement, arrangement or understanding in which the fiduciary caused the IRA assets to be “used in a manner designed to benefit” the fiduciary (or any person in which the fiduciary had an interest); and (2) Employment of the fiduciary by the partnership, or payment of unreasonably large compensation, or compensation based on the IRA’s return on investment might trigger a prohibited transaction.
9 See IRS Employee Plans Technical Guidance, Prohibited Transactions, IRM 18.104.22.168.6 (June 14, 2002) (“If a fiduciary receives any consideration for his own personal account from any party dealing with the plan in connection with a transaction involving the income or assets of the plan, it is a prohibited transaction.”) (emphasis added).
10 Wall Street Journal online, “Mr. Romney’s Unorthodox IRA” (January 19, 2012) http://online.wsj.com/article/SB10001424052970204468004577168972507188592.html.
11 See Treas. Reg. § 54.4975-6(a)(5)(i) (The fiduciary prohibition transaction rules do not permit IRA owners to direct the IRA trustee to enter into any transaction in which the owner has an interest that may affect the “exercise of his judgment as a fiduciary”; the typical conflict of interest situation).
12 See Regs. §1.219-1(a); Prop. Regs. §1.219(a)-2(a) (contributions above the IRA limits or of “noncash” are considered an excess contributions). See also § 408(a)(1) (an IRA’s governing instrument must prohibit noncash contributions other than rollovers) and § 4973(a) (an excise tax of 6% of the value of the IRA per year can apply).
13 See IRC § 408(e)(2); Treas. Reg. § 1.408-1(c)(2)(i).