As of early 2016, the average retirement savings of all American families was $95,776 —not enough to go very far during those retirement years. Of course, self-directed account holders understand that they have the potential to grow that figure more aggressively through investments in alternative assets, such as real estate. However, given this U.S. figure, it’s tempting for account holders to consider using personal funds along with the funds in a self-directed retirement plan to make those nontraditional investments.
It sounds tempting, yes … but it could be a prohibited transaction that benefits the IRA owner rather than benefiting the retirement account. According to Internal Revenue Code Sections 408 & 4975, a disqualified person is generally defined as the IRA holder, any of his or her ascendants or descendants, and any entity controlled by such persons. Disqualified persons are prohibited from engaging in certain types of transactions.
In 2015, an Arkansas court decided on a bankruptcy case, which concerned the legality of partnering with one’s retirement funds to make alternative asset investments. The court held that forming a partnership between a self-directed IRA and an entity owned by the IRA holder (and spouse) was a prohibited transaction. The case involved the Kellermans, spouses who each owned a 50 percent share in Panther Mountain Land Development, LLC. In order to acquire and develop a four-acre property, the company partnered with Mr. Kellerman’s self-directed IRA: the IRA contributed property and Panther Mountain contributed property and cash. Since the couple owned Panther Mountain personally, it became a case of self-dealing … and triggered a prohibited transaction under IRC 4975(c)(1)(D).
By entering into a transaction with IRA funds that in some way directly or indirectly involves a disqualified person, the IRA owner must prove the transaction does not violate any prohibited transaction rules under IRC Section 4975, which can be difficult to satisfy, as the Kellermans found out. As the court stated, using assets of a self-directed IRA for the benefit of disqualified persons (in this case, their personally owned land development company) was a direct conflict of interest.
Of course, this was a very complicated case and every detail has not been hashed out within this article. It is also important to note that there are instances where an IRA account owner may partner with their own IRA or other disqualified parties IRAs and personal funds; however; there are many tests in order to determine if it is allowable and these partnerings must be structured and maintained in very specific ways.
At Next Generation Trust Services, our rigorous transaction review process is in place to help our clients become aware of when a transaction may be considered prohibited. Although combining self-directed retirement funds and personal funds on a transaction is not necessarily prohibited, it can be very risky and trigger the IRC Section 4975 prohibited transaction rules. If you are considering such a transaction, we advise that you consult an attorney that specializes in ERISA issues; and, as always, our helpful professionals are available to answer your questions about self-directed investments at Info@NextGenerationTrust.com or 1-888-857-8058.
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