Author: Adam Bergman

Navigating the Plan Asset Rules for a Self-Directed IRA Investment

For Self-Directed IRA investors seeking to make alternative asset investments, there are a set of rules known as the “Plan Asset Rules” that must be considered before investing into an investment fund or operating business.  Most Self-Directed IRA investors are solely focused on the IRS prohibited transaction under Internal Revenue Code (IRC) Section 4975 but are unaware that triggering the Plan Asset Rules can correspondingly trigger the IRS prohibited transaction rules in a transaction that may otherwise not be prohibited.

Because an IRA investor is already conscience of the prohibited transaction rules, they are not as imperative as say one with a pension plan. For those investors, triggering the Plan Asset Rules can require the investment fund manager to navigate various ERISA fiduciary requirements, as well as potentially triggering the IRS prohibited transaction rules.

This article will explain how the Plan Asset Rules work, along with exceptions to the rules.  It will also detail the potential impact for a Self-Directed IRA or pension plan that triggers the IRS prohibited transaction rules.  In addition, we will offer some examples that displays how the Plan Asset Rules could impact your investment.

The Impact of Triggering the IRS Prohibited Transaction Rules

Before we dive into the Plan Asset Rules, it is important for a Self-Directed IRA investor to understand how the IRS prohibited transaction rules work. This is because triggering the Plan Asset Rules could activate them as part of the "look-through" rules.

When it comes to making investments with a Self-Directed IRA, the IRS generally does not tell you what you can invest in, only what you cannot invest in.  The types of investments that are not permitted to be made using retirement funds is outlined in IRC Section 408 and 4975.  These rules are generally known as the “Prohibited Transaction” rules.  Other than life insurance, collectibles, and transactions that involve a “disqualified person,” one can use his or her IRA to make just about any investment they choose.  A “disqualified person” is generally defined as the IRA holder and any of his or her lineal ascendants and descendants and any entities controlled by such persons.

Triggering the IRS prohibited transaction rules under IRC 4975 have serious tax implications. IRC Section 4975(a) imposes a 15% excise tax (the first-tier excise tax) on a prohibited transaction. In addition, IRC Section 4975(b) imposes a 100% excise tax (the second-tier excise tax) on a prohibited transaction if that prohibited transaction is not corrected during the taxable period. The tax applies to any disqualified person who participates in the prohibited transaction (other than a fiduciary acting only as such); the applicable excise tax is applied to the amount involved in the prohibited transaction.

The Plan Asset Rules

The Department of Labor’s (DOL) plan asset regulations are designed to cause the assets of a certain investment fund or entity owned by an IRA or pension plan to be treated as owned directly by the IRA or pension plan for purposes of DOL fiduciary rules as well as the IRS prohibited transaction rules.  In other words, the Plan Asset Rules could turn a transaction that is not, on its face, subject to the IRS prohibited transaction rules and make it subject to them.  This is the main reason that many investment funds and private placements investments will disclose in their documentation that they will seek to satisfy the exceptions to the Plan Asset Rules, which are discussed below.

Intent of the Plan Asset Rules

The Plan Asset Rules are important to understand if you are a Self-Directed IRA investor because if relevant, they would trigger a “look through,” which, would treat not only the interests in an investment fund owned by IRA or the pension plan as a plan asset, but also the assets of the investment fund as a plan assets. Whereas, if the Plan Asset Rules look-through applies, the ERISA fiduciary and/or IRS prohibited transaction rules would apply to the IRA investor even though the direct investment into the fund or entity was not in itself a prohibited transaction. 

What is a Plan Asset?

Under the Plan Asset Regulations, when an IRA or a pension plan acquires an equity interest in an entity that is neither publicly traded nor a security issued by an investment company registered under the Investment Company Act of 1940 (e.g., a mutual fund), the assets of the IRA or ERISA plan investor include its acquired equity interest as well as an undivided interest in all of the underlying assets of the entity unless an exemption applies. These rules are widely called the “look-through plan asset rules.”  Thankfully, the Plan Asset Rules provide a number of exemptions from look-through plan asset treatment to certain types of entities, including certain investment funds and operating companies.

Exceptions to the Plan Asset Rules

There are a number exceptions that apply so that an IRA or pension plan investment into a company or investment fund would not trigger the Plan Asset Rules. No IRA or pension plan wants to trigger them! Under the Plan Asset Rules, if an IRA or pension plan invests in an entity, the plan’s assets include its investment, but do not necessarily include any of the underlying assets of the entity. However, in the case of a plan’s investment in an “equity interest” of an entity that is neither a “publicly-offered security” nor a mutual fund, its assets include both the equity interest and an undivided interest in each of the underlying assets of the entity (the Look-Through Rule), unless it is established that:

1. Equity participation in the entity by IRA or pension plan is less than 25%, or
2.  The entity is an “operating company.”

Operating Company

IRA and pension plans are generally able to invest in operating companies (i.e., companies selling widgets) without any regulatory impact on the portfolio companies in which they invest. Prior to the Plan Asset Rules in 1986, it was unclear whether a venture capital fund or private equity fund fell within the definition of an operating company and whether the fund’s assets would be considered plan assets subject to ERISA or the IRS prohibited transaction rules.

In addition, an entity’s assets will not be considered “plan assets” (i.e., the Look-Through Rule will not apply) if plan investors are investing in a “publicly offered security." The term “operating company” also includes an entity that is a “venture capital operating company” (VCOC) or a “real estate operating company” (REOC).

Venture Capital Operating Company (“VCOC”)

An entity will be deemed a VCOC and, thus, not be subject to the application of the Plan Asset Rules if:

• On such initial valuation date, or at any time within such annual valuation period, at least 50 percent of its assets (other than short-term investments pending long-term commitment or distribution to investors), valued at cost, are invested in “venture capital investments” or “derivative investments” (the “50% Test”); and
• During such 12-month period (or during the period beginning on the initial valuation date and ending on the last day of the first annual valuation period), the entity, in the ordinary course of its business, exercises management rights with respect to one or more of the operating companies in which it invests (the “Actual Exercise Test”).

For purposes of the VCOC exception, the “initial valuation date” is the first date on which an entity makes an investment that is not a short-term investment of funds pending long-term commitment.  An entity must qualify as a VCOC on its initial valuation date, or it can never qualify as a VCOC. Accordingly, the 50% Test must be satisfied on the initial valuation date. An “annual valuation period” is an annually recurring period of not more than 90 days that begins no later than the anniversary of an entity’s initial valuation date.

Real Estate Operating Company (“REOC”)

An entity will be deemed an REOC and, thus, not subject to the application of the Plan Asset Rules if:

• On such initial valuation date, or on any date within such annual valuation period, at least 50 percent of its assets, valued at cost (other than short-term investments pending long-term commitment or distribution to investors), are invested in real estate that is managed or developed and with respect to which such entity has the right to substantially participate directly in the management or development activities (“REOC 50% Test”); and
•  During such 12-month period (or during the period beginning on the initial valuation date and ending on the last day of the first annual valuation period) such entity in the ordinary course of its business is engaged directly in real estate management or development activities (the “REOC Actual Exercise Test”).

The Plan Asset Regulations provide a few examples to better illustrate how the REOC rules would apply. For example, where a plan invests in a limited partnership that is engaged primarily in investing and reinvesting assets in equity positions in real property, such limited partnership would not qualify as a REOC if the properties acquired by the limited partnership are subject to long-term leases under which substantially all management and maintenance activities for the property are the responsibility of the lessee. Though, the limited partnership would qualify as a REOC (assuming it otherwise satisfies the 50% Test) if it owned several shopping centers in which individual stores are leased for relatively short periods to various merchants.

In sum, an IRA and a pension plan can invest in an operating company without triggering the Plan Asset Rules. In addition, if an IRA or pension plans can satisfy the VCOC or REOC rules, then the investment would not be deemed subject to the Plan Asset Rules.  Note – the investment can still be subject to the IRS prohibited transaction rules.

Less than 25% Ownership

The “Plan Asset Rules” would not apply to plan investments in an entity or fund if equity participation by the IRA or pension plan investor is not “significant.” Equity participation by an IRA or pension plan is “significant” on any date if, immediately after the most recent acquisition of any equity interest in the entity, 25 percent or more of the value (in the aggregate) of any class of equity interests in the entity is held by “benefit plan investors.”  The definition of “Benefit Plan Investors” includes IRAs, 401(k) plans, and pension plans. This is known as the 25% test.  The 25% limit must be satisfied separately with respect to each class of equity issued by an entity or fund. The 25% Test must be satisfied on an ongoing basis. For example, the 25% Test could be failed in connection with a subsequent investment, transfer or redemption

What is at Stake for a Self-Directed IRA Investor?

If a Self-Directed IRA investment is deemed to trigger the Plan Asset Rules because the investment will not satisfy an exception to the “look-through” rules, all the fund’s activities would be subject to the prohibited transaction rules of IRC 4975. Among other things, transactions
with affiliates would be restricted.

However, it is important to remember that triggering the look-through rules and, thus, the IRS prohibited transaction rules on a particular investment does not mean the investment will be deemed prohibited. Triggering the Plan Asset Rules simply means that the IRS prohibited transaction rules could apply to the investment at hand.

For Self-Directed IRA investors, the IRS prohibited transaction rules are always under consideration so triggering the Plan Asset Rules is not a major deal for most IRA investors.  However, for investment funds and investment managers, triggering the Plan Asset Rules has greater significance.

For example, if a pension plan invests in an entity whose assets are considered plan assets, the manager of the entity would be deemed a plan fiduciary to the extent it exercises any authority or control respecting management or sale of the entity’s assets or provides investment advice for a fee. Any manager that is considered a plan fiduciary would need to comply with ERISA’s prohibited transaction provisions.

In addition, for a fund manager that triggers the Plan Asset Rules, becoming subject to the ERISA fiduciary rules is extremely problematic. Plan fiduciaries are required to act “with the care, skill, prudence, and diligence under the situations then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character.” These duties must be discharged solely in the interest of the participants and beneficiaries of the plan.

Examples

Below are a number of examples that illustrate the broad application the Plan Asset Rules can have on Self-Directed IRA investors:

1. Joe wants to use his Self-Directed IRA to invest 27% private equity fund in which he is a partner in the general partnership entity of the fund that receives management fees and the carried interest.  Because Joe’s IRA will own 25% or more of the fund, the Plan Asset look-through rules will apply and can trigger the IRS prohibited transaction rules.
2. Amy will be using her IRA to invest in a real estate fund that primarily invests in passive real estate investments.  However, the fund will also be making several real estate investments in assets where Amy will be paid to manage the real estate properties.  The fund will not satisfy the REOC rules since less than 50% of its assets are invested in active real estate activities.  Hence, Amy’s receipt of compensation for her management services could trigger the Plan Asset look-through rules and thereby initiate the application of the IRS prohibited transaction rules.
3. Gary is the manager of an investment fund that will be owned 30% by pension plans.  The investment fund will be investing in exotic options and cryptos. Since the fund will be owned greater than 25% by pension plans and it will not satisfy any of the operating company exceptions, the pension plans and Gary will be subject to the Plan Asset Rules. In Gary’s case, he would be subject to ERISA fiduciary rules which could be problematic based on the nature of the fund’s investments.
4. Mara is seeking to use her Self-Directed IRA to invest in a passive venture capital fund that does not get involved in any management activities of its investments. Mara is an executive at one of the investment companies and receives a salary from the business.  Because the venture capital fund will not satisfy the VCOC definition, the investment could trigger the Plan Asset look-through rules and thereby initiate the application of the IRS prohibited transaction rules.

Conclusion

The Plan Asset Rules are generally a much greater headache for an investment fund manager working with IRA or pension plan clients and cannot satisfy the 25% or operating company exception to the Plan Asset Rules since triggering them would cause the manager to be subject to the ERISA fiduciary and prohibited transaction rules   In the case of an individual Self-Directed IRA investor, the individual would already be required to address the IRS prohibited transaction rules so triggering the Plan Asset Rules would not be overly onerous.  In sum, the Plan Asset Rules offer greater risks and complications to investment managers seeking pension plan investors due to the triggering of the ERISA fiduciary and prohibited transaction rules.

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by Adam Bergman