Because of an agreement they signed with their brokers, some IRA owners may unknowingly be vulnerable to having their whole account taxed. A recent IRS announcement provides a temporary reprieve for investors who've signed a cross- collateralization agreement that extends credit between their personal assets and their IRA assets. Whether this relief will be permanent, however, is uncertain, and advisors should pay close attention to IRA agreements.
In order to enjoy the tax-deferred growth offered by an IRA, owners must avoid engaging in what are known as prohibited transactions. There are a number of prohibited transactions, but they all carry the same tax consequences: The entire IRA in which the prohibited transaction occurred is deemed to have been distributed on Jan. 1 of the year in which the prohibited transaction first took place. That means the loss of all future tax deferral, immediate taxation of the whole account and, if the owner was younger than 59 1/2 at the time, assessment of the 10% penalty for early distributions.
EXTENSION OF CREDIT
One prohibited transaction that has raised concern regards the lending of money or any other extension of credit between a plan and a disqualified person. An IRA cannot extend or receive credit (borrowing or lending money) from any disqualified person, which includes the IRA owner himself or herself.
An extension of credit goes beyond one party lending money to another party. An extension of credit is considered to be made when IRA owners personally guarantee a debt of their IRA, or when they use their IRA assets to guarantee their personal debt.
In recent years, the Department of Labor, which is responsible for defining prohibited transactions, has been asked to rule on related issues. The bottom line is that guaranteeing a debt of an IRA with non-IRA assets is a prohibited transaction. It's the same as loaning money to your IRA.
In October 2009, Timothy Berry, an Arizona tax lawyer, requested a Labor Department advisory opinion letter to determine if his client's IRA agreement violated the prohibited transactions rules. The IRA agreement stated that the broker would have a security interest in all of an individual's accounts at the institution, including non-IRA accounts. These accounts could each be used to cover any debts generated by any of the accounts. In effect, that meant that the broker could use the client's IRA account to cover debts generated in a non-IRA account.
In the agency's opinion, issued in Advisory Opinion Letter 2009-03A, this arrangement was tantamount to personally guaranteeing a loan - an extension of credit - and, as such, execution of the agreement would be a prohibited action. In addition, the opinion stated that using an IRA account to guarantee assets in a personal non-IRA account would also be a prohibited transaction.
Almost two years to the day after receiving his first advisory opinion letter, Berry received a second, Advisory Opinion Letter 2011-09A. This time, he wanted a ruling on an account intended to trade futures. Based on the nature of the investment, it was possible to incur losses above the account value.
Although there was no question this would be a clear extension of credit from the IRA owner to his IRA, Berry hoped he had an ace up his sleeve. Prohibited Transaction Exemption 80-26 created a class exemption allowing certain parties to make certain loans to a retirement plan in limited circumstances. The allowed loans were restricted to those loans that were made "for the payment of ordinary operating expenses of the plan [or] for a purpose incidental to the ordinary operation of the plan."
The Labor Department first addressed whether an IRA owner's personal guarantee to cover losses incurred in an IRA account could be considered an ordinary operating expense of the plan. Although the agency acknowledged that the rules do not specifically define operating expenses, it indicated that the preamble to the original notice included examples of operating expenses, such as "plan benefits, insurance premiums and/or administrative expenses." These expenses were not consistent with guaranteeing an investment loss and could not be treated as an ordinary expense eligible for relief under this exemption.
Next, the agency examined whether an IRA owner's personal guarantee to cover IRA losses could be considered an expense incidental to the ordinary operation of the plan. Here again, the Labor Department acknowledged that there was no formal definition of expenses "incidental to the operation of the plan," but that examples of such expenses could be found in subsequent amendments.
IMPACT OF ADVISORY OPINION
As before, the agency found these types of expenses inconsistent with an IRA owner's personal guarantee to cover IRA debts, an expense related to an investment loss, and indicated that such agreement would not qualify as an expense incidental to ordinary plan operation. As a result of this new advisory opinion, clients executing the type of agreement outlined by Berry would have a prohibited transaction, resulting in the immediate distribution of the entire IRA or Roth IRA.
Advisory Opinion Letter 2011-09A generated concern about the possibility that many individuals may have engaged in prohibited transactions simply by executing their account agreements. In response, the IRS issued Announcement 2011-81, temporarily providing relief to certain taxpayers who engaged in the prohibited transaction of extending credit between personal assets and IRA assets via a cross-collateralization agreement. The announcement says that even though a prohibited transaction technically would have occurred at the time such a contract was signed, the IRS will treat it as a prohibited transaction only if non-IRA money was used to satisfy outstanding debts of the IRA and/or vice versa. The announcement also noted that the Labor Department was considering making exempt such cross-collateralization agreements from being prohibited transactions.
The Labor Department is expecting a request for a class-action exemption, which, if granted, would allow IRA owners to enter into these types of agreements permanently. Although the IRS has some leeway to adjust how it treats a prohibited transaction, only the Department of Labor can issue an exemption. Doing so could allow brokers to tap a client's non-IRA funds for losses in an IRA that exceed the value of the assets. Until an exemption is granted, though, any personal non-IRA assets used to cover losses in an IRA, or vice versa, will be a prohibited transaction, for which there is currently no relief.
It would be wise for advisors to contact certain clients with IRA accounts and explain what prohibited transactions are and the tax implications that generally occur when such transactions take place. It's also recommended to review clients' custodial/account agreements to see if they have any cross- collateralization provisions.
If you find any, it may be smart to advise transferring assets to a new IRA until the Labor Department decides whether to permanently exempt such agreements. If cross-collateralization takes place, clients will have conducted a prohibited transaction. FP
Ed Slott, a CPA in Rockville Centre, N.Y., is an IRA distribution expert, and an author of a monthly newsletter on IRAs and several books. Post questions and comments on the Ask Ed Slott blog at financial-planning.com.