Mitt Romney's IRA has come under considerable scrutiny this year, much of it centered on whether it was invested offshore in order to avoid tax consequences. But there has been little focus on whether the Republican presidential candidate's IRA could be unsound at its core. Does Romney benefit, directly or indirectly, from the investments made by his IRA? Was his account allowed to purchase assets on a preferred basis - which could constitute an invalid constructive contribution to his IRA?
Those are hypothetical questions and there is no publicly available evidence of wrongdoing. Of course, whether Romney's IRA committed a prohibited transaction could forever be a secret among him, his advisors and the federal government.
Retirement plan experts consulted for this story said prohibited transaction issues can cause significant problems, whether you are a planner advising a client with $100,000 in a self-directed IRA or a Romney with an IRA worth several million dollars. (The Romney campaign did not reply to several attempts by Financial Planning to reach a representative to discuss the candidate's IRA investments.)
Starting with the Republican primaries and now with general election drawing to a close, Romney has faced criticism about his wealth, widely estimated at about $250 million, and how he built it after co-founding Bain Capital. Earlier this year, Romney released his 2010 federal tax return as well as estimated figures for 2011.
A HUGE IRA
One piece of information that drew considerable attention was Romney's very large IRA, reported to be worth anywhere between $20 million and $100 million. Initially, there was skepticism that Romney's IRA could be that large, based on federal contribution limits (currently $5,000, or $6,000 for those older than 60). But several possible explanations exist, including: 1) Large annual contributions were made to a different type of retirement plan - for instance, a defined benefit plan or a 401(k) plan - that might allow tens or even hundreds of thousands of dollars of contributions per year and were later rolled over to the IRA; and 2) Very successful investing on a tax-deferred basis within the IRA.
Hypothetically, assume Romney was able to accumulate $2million in retirement savings by the time he was 44 years old (which, given his almost instant success in the business world, is not out of the question). If we then assume that this $2million was very successfully invested into lucrative private equity investments, which resulted in an average 20% annual return over the next 20 years, Romney's IRA would now be worth more than $75 million.
Because the account was probably invested in nontraditional types of investments, such as private equity funds not available in public securities markets, it would be categorized as a self-directed IRA. That is allowed, but can result in two major legal or tax problems.
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 receives income from a trade or business regularly carried on by the IRA that is not otherwise exempt from current tax under the unrelated business taxable income rules, or it receives income that would normally be exempt from tax under the rules on unrelated business taxable income, but the income results from debt-financed property.
Published reports have questioned the appropriateness of Romney's IRA investing in Cayman Islands companies, which could then be used to invest in private equity funds run by Bain Capital - all without triggering unrelated business taxable income consequences. Although this issue is significant because unrelated business taxable income is taxed at trust rates (35%), assume that Romney's IRA legitimately avoided this problem and has always grown tax-deferred.
The second major 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 and the Employee Retirement Income Security Act both describe certain transactions that are not allowed within a retirement account.
These prohibited transactions include various types of financial interactions between a disqualified person - which includes the IRA account owner, a spouse and certain other family members, business entities and partners - 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 (for example, self-dealing).
6) The receipt of consideration by a fiduciary for his or her own account from any party dealing with a plan in connection with a transaction involving the assets or income of the plan (such as a kickback).
Prohibited transactions occurring as a result of the first four items are normally fairly easy to detect because they involved direct interactions between the IRA and a disqualified person. Assume a client's IRA account has not committed this type of blatant prohibited transaction. However, that assumption does not exclude potential prohibited-transaction problems.
One of the key characteristics of a self-directed IRA is that the owner has discretionary authority over the IRA's investments. This is important because it results in the owner being characterized as a fiduciary, and thus brings into play what is commonly referred to as fiduciary prohibited transactions (listed under the fifth and sixth items above).
Both the Department of Labor and the 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. For example, the Labor Department has reviewed situations 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. In addition, tax courts, the Labor Department and the IRS have all stated that if a fiduciary or another disqualified person - such as the IRA owner - benefits, directly or indirectly, as a result of the use of tax-deferred retirement assets, a prohibited transaction could occur.
In summary, a self-directed IRA owner cannot execute investments that result in a conflict between his or her loyalty to the IRA and his or 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 Romney's IRA could be challenged. According to The Wall Street Journal, Romney's IRA is invested in numerous 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 is likely to result 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. Romney left Bain Capital in 1999 but, as part of his departure agreement, retained profit sharing rights as a retired partner. In fact, Romney has earned $13 million of carried interest income over the past two years alone, according to the Romney campaign.
Therein lies a potential problem. If an ongoing investments being made by an IRA are resulting in a direct or indirect benefit to the account holder, a prohibited transaction argument exists. It is likely that a taxpayer and his accounting and legal teams would counter that the account owner is not a fiduciary because his investments are controlled by a blind trust or third-party fiduciary. In Romney's case, if he is not in control of his IRA's investments (either directly or indirectly) why, according to several reports, is his IRA still invested into so many funds run by Bain Capital? Would an independent fiduciary continue investing in these funds? If Romney is not controlling the IRA, but is simply directing the IRA trustee, he still may have a fiduciary prohibited transaction problem.
Although the federal legal framework governing IRAs is widely seen as needing clarification, both of the following scenarios 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-differed funds are not truly owned by the IRA account holder until they are withdrawn 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 or investment structure. For example, if the IRA is allowed to buy an asset at an artificially decreased price or earns income at a preferred rate based on the fact that a disqualified person is involved, at a minimum, an excess IRA contribution could result.
If a prohibited transaction (even many years ago) was committed, the IRA's tax-exempt status could be revoked and the entire value of the IRA could be deemed to have been distributed effective Jan. 1 of the year in which the prohibited transaction occurred.
The result of this harsh rule can be financially disastrous. Assume the combined value of Romney's retirement accounts was $20 million (the low end of published estimates) when he left Bain in 1999. Also assume Romney rolled all of his retirement plans into one IRA in 1999, an event that is not uncommon when someone changes employers or careers. Now consider the potential outcome if a prohibited transaction in early 2000, which would revoke the IRA's tax-exempt status as of Jan. 1, 2000. In simplified terms, the result would be:
* $20 million of additional income in 2000. Because this income came from an IRA, it would be taxed at ordinary income rates (the top rate was 39.6% in 2000). Tax due: $9.9 million.
* The constructive distribution would also be subject to the 10% early distribution penalty because Romney was 52 years old in 2000. Penalty amount: $2 million.
* The $9.9 million tax due would be subject to interest and underpayment penalties from 2000 until 2012. Although the IRS will occasionally agree to reduce penalties, interest cannot be waived. Additional amount due: $8.1 million (assuming interest at a 5% average rate).
* Because the IRA would have lost its tax-exempt status in 2000, all earnings within the IRA since then would be treated as being earned individually. Assuming that the assets grew another $55 million since 2000 and that Romney would be taxed on these earnings at 35%, the additional tax due would be $19.25 million.
* Penalties and interest could apply to this tax liability as well, resulting in an additional amount due of $15.75million (assuming interest at a 5% average rate and no penalties).
* The total lost to the IRS would be about $55 million, and 73% of the IRA's value would be lost.
Certainly, the rules that govern self-directed IRAs can be obtuse. But the consequences of an advisor ignoring these regulations could be extremely detrimental to any high-net-worth client who's an IRA investor.
Warren Baker is lead attorney in the self-directed IRA tax consulting group at Amicus Law Group in Seattle.