While an individual retirement account (IRA) is not subject to the Employee

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1 Vol. 19, No. 5 May 2012 Do You Really Want to Do That? IRAs and the Prohibited Transaction Provisions By David C. Kaleda While an individual retirement account (IRA) is not subject to the Employee Retirement Income Security Act of 1974 (ERISA), an IRA is subject to the prohibited transaction provisions in Section 4975 of the Internal Revenue Code of 1986, as amended (Code). The Code s prohibited transaction provisions in large part mirror those in ERISA. In fact, the Employee Benefit Security Administration (EBSA) of the Department of Labor (DOL) has the responsibility to interpret the prohibited transaction provisions for purposes of both the Code and ERISA. 1 The impact of the Code s prohibited transaction provisions on IRAs has been most recently highlighted in DOL guidance stating that cross-collateralization and indemnification provisions in brokerage and other account agreements related to IRAs result in non-exempt prohibited transactions. In addition, the DOL s proposed regulations to change the definition of fiduciary appear to have raised awareness that providing services to IRAs presents prohibited transaction issues. The purpose of this article is to provide an overview of how the prohibited transaction provisions impact IRAs particularly in light of recent DOL guidance in this area. Because of the increased focus on IRAs by the EBSA and the significant tax implications involved with David C. Kaleda is a partner in Alston & Bird s Employee Benefits & Executive Compensation Group in Washington, DC. entering into a prohibited transaction with IRA assets, parties that provide services to IRAs should consider the impact the prohibited transaction rules have on their clients IRAs. Such providers do not want to be responsible for subjecting themselves or their clients to excise taxes or cause their clients IRAs to lose their tax-favored status. In order to prevent these negative tax consequences, registered investment advisers, broker-dealers, and other IRA service

2 providers should consider adopting compliance procedures designed to avoid prohibited transactions (PTs) just as they do to assure compliance with Securities and Exchange Commission (SEC), Financial Industry Regulatory Authority (FINRA), and similar requirements. Application of Prohibited Transaction Provisions Section 4975(e) of the Code prohibits certain transactions between a disqualified person and a plan, which includes among other things an individual retirement account under Section 408(a) of the Code, an individual retirement annuity under Section 408(b) of the Code, and a health savings account (HSA) under Section 223(d) of the Code. 2 In addition, the Code prohibits a fiduciary with respect to the IRA from engaging in certain self-dealing prohibited transactions. While this article is focused on IRAs under Section 408(a) of the Code, the below discussion also applies to individual retirement annuities and HSAs. Prohibited Transactions Involving Disqualified Persons The Code prohibits the following transactions between an IRA and a disqualified person: Any direct or indirect sale or exchange, or leasing, of any property between the IRA and a disqualified person; 3 Any direct or indirect lending of money or other extension of credit between the IRA and a disqualified person; 4 Any direct or indirect furnishing of goods, services, or facilities between the IRA and a disqualified person; 5 and Any direct or indirect transfer to, or use by or for the benefit of, a disqualified person of the income or assets of the IRA. 6 With respect to an IRA, a disqualified person (DP) is broadly defined to include the following persons or entities: 7 a) A fiduciary with respect to the IRA; 8 b A person providing services to the IRA; 9 c) A member of the family of any individual described in subparagraph (a) or (b) above 10 (a family member for this purpose includes a spouse, ancestor, lineal descendant, and any spouse of a lineal descendant 11 ); d) A corporation, partnership, or trust or estate of which (or in which) 50 percent or more of: (i) The combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of such corporation, (ii) The capital interest or profits interest of such partnership, or (iii) The beneficial interest of such trust or estate, is owned directly or indirectly, or held by persons described in subparagraph (a) or (b); 12 e) An officer, director (or an individual having powers or responsibilities similar to those of officers or directors), a 10 percent or more shareholder, or a highly compensated employee (earning 10 percent or more of the yearly wages of an employer) of a person described in subparagraph (d); 13 or f) A 10 percent or more (in capital or profits) partner or joint venturer of a person described in subparagraph (d). 14 Based upon the forgoing, the following parties are often DPs with respect to IRAs: Owners (and their spouses and family members); Beneficiaries (and their spouses and family members); THE INVESTMENT LAWYER 2

3 Broker-dealers; Trustees or custodians; Investment advisers (whether or not registered); Investment managers (whether or not registered); and Persons or entities that are affiliated with the above-listed. In other words, virtually all parties involved in an IRA relationship, their family members, and certain organizations with which they have an affiliation will be disqualified persons. The above-listed transactions are often called the per se prohibited transaction provisions. In other words, the motive or intent of the party causing the transaction is not relevant. Thus, merely entering into one of these transactions in the absence of an exemption (discussed below) will result in a prohibited transaction between the IRA and the DP and will result in an excise tax liability applicable to the DP. Fiduciary Self-Dealing Prohibited Transactions The Code also prohibits fiduciaries with respect to an IRA from engaging in what are commonly known as fiduciary self-dealing prohibited transactions. Specifically, the Code prohibits the following: An act by a DP who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account 15 ; and Receipt of any consideration for his own personal account by any DP who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan. 16 A fiduciary for purposes of the Code includes any person or entity that does any of the following: Exercises any discretionary authority or discretionary control respecting management of the IRA; Exercises any authority or control respecting management or disposition of the IRA s assets; Renders investment advice with respect to IRA assets for a fee or other compensation, or has any authority or responsibility to do so; or Has any discretionary authority or discretionary responsibility in the administration of the IRA. 17 This definition provides for a functional test. In other words, it is irrelevant whether the governing documents of the IRA or the contracts or arrangements between the IRA and DPs designate any party as a fiduciary. In the case of a self-directed investment IRA under which the owner or beneficiary retains ultimate investment discretion over the IRA s assets, the owner or beneficiary, as applicable, is a fiduciary. If persons and entities related to the fiduciary, which are referred to as affiliates in the Treasury Regulations, benefit from the fiduciary s conduct, the fiduciary (and possibly the affiliate) will be liable for any prohibited self-dealing. The Treasury Regulations define affiliate in the context of providing fiduciary investment advice as, among other things, (i) any person directly or indirectly, through one or more intermediaries, controlling, controlled by, or under common control with such person and (ii) officers, directors, partners, employees and relatives of such person. The regulations state that the term control means the power to exercise a controlling influence over the management or policies of a person other than an individual. 18 A logical reading of the regulations requires the use of this definition in the context of other fiduciary conduct. As such, the class of individuals and entities that are related (that is, affiliated) in instances where potential self-dealing may occur is generally broader than when a per se PT may occur. Based upon the forgoing, the following are examples of parties that can be fiduciaries to 3 Vol. 19, No. 5 May 2011

4 IRAs in the normal course of their businesses: IRA owners (and their spouses and family members) when the IRA is a self-directed investment IRA; Discretionary trustees; Investment advisers; Investment managers; and Persons or entities that are affiliated with the above-listed. Such parties must be particularly sensitive to situations in which they or an affiliate may benefit from the activities of the fiduciary. For example, if a fiduciary provides investment advice to the IRA owner and, as a consequence of following such advice, invests the IRA in investment products managed by an affiliate of the advice provider, a self-dealing PT will occur if the advice provider or its affiliate receives additional compensation by reason of such investment unless an exemption applies. Consequences of Violating the Prohibited Transaction Provisions The consequences of engaging in a non-exempt PT can be significant. Section 4975(a) of the Code imposes a 15 percent excise tax on the amount involved in a PT. In the event that the IRS notifies an IRA owner or beneficiary that it has discovered a PT and such PT is not resolved within a certain period of time, a 100 percent excise tax on the amount involved is imposed under Section 4975(b) of the Code. The tax is assessed against the DP engaged in the PT. However, the tax will not be imposed on a fiduciary involved in the DP unless the fiduciary was acting in some other capacity that made it a DP (such as a service provider). Furthermore, if the PT is caused by the IRA owner or beneficiary, an excise tax is not imposed. However, the IRA loses its tax-favored status and any gains attributable to assets within the IRA are immediately included in income. 19 Prohibited Transaction Exemptions The Code s prohibited transaction provisions are intentionally broad. The statute essentially starts with the premise that most transactions involving the IRA are PTs. However, the Code further provides for (i) statutory exemptions set forth in Section 4975(d) and (ii) both class and administrative class exemptions issued pursuant to Section 4975(c)(2) of the Code. These exemptions permit transactions that would otherwise be a PT. The exemptions, however, are only available if certain actions designed to protect the interests of the IRA s owners and beneficiaries are taken pursuant to the terms of the exemption. The statutory exemptions permit many common transactions if the requirements of such provisions and the underlying regulations are met. For example, several statutory exemptions permit the following: Payment of reasonable compensation by the IRA to service providers for service necessary to the operation of the IRA; 20 Investment of IRA assets in interest bearing bank deposits even if the bank is a fiduciary with respect to the IRA as long as an independent fiduciary makes the investment decision; 21 Cross-trading among IRA accounts;22 Block-trading with respect to multiple IRA accounts; 23 Provision of investment advice to owners and beneficiaries of self-directed investment IRAs; 24 Transactions between an IRA plan and a person that is a non-fiduciary DP solely by reason of providing services to the IRA or solely by reason of an affiliation with such a service provider if the IRA receives no less, nor pays no more, than adequate consideration, for such services (commonly referred to as the service provider exemption ); 25 Transactions involving the purchase or sale of securities between an IRA and a DP if the transaction is executed THE INVESTMENT LAWYER 4

5 through an electronic communication network, alternative trading system, or similar execution system or trading venue; 26 and Foreign exchange transactions between a bank or broker (or any affiliate of either) and an IRA with respect to which such bank or broker (or affiliate) is a trustee, custodian, fiduciary, or other DP. 27 In addition to the statutory exemptions, the DOL may also issue administrative exemptions, which are either (i) class exemptions or (ii) individual exemptions. Class exemptions are similar to statutory exemptions in that they provide exemptive relief with respect to certain transactions between all IRAs and DPs in the event that certain requirements set forth in the exemption are met. One of the most commonly used and effective class exemptions is the qualified professional asset manager exemption, more commonly known as the QPAM exemption. 28 As a threshold matter, in order to be a QPAM, a party must fall into one of the following categories: A bank, as defined in section 202(a)(2) of the Investment Advisers Act of 1940 (Advisers Act) that has the power to manage, acquire or dispose of assets of a plan and such bank has, as of the last day of its most recent fiscal year, equity capital in excess of $1 million; An insurance company which is qualified under the laws of more than one state to manage, acquire, or dispose of any assets of a plan, which company has, as of the last day of its most recent fiscal year, net worth in excess of $1 million and which is subject to supervision and examination by a state authority having supervision over insurance companies; or An investment adviser registered under the Advisers Act that has total client assets under its management and control in excess of $85,000,000 as of the last day of its most recent fiscal year, and either (A) shareholders' or partners' equity in excess of $1 million or (B) payment of all of its liabilities including any liabilities that may arise by reason of a violation of the PT provisions is unconditionally guaranteed by another adviser or broker dealer that meets certain requirements. 29 The bank, savings and loan association, insurance company or investment adviser must acknowledge in a written management agreement that it is a fiduciary with respect to the IRA at issue. If a party to a transaction involving an IRA is a QPAM and meets certain other requirements, a majority of transactions involving IRA assets in which the counterparty is a disqualified person will not result in a non-exempt PT. Importantly, the QPAM exemption cannot be used to exempt a fiduciary self-dealing PT (such as a transaction in which the fiduciary uses assets for its own benefit or account or in which the counter-party is an affiliate) including in most cases where the counterparty is an affiliate of the QPAM. In addition, the QPAM exemption cannot be used to exempt (i) transactions involving securities lending, acquisitions by IRAs of interests in mortgage pools, or transactions involving mortgage financing arrangements for which there are separate class exemptions or (ii) the payment of compensation by the IRA to a DP for which there is a particular statutory exemption. While the QPAM exemption can be very effective, there will be investment advisers to IRAs that will not meet the aforementioned assets under management or equity requirements and other service providers to IRAs (such as brokers) who will never meet the QPAM exemption. However, there may be other ways to avoid prohibited transactions. For example, the service provider exemption in Section 4975(d)(20) of the Code noted above, which was added to the Code by the Pension Protection Act of 2006, 30 permits certain transactions as long as the counterparty is not a fiduciary with respect to the management or disposition of the IRA s assets. Even if the QPAM or service provider exemptions are not available, the DOL has 5 Vol. 19, No. 5 May 2011

6 issued a myriad of class exemptions that can be used with respect to IRAs. Those exemptions permit common transactions that may occur between a DP and IRA and some of them include the following: CPTE 75-1: Transactions between IRAs and non-fiduciary broker dealers (including principal and agency transactions and extensions of credit). 31 CPTE 77-4: Investments by trustee-directed IRAs in mutual funds managed by the trustee s affiliates. 32 CPTE 81-8: Investments in various short term instruments including bankers acceptances, commercial paper, repurchase agreements, and certificates of deposit. 33 CPTE 83-1: Transactions involving mortgage pool investment trusts. 34 CPTE : Transactions between IRAs and fiduciary broker-dealers. 35 CPTE 88-59: Transactions with certain residential mortgage financing arrangements. 36 CPTE 90-1: Transactions with insurance company pooled separate accounts. 37 CPTE 92-5: Transfers of individual life insurance and annuity contracts to IRAs. 38 CPTE 92-6: Transfers of individual life insurance and annuity contracts from IRAs. 39 CPTE : Securities lending transactions. 40 In the event that a DP wants to avail itself of one of these or other class exemptions issued by the DOL, the terms should be reviewed carefully to determine if they apply to the proposed transaction. Notably, most of the exemptions do not permit self-dealing transactions by a fiduciary or between a fiduciary and its affiliates. As a last resort, an IRA owner, beneficiary, adviser, custodian, or other disqualified person may apply for an individual exemption from the DOL. Unlike statutory and class exemptions, individual exemptions only apply to the applicant. Even if an IRA owner applied the terms of an individual exemption issued to another party, the owner could not use that exemption as a basis for claiming a PT did not occur and would be subject to the negative tax consequences described above. The process for obtaining an exemption often lasts more than one year due to requirements like the publication of the proposed exemption in the Federal Register in order to allow for public comment. However, the DOL does provide an expedited program, commonly referred to as an EXPRO exemption, which can take well less than one year. 41 At the end of the day, most transactions involving IRA assets will result in a transaction that is prohibited under Section 4975(c) (1) of the Code. However, a substantial number of those transactions will be covered by one of the statutory or class exemptions. An IRA owner, beneficiary, and service provider must be able to recognize its status as a DP (including as a fiduciary) and be prepared to demonstrate how it will meet the requirements underlying any necessary exemptions. This is particularly important for providers who are fiduciaries with respect to the IRA because they will be initiating transactions with counterparties who may be DPs. Furthermore, such fiduciaries must be aware of potential self-dealing PTs because very few of the exemptions allow for self-dealing. In other words, such fiduciaries may have to structure transactions to eliminate the existence or the potential for self-dealing (or simply not engage in the transaction). ERISA Plan Asset Issues Managers and advisers (and certain service providers) to entities the assets of which are deemed to be plan assets as defined under Section 3(42) of ERISA and 29 C.F.R , as amended by Section 3(42) of ERISA, will be DPs (and probably fiduciaries) with respect to IRAs invested in the THE INVESTMENT LAWYER 6

7 entity. Therefore, all of the entity s activities must be monitored for purposes of assuring that non-exempt prohibited transactions do not occur. Notably, an entity s assets may be plan assets even if no employee benefit plans subject to the fiduciary provisions of Part 4 of Title I of ERISA (typically private sector employer sponsored 401(k), profit sharing, and pension plans) invest in the entity. The aforementioned ERISA section and regulation are collectively referred to as the plan assets regulation. If an IRA purchases an equity interest in an entity, including an investment fund, the assets of that entity will not be plan assets if: The entity is an operating company (such as a real estate operating company or a venture capital operating company); The equity interest is publicly offered as established in the plan asset regulation, which among other things requires some type of registration under the Securities Act of 1933 or the Securities Exchange Act of 1934; or The entity is an investment company registered under the Investment Company Act of However, if the entity does not fall within one of the aforementioned categories and if 25 percent or more of the value of any class of equity interests in the entity is held by benefit plan investors, the assets of the fund will be deemed to be plan assets. 43 For ease of reference, the entity in which equity interests are held is called a fund. For purposes of determining whether the 25 percent threshold has been reached, benefit plan investors include plans that are subject to the fiduciary provisions of Part 4 of Title I of ERISA and the plans defined in Section 4975(e)(1) of ERISA, which include IRAs. 44 Thus, for example, even if a fund is not open to investors subject to the fiduciary provisions of ERISA, but is open to IRAs, the 25 percent threshold can be reached. Furthermore, equity interests owned by the fund manager and other parties that exercise discretion with respect to fund assets or provide investment advice with respect to the fund (and their affiliates) cannot be counted. 45 This prevents fund-related parties from surpassing the 25 percent limit simply by investing in the fund or increasing its investment in the fund. The importance of calculating the 25 percent threshold or otherwise assuring that the fund otherwise meets one of the other categories allowing it to avoid plan asset status cannot be overstated. If the fund s assets are plan assets, the fund s activities must be conducted in a manner that prevents the occurrence of non-exempt PTs by relying on the exemptions and DOL guidance discussed above. While a fund could be run in such a manner, it may be very difficult to re-engineer the fund after the fact. In other words, if the fund manager wants to make the fund available to an unlimited number of benefit plan investors, it should make that decision at the time the fund is being organized in order to assure that the necessary procedures will be in place to avoid non-exempt PTs. 46 Recent Guidance on PTs Indemnification & Collateralization Agreements Recently, the DOL issued guidance that brought to light the potentially severe consequences of engaging in PTs with respect to IRAs. Last year, the DOL issued Advisory Opinion A in which it determined that an IRA owner s mere entering into a brokerage account agreement that included an indemnification provision whereby the owner would use non-ira assets to pay the obligations of his or her IRA resulted in a PT. The DOL concluded that the indemnification agreement resulted in an impermissible extension of credit between the IRA and the IRA owner, which is prohibited under the Code s PT provisions. Moreover, because the IRA owner entered into the brokerage agreement, the IRA would lose its tax-favored status, thus subjecting the assets of the IRA to immediate income inclusion and taxation. More specifically, the IRA owner wanted to enter into futures contracts through the broker using the assets of his IRA, which was a selfdirected IRA (that is, the IRA owner made the 7 Vol. 19, No. 5 May 2011

8 investment decisions, thus being a fiduciary). In operation, the IRA may incur an investment loss or incur taxes in connection with entering into futures contracts. Pursuant to the indemnification provisions in the brokerage agreement, the IRA owner agreed to pay any loss or any taxes that exceeded the amount of assets held in the IRA from his own personal assets. By contractually committing to indemnifying an IRA against an excess loss (even before such loss was actually incurred) with non-ira assets, the DOL concluded that an impermissible extension of credit occurred for purposes of the Code s prohibited transaction provisions. The DOL noted that its conclusion was consistent with DOL Advisory Opinion in which it determined that the creation of cross-collateralization arrangements whereby an IRA owner granted to a broker a security interest in the individual s non-ira accounts in order to cover actual or possible indebtedness of, or arising from, the individual s IRA with the broker, would be an impermissible extension of credit. Furthermore, the DOL rejected the position that Prohibited Class Exemption could be relied upon as a basis for allowing the indemnification provision to stand. This exemption allows a disqualified person to make interest free loans to an IRA if the loan is used for the payment of ordinary operating expenses related to the IRA or for a purpose incidental to the ordinary operation of the IRA. The DOL concluded that the recovery of a loss attributable to investments in futures contracts was not incidental to the ordinary operation of the IRA based upon the plain meaning of the wording used in the exemption. Furthermore, the DOL stated that because entry into a brokerage agreement that contained the indemnification agreement was a condition precedent to investing in the futures contracts, the underlying extension of credit could not be construed as merely incidental to the ordinary operation of the IRA. Shortly after the DOL issued its opinion, the IRS issued an announcement in which it stated that it would not disqualify an IRA that was impacted by the offending indemnification or cross-collateralization provisions discussed in the aforementioned DOL opinions notwithstanding the fact that mere existence of the offending provisions resulted in a selfdealing PT by the IRA owner. However, it could disqualify an IRA with respect to which such provisions had been enforced by the broker. 47 The IRS suggested that the DOL may be considering a retroactive class exemption that will allow these provisions to be removed from the agreements. Potential Self-Dealing in Compensating IRA Fiduciaries Another area involving PTs in which service providers, particularly those that are fiduciaries, should be concerned is the receipt of compensation from the IRA for its services. As noted above, the payment of reasonable compensation by the IRA to a service provider may be exempt under Section 4975(d)(2) of the Code if the services are necessary to the operation of the IRA. However, in both the Treasury Regulations and the DOL s interpretation of those regulations, that exemption does not apply to self-dealing PTs. Therefore, fiduciaries with respect to IRAs and funds the assets of which are plan assets (as described above) must be aware of potential self-dealing involving their fee arrangements. According to Section of the Treasury Regulations, the exemption under Section 4975(d)(2) of the Code does not apply to self-dealing PTs. The self-dealing PT provisions are designed to prevent a fiduciary from using any of the authority, control or responsibility that makes it a fiduciary to enter into transactions in which it has an interest because the resulting conflict will prevent the fiduciary from acting in the best interests of the IRA s beneficiaries. Therefore, the regulations state that a fiduciary may not use any of the authority, control or responsibility that makes it a fiduciary to make the IRA pay an additional fee to the fiduciary or its affiliates. In addition, a fiduciary may not cause an IRA to enter into a transaction involving plan assets whereby such fiduciary or its affiliate will receive a fee or other consideration from a third party in connection with such transaction. In Advisory Opinion A, (the Community Bank Opinion), the DOL THE INVESTMENT LAWYER 8

9 addressed how self-dealing would not be exempt under Section 4975(d)(2) of the Code and that some type of fee-leveling is needed to avoid non-exempt PTs. In its opinion, the DOL reviewed a bank s investment management program made available to IRAs for which the bank was the custodian. Through a series of five model investment strategies, the bank provided investment advisory services to IRA holders for which the adviser would receive a fee. Through the advice program, the bank would make recommendations to IRA holders on how to invest their IRA assets in several funds offered through the program. Some of the funds were advised by a bank affiliate (Affiliated Funds) and others were advised by unrelated third parties (Unaffiliated Funds) offered under the program. The IRA holder had the ultimate discretion whether to follow the advice. As such, the bank was acting as a fiduciary investment adviser as described in Treasury Regulation (c), but did not have ultimate discretionary authority with regard to the investment of IRA assets. The DOL concluded that prohibited transactions under Code 4975 would not occur if (i) the bank or its affiliates did not receive fund management fees, 12b-1 fees, or sub-transfer agency fees from the Affiliated Funds offered under the program (that is, such fees were waived), or (ii) such fees were offset against the investment advisory fees paid by the IRA to the bank for provision of the advisory program (commonly referred to as fee-leveling). Furthermore, the DOL stated that no self-dealing would occur with respect to the Unaffiliated Funds if fee waivers or fee-leveling occurred with respect to 12b-1 fees, sub-transfer agency fees, and other types of revenue sharing paid by the funds. The premise of the DOL s opinion was that by not receiving any fees from the funds or offsetting such fees against the program advisory fee, the bank would not be using any of its authority as a plan fiduciary, in this case an investment adviser as defined under Section 4975(e)(3)(B) of the Code, to cause the payment of additional compensation to the bank. Based upon the foregoing, fiduciaries with respect to IRAs must be particularly sensitive to the fees it receives and to make sure prohibited self-dealing does not occur. Such fiduciaries may take advantage of one of several exemptions or other types of guidance that establish how the arrangement can be structured: Fee leveling or fee waivers as discussed in the Community Bank Opinion. Fee leveling as described in Class Exemption 77-4 (applies to a discretionary bank trustee that invests IRA assets in mutual funds managed by bank affiliates). Computer modeling investment advice programs that comply with DOL Advisory Opinion A (commonly referred to as the SunAmerica Opinion). Fee-leveling or computer modeling that complies with the statutory exemption in Section 4975(d)(17) of the Code. 48 Furthermore, a fiduciary with respect to a fund or other entity the assets of which are plan assets should also consider the impact of compensation arrangements. While in many cases a simple management fee based upon a percentage of assets under management should be covered by the statutory exemption in Section 4975(d)(2) of the Code, the DOL has indicated that any performance fee paid to the manager or other fund-related parties must be set up in a way that does not cause fiduciary self-dealing. 49 The DOL looks to factors such as whether the performance fee is based upon measurements that cannot be manipulated by the fiduciary (such as an increase in the value of fund assets that are valued by independent third parties or based upon independent market quotations or comparison to an index established by an independent third party), whether the fee is based upon realized gains and losses, and other factors to determine if a self-dealing prohibited transaction occurred. 50 In effect, the DOL looks to see if the fee arrangement is structured so that the amount cannot be subjectively determined by the fiduciary. 9 Vol. 19, No. 5 May 2011

10 Potential Broadening of Fiduciary Definition & Impact on IRA Providers In 2010, the DOL issued proposed regulations that would significantly change the definition of fiduciary under the Code and ERISA. 51 The proposal, if adopted in its current form, would broaden the class of financial services providers that will be fiduciaries (and accordingly DPs) with respect to IRAs. In issuing the proposal, the DOL indicated an intent to capture certain transactions as fiduciary acts even when they were not viewed as such by the DOL in prior guidance. The proposed regulations were withdrawn late last year in order to address public comments regarding the financial impact of the regulations on certain service providers and for other purposes. 52 The DOL intends to issue re-proposed regulations before the end of Under current regulations, an investment advice provider is a fiduciary if all of the following five conditions are present: The provider renders advice as to the value of securities or other property, or makes recommendations as to the advisability of investing in, purchasing or selling securities or other property; On a regular basis; Pursuant to a mutual agreement, arrangement or understanding, with the plan or a plan fiduciary; That the advice will serve as a primary basis for investment decisions with respect to plan assets; and, That the advice will be individualized based on the particular needs of the plan. 53 The DOL issued the proposed regulations because it was concerned that the current fiduciary regulation, promulgated 35 years ago, did not reflect the current retirement plan and IRA market conditions, which include a significant shift toward individual account plans and IRAs under which participants, beneficiaries, and owners have investment discretion with respect to amounts held in their accounts. 54 Furthermore, the DOL wanted to clarify for investors when advice providers may be subject to a conflict of interest. Under the proposed rule, any party who performs one of the below tasks with respect to a plan (including an IRA), a plan fiduciary (such as the owner of a self-directed IRA), or plan participant or beneficiary (such as an IRA owner or beneficiary) will be a fiduciary: Provides advice, or an appraisal or fairness opinion, concerning the value of securities or other property; Makes recommendations regarding the advisability of investing in, purchasing, or holding securities or other property; Provides advice or makes recommendations as to management of securities or other property; Represents or acknowledges that he or she is acting as an ERISA fiduciary; Is a fiduciary as determined under the Advisers Act; Is a fiduciary by reason of exercising discretion or control over management of a plan or its assets; or, Provides the advice or recommendations as to the items listed in the first three bullet points pursuant to an arrangement or understanding that such advice may be considered by a plan, plan fiduciary, or plan participant or beneficiary in making investment or management decisions. Effectively, the proposed regulation establishes broad categories of parties that could be fiduciaries. For example, the DOL suggested that a service provider such as a broker could be a fiduciary with respect to a plan if it recommended to an ERISA-governed plan participant to rollover his or her account balance to an IRA in order to take advantage of investment options not currently available under the THE INVESTMENT LAWYER 10

11 plan. 55 This position is contrary to the one the DOL took in Advisory Opinion A in which it determined such a provider was not a fiduciary. Furthermore, unlike in the current regulations, a party can be a fiduciary even if it provides advice only once rather than on a reoccurring basis. If these regulations were to be adopted in their current form, certain service providers would likely have to presume fiduciary status in order to avoid non-exempt self-dealing prohibited transactions. At that point, the fiduciary will have to determine if one of the exceptions to this presumption of fiduciary status applies. The proposed regulation establishes two situations in which a party will not be a fiduciary even if it falls into certain of the broad categories previously listed. Seller s Rule A party is not a fiduciary if it provides advice or recommendations in the circumstances set forth in the first three bullet points above if: 1. The party can demonstrate that the recipient of the advice or recommendations knows or reasonably should know that (i) the person providing the advice or recommendation is acting in its capacity as a purchaser or seller (or as an agent of or appraiser for such purchaser or seller) and (ii) such person s interests are adverse to those of the plan or its participants and beneficiaries; and 2. A party must make clear in writing to the plan fiduciary that the provider is not giving impartial investment advice. This exemption would appear to allow broker-dealers to trade on behalf of IRAs and still receive transaction-based fees (such as commissions) as long as the broker clearly disclosed to the IRA owner and beneficiaries that its interests were adverse to its clients. Based upon the above, registered investment advisers and those that state they are a fiduciary would not be able to take advantage of this exception. The Seller s Rule raises many questions regarding its application. For example, if an entity is both a registered adviser and a registered broker dealer, the proposal is not clear whether this exemption would be available because of the status as a registered investment adviser (presumably there would be the option of offering the services wearing the broker hat, thus permitting commissions). Investment Platform Exception A party will not be an investment advice fiduciary with respect to an individual account plan if: 1. The party markets or makes available to such plans (for example, through an investment platform) securities or other property without regard to the individualized needs of the plan, its participants, or beneficiaries; 2. An independent plan fiduciary can select investment alternatives in which participants and beneficiaries can invest account balances; and 3. The party must make clear in writing to the plan fiduciary (such as the IRA owner) that the provider is not giving impartial investment advice. This exception is primarily aimed at brokers, registered investment advisers, and other financial service providers and allows them to make a menu of funds or other investments available to its clients, without assuming fiduciary status. Presumably, this exception applies to IRAs in which the investments are selfdirected though the language of the proposed regulation is not entirely clear on this point. To the extent a financial services provider is a fiduciary and the Seller s Rule or Platform Exception is not available, such provider will need to turn to the exemptions and other guidance discussed above to avoid the occurrence of non-exempt prohibited transactions. Thus, fee structures will need to be adjusted in order to avoid self-dealing with regard to payments made to the provider (such as moving from a transaction-based fee structure to a wrap fee structure) and to avoid self-dealing among affiliates (such as fee-leveling or 11 Vol. 19, No. 5 May 2011

12 offsets in accordance with CPTE 77-4 and the Community Bank Opinion). Brokers who are affiliated with a fiduciary may consider availing itself of CPTE , which provides for the recapture of profits on brokerage commissions to avoid self-dealing PTs. Clearly, any change to the definition of fiduciary will have a considerable impact on the business of financial services providers that offer IRAs or provide services with respect to such accounts. While the Code s PT provisions have always applied to IRAs and status as a fiduciary has always posed an issue of self-dealing with respect to IRA assets, any expansion of the definition will likely cause more financial services providers to be exposed to liability for self-dealing PTs. Procedures will need to be adopted to take advantage of any exceptions made a part of the new regulations or to meet the exemptions or other requirements discussed in this article. The author believes that the anticipated proposed regulations will in many ways be similar to those that were withdrawn in Conclusion IRAs are subject to the prohibited transaction provisions and providers of services to IRAs need to be aware of these rules and implement compliance procedures designed to avoid them, including by taking advantage of the various exemptions made available under the Code and by the DOL through its class exemptions. Furthermore, a party providing services to an IRA can be a fiduciary with respect to an IRA. Thus, while such fiduciaries are not subject to the fiduciary duty provisions of ERISA (such as the prudence and duty of loyalty requirements in Section 404(a) of ERISA), they are prohibited from engaging in self-dealing and should be concerned with minimizing the existence of conflicts of interest. The PT provisions can be implicated by transactions that many providers would deem as normal such as including indemnification provisions in account agreements and receiving transaction-based compensation rather than wrap or similar fee arrangements. Furthermore, the presence of IRA investors in fund-related parties may lead to PT issues because of the plan assets regulation. While the DOL s proposed definition of fiduciary may increase the likelihood of PTs occurring, the avoidance of PTs should be a concern of providers to IRAs whether or not that definition changes. Therefore, registered investment advisers, brokers and other IRA service providers should consider adopting compliance procedures designed to avoid PTs just as they do to assure compliance with SEC, FINRA and similar requirements. Notes 1. Reorganization Plan No.4, 1978 (43 FR 47713, Oct. 17, 1978). 2. I.R.C. 4975(e)(1). 3. I.R.C. 4975(c)(1)(A). 4. I.R.C. 4975(c)(1)(B). 5. I.R.C. 4975(c)(1)(C). 6. I.R.C. 4975(c)(1)(D). 7. The references in notes 8 through 10 below are the disqualified persons most often involved with IRAs. However, note that the DP definition is considerably broader if an IRA is determined by the DOL to be offered by an employer or an employee organization ( i.e., a labor union) in a manner that makes it an employee benefit plan for purposes of ERISA and thus subject to the fiduciary conduct provisions in Part 4 of Title I of ERISA. See I.R.C. 4975(e) (2)(C) through (E). Because such IRAs are typically made available in a way that they are not subject to the ERISA fiduciary duty provisions, the author assumes for purposes of this article that the definitions of DP involving employers and employee organizations will not be applicable. 8. I.R.C. 4975(e)(2)(A). 9. I.R.C. 4975(e)(2)(B). 10. I.R.C. 4975(e)(2)(F). 11. I.R.C. 4975(e)(6). 12. I.R.C. 4975(e)(2)(G). 13. I.R.C. 4975(e)(2)(H). 14. I.R.C. 4975(e)(2)(I). 15. I.R.C. 4975(c)(1)(E). 16. I.R.C. 4975(c)(1)(F). 17. I.R.C. 4975(e)(3) C.F.R ; See also 29 C.F.R g-1 & CPTE I.R.C. 408(e)(2). 20. I.R.C. 4975(d)(2); 26 C.F.R (a); ERISA 408(b)(2); 29 C.F.R b-2. THE INVESTMENT LAWYER 12

13 21. I.R.C. 4975(d)(4); 26 C.F.R (b); ERISA 408(b)(4); 29 C.F.R b I.R.C. 4975(d)(22); ERISA 408(b)(19); 29 C.F.R b I.R.C. 4975(d)(18); ERISA 408(b)(15). 24. I.R.C. 4975(d)(17); ERISA 408(b)(14); 29 C.F.R g I.R.C. 4975(d)(20); ERISA 408(b)(17). 26. I.R.C. 4975(d)(19); ERISA 408(b)(16). 27. I.R.C. 4975(d)(21); ERISA 408(b)(18). 28. CPTE In addition, a QPAM can be a savings and loan association, the accounts of which are insured by the Federal Savings and Loan Insurance Corporation, that has been granted trust powers with respect to a plan by a state or federal authority having supervision over savings and loan associations, and, as of the last day of its most recent fiscal year, equity capital or net worth in excess of $1 million. 30. I.R.C. 4975(d)(20) as amended by 611(d)(2)(A) of the Pension Protection Act of FR 5883 (Feb. 3, 2006) FR (Nov. 16, 1976) FR (April 9, 1985) FR (May 18, 1982) FR (Oct. 17, 2002) FR (Dec. 11, 1984) FR (July 26, 1989) FR (July 11, 1991) FR (Sept. 3, 2002) FR (Oct. 31, 2006). 41. CPTE C.F.R (a)(2). 43. Id. 44. ERISA 3(42) C.F.R (f)(1). 46. Note also that once the fund s assets are plan assets, the fund will also become subject to ERISA s fiduciary duty provisions if any ERISA-governed plans are permitted to invest in the fund. 47. IRS Ann C.F.R g 1(a)(4). 49. DOL Adv. Op A. 50. Id. See also DOL Adv. Op A, DOL Adv. Op A, & DOL Adv. Op A FR (Oct. 22, 2010). 52. EBSA News Release, US Labor Department s EBSA to re-propose rule on definition of a fiduciary (09/19/2011), C.F.R ; See also 29 C.F.R FR FR Copyright 2012 CCH Incorporated. All Rights Reserved Reprinted from The Investment Lawyer May 2012, Volume 19, Number 5, pages 33-44, with permission from Aspen Publishers, Wolters Kluwer Law & Business, New York, NY, ,