On September 17, 2014, the Small Business Administration agreed to provide its credit enhancement guarantee in an Arizona bank’s financing transaction involving self-directed IRA investment in a startup operating company arrangement. This is an important development in the retirement plan industry where the self-directed segment consists of a growing $130 billion in plan assets. Moreover, it is well known SBA ERISA policy considerations frequent Department of Labor policy considerations.
Recent events in the courts and academic journals cast an unfavorable hue over such prospects. First, the United States Tax Court issued two 2013 decisions in Peek and Ellis distilling disqualified person operating company investment as a self-directed ERISA plan weak-form fiduciary abuse. The consequence was straightforward: the taxpayer-favorable operating company exception to the plan asset look-through rule was thereby preempted. In these cases, respective account holder personal loan guaranties of operating company indebtedness and receipt of operating company reasonable compensation for non-plan-administration services resulted in prohibited transactions and the attendant consequences.
Also, a Tax Adviser commentator proclaimed in the journal’s April 1, 2014 issue that the Ellis decision placed self-directed IRA investment in a startup operating company among the unwise choices to be made by an account holder. This paper superficially evaluated the Ellis outcome without embracing an understanding of the ERISA policy considerations underpinning the decision. As a result, the platform sanctioned analysis giving short shrift to this important matter.
Peek and Ellis consistently teach that if an account holder intends to properly invoke the operating company exception to the plan asset look-through rule, the first matter is to STOP THE CONSTRUCTIVELY OWNED DISQUALIFIED PERSONS ENTITY CHAIN!!!! The operating company’s status as a disqualified person, Peek and Ellis demonstrate, is a sufficient weak-form fiduciary abuse to preempt the operating exception, resulting in the operating company’s underlying assets to be deemed as plan assets. Since plan assets and a disqualified person are necessary and sufficient elements of a prohibited transaction, once the Tax Court held the operating company’s underlying assets were plan assets, the result was a fait accompli.
My paper, “Self-Directed ERISA Plan Prohibited Transaction Chinese Walls,” comments the Peek and Ellis Tax Court decisions as teaching that if an account holder wants to invoke the operating company exception to the plan asset look-through, the first thing is to STOP THE CONSTRUCTIVELY OWNED DISQUALIFIED PERSONS ENTITY CHAIN!!!! In the non-ESOP scenario, that means once the self-directed plan limits its direct operating company investment to less than 50%, then the operating company is not a disqualified person within the meaning of section 4975(e)(2)(G). Under such circumstances, the operating company exception to the plan asset look-through rule translates the underlying assets do not involve plan assets. No plan assets, no prohibited transactions. Viva account holder operating company personal guaranties of indebtedness and reasonable compensation without prohibited transaction penalties!!!!
When properly invoked, exceptions to the plan asset look-through rule translate the underlying assets of the investee-company are not plan assets. The two exceptions cited in 29 CFR §§2510.3-101(a)(2)(i) and (ii) are the operating company and de minimis interest exceptions. In the transaction approved by the SBA, both exceptions applied. That is, the transaction structure involved dual Chinese Walls. Let’s see how it worked.
The account holder (AH) caused traditional IRA funds to be transferred to a self-directed IRA custodian. AH then formed C-Corp to mitigate UBTI and UDFI weak-form fiduciary abuses. That is, the self-directed IRA invested funds in C-Corp in consideration of 100% of its capital stock. As a result, C-Corp is a disqualified person within the meaning of section 4975(e)(2)(G).
Next, C-Corp invested most of its funds in Parent-LLC, a non-operating company treated as a partnership for tax purposes, in consideration for receiving 24% of the capital equity interests in the LLC. Since C-Corp was the only benefit plan investor and since no person exercised discretionary authority or control over Parent-LLC’s assets, the de minimis interest exception to the plan asset look-through applied. This created Prohibited Transaction Chinese Wall No. 1, meaning Parent-LLC was not a disqualified person and its assets were not plan assets.
Further, since Parent-LLC invested most of its funds in consideration of 51% of operating company Subsidiary-LLC’s capital equity interests, Subsidiary-LLC (also treated as a partnership for tax purposes), was not a disqualified person within the meaning of section 4975(e)(2)(G) nor were its assets plan assets. Once the Constructively Owned Disqualified Persons Entity Chain is disrupted it cannot be revivified merely owing to further devolving, sequential entity chain investment. Since Parent-LLC owns the majority of Subsidiary-LLC’s capital equity interests, the operating company exception to the plan asset look-through rule applies. Thus, the second Prohibited Transactions Chinese Wall is created, further insulating the account holder from prohibited transaction determinations arising when he or she personally guaranties Subsidiary-LLC indebtedness or receives Subsidiary-LLC reasonable compensation.
Several ERISA policy considerations implicate the success of this transaction structure in garnering SBA approval in the face of Peek, Ellis, and the Tax Adviser commentary. First, asset exposure fiduciary abuses were eliminated when the account holder isolated the investment in C-Corp. The elimination of the abuses is reflected by the elimination of UBTI or UDFI exposure to the self-directed IRA. Second, ERISA policy favors investment diversification for non-ESOP ERISA plans by imposing disqualified person status at capital equity interest levels at 50% or higher. Since the self-directed IRA in the case approved by the SBA met all ERISA policy considerations, the structure results in dual Prohibited Transaction Chinese Walls.
The lesson is clear. Whenever structuring self-directed retirement plan investment transactions, one must consider the wide breadth of ERISA policies implicated by all provisions of the income tax code transparently designed to correct weak-form fiduciary abuses. Peek and Ellis teach if the admonishment is not fully countenanced, severe adverse consequences result. When ERISA policies are embraced, then taxpayer-favorable exceptions, like the exceptions attendant to the plan asset rule, will be respected.
 See, Peek v. Commissioner, 140 T.C. 12 (May 9, 2013).
 See, Ellis v. Commissioner, T.C. Memo 2013-245 (October 29, 2013).
 See, O’Malley, “Ellis, the Case of a Misdirected IRA,” The Tax Adviser, Tax Clinic (April 1, 2014).
 The paper is available on my Algorithm-LLC.com website under the Research Corner webpage at: http://www.algorithm-llc.com/research-corner/. Scroll down the page until you find the paper under the Tax Planning Working Papers topic.
 See, Middleton v. Stephenson, 2011 U.S. Dist. LEXIS 141495 (DC Utah, Central Division December 8, 2011). This case involved an ESOP. An ESOP can own 100% of the operating company without amounting to a disqualified person fiduciary abuse. Accordingly, 100% operating company capital equity interest ownership by an ESOP still results in successful application of the operating company exception to the plan asset look-through rule where its underlying assets are deemed not to involve plan assets.
 I discuss “weak-form fiduciary abuses” in my paper titled, “Changes in Form 5498 Reporting and Foreseeable IRS Correction of Self-Directed ERISA Plan Fiduciary Abuses,” available on my Algorithm-LLC.com website under the Research Corner webpage at: http://www.algorithm-llc.com/research-corner/. Scroll down the page until you find the paper under the Tax Planning Working Papers topic.
 The initial investment transaction is not a prohibited transaction. See, Swanson v. Commissioner, 106 T.C. 76 (February 14, 1996).
 See, 29 CFR §2510.3-101(h).