Boy do I get a lot of blowback every time I share my findings about why the government has declared ROBS illegal!

Why is there not a specific government ruling on ROBS?

Great question!

It’s because once an issue has been ruled on, they don’t repeatedly consider it. “They” are the Department of Labor, and the first step of learning about Self-Directed IRA and 401(k) rules is finding out that “prohibited transactions” are an issue outside the jurisdiction of the IRS and in the hands of the Department of Labor (DOL).

When ROBS Was Ruled On

It was 2006. Debra Buchanan, the creator of the IRA LLC, asked the DOL a question about structuring an investment deal to avoid “prohibited transaction” status. (This was before she split with Guidant and became my legal counsel, but that’s another story.)

The DOL came back and said (paraphrased)

It doesn’t matter how you structure things or pursue exemptions. We’ve been clear throughout various rulings ["Advisory Opinions"] that a specific part of the law books [IRC 4975(c)(1)(D)] makes it prohibited for IRA or 401(k) funds to be used to benefit their account owner or family, unless it’s a taxable distribution.

That’s translated into humanspeak. You can see the actual ruling here. Untranslated legal language in it says:

…Department opinions interpreting [regulations] have made clear that a prohibited transaction occurs when a plan invests in a corporation as part of an arrangement or understanding under which it is expected that the corporation will engage in a transaction with a party in interest (or disqualified person).

The ROBS Coffin Is Sealed

This issue is so straightforward because DOL ruled on it as a bigger issue. DOL has received countless letters that ask “But what if I structure my Corporation this way or that way… do I then successfully evade the rules and regulations?”

And they always respond, “No. Using Self-Directed IRA or 401(k) funds to benefit the account owner or their family is always prohibited unless it’s through a taxable distribution.”

Tip: Don’t Piss Off The Government

I know that’s kind of common knowledge, but I wonder if you notice from the DOL language—”Department opinions interpreting [regulations] have made it clear”—that they are already (in 2006) annoyed at all the clever attempts at evading the rules and regulations.

Not a whole lot of wiggle room here. Zero, to be exact.

I know, I know… it’s bitter medicine. Especially if you dreamed up an awesome future all provided to you by ROBS.

But it’s quite easy to swallow if you get real and refocus your attention on legal strategies that actually work.

Prohibited transactions is a chief topic when exploring self-directed IRA & Solo 401(k) investing. When a person first discovers that his retirement accounts have been chained to Wall Street brokerages without necessity, his mind starts to imagine the possibilities.

Real Estate? Yes.
Private Businesses? Sure.
Precious Metals? Absolutely.
Getting my hands on my retirement money now? Slow down there.

There are two types of limitations on the average retirement account. One is an unnecessary restriction of investment options to securities products. That can be eliminated through restructuring your accounts and funds. The second limitation is legal and cannot be removed.

Setting up a self-directed IRA or 401(k) is about removing limitations. Once you have it setup outside the nearly monopolistic network of securities dealers, you can invest in almost anything… but you must fully understand the legal limitations.

The general premise behind prohibited transaction rules is that the government wants you to grow your retirement account as big as possible because they plan to tax it later on when you distribute the funds to yourself for spending. Without prohibited transactions rules, anyone in their right mind would grow their retirement account and then make “losing investments” that actually put their retirement funds into their own hands.

For example, imagine you grow your IRA to $1 million and now you’re ready to get that money into your own hands so you can spend it. You could distribute it to yourself and pay ordinary income taxes on the distributions. Or you could invest it into your business that you personally own and operate. The latter could be an “investment” from the IRA. Once the money is in your business you could do whatever you want with it. And maybe your business doesn’t pay anything back to your IRA. Maybe it was a “losing investment” for your IRA. Taxes avoided. Woo hoo!

The only problem with the above scenario is that the real loser isn’t your IRA–it’s the government who didn’t collect distribution taxes because your IRA “lost” all its money. For this reason, the prohibited transaction rules make the above scenario illegal. The government made the PT rules to ensure that you don’t end up “losing” your retirement money. There are six PT rules. Four of the rules are commonly quoted, written about, and understood easily. The remaining two rules seem to elude or mystify most people, so let me bring clarity to the matter.

In order to be legally compliant, every retirement plan transaction must involve a genuine effort to benefit the retirement plan itself without benefiting the plan owner or his relatives. Let’s go ahead and knock out the most common strategies that are wrongly believed to successfully “get around” the rules:

Benefit Swapping

Joe & Frank are friends and each of them setup a self-directed IRA. Joe’s IRA loans $50,000 to Frank and Frank’s IRA loans $50,000 to Joe. This doesn’t break the 4 rules that are most focused on, but it does break the usually-ignored rules. For each loan transaction the borrower is not a “disqualified person” for the IRA to transact with, but the loan is a conflict of interest for the IRA owner because he expects to receive a loan back from the other person’s IRA. Because his decision to extend the loan from his IRA involves the expectation of a chain of events that is designed to benefit him personally, this is a prohibited transaction.

Another example would be if Joe’s IRA and Frank’s IRA each bought a vacation condo, and each IRA let the other person stay in the condo. Real estate is a popular investment for self-directed IRAs, but if an IRA owns real estate its owner (and his relatives) are not allowed to make personal use of the property, regardless of whether fair market rent is paid. If Joe vacationed in property owned by Frank’s IRA and Frank vacationed in property owned by Joe’s IRA, it would be a prohibited transaction. Just like the loan swapping, what makes it prohibited is the fact that when the IRA owner made the decision to enter into the transaction, he expected to receive a personal benefit as a result of the transaction. This applies to direct benefis and indirect benefits that come about as an expected chain of events.

Strawperson

Joe wants to sell his house, but he can’t find a buyer. His IRA has enough money in it to buy the house from Joe, but that would be a prohibited transaction because Joe is a disqualified person. So Joe arranges for his friend Frank to buy the house from him who will later sell the house to Joe’s IRA. Joe thinks he didn’t break any rules because Frank is not related to Joe and thus is not a disqualified person. In this scenario, in the eyes of the law Frank is a “strawperson”… a person who is not involved in the transaction for genuine reasons. Frank doesn’t really want to buy and then own Joe’s house. He is just entering into the transaction to add separation to the real transaction. The law removes the strawperson to examine the real transacting parties. In this case the real parties are Joe and his IRA. Effectively, Joe sold his house to his IRA. That is a prohibited transaction and it remains a prohibited transaction even with Frank the strawperson inserted into the chain of transactions.

The same strawperson strategy fails the test no matter how it is constructed. If Joe’s IRA loaned money to Frank and Frank subsequently loaned money to Joe, it would violate the PT rules.

The lesson

Setting up a self-directed IRA or Solo 401(k) brings your retirement funds to an unlimited investment platform in the sense that you can invest in virtually any type of asset. You will save yourself a lot of time and headache (and possibly tons of money) if you clearly understand the remaining limitation: you must invest solely to grow your retirement account without engaging in conflicts of interest.

Now that’s not so bad is it? The merits of whether the income tax is good for our country in the first place is a topic for another discussion. But within our current system, it’s not so much to ask that you avoid all conflicts of interest. Use your retirement account for its intended purpose–to grow massive wealth. There is a whole world of opportunities out there that don’t involve a potential conflict of interest!

I’ve written a comprehensive guide book on prohibited transactions. These will be available for sale soon for $39 + $5 shipping. I’m making 50 copies available completely free of charge on a first come first serve basis.

If you’d like one of these 50 free copies, please email your name & shipping address to:

specialoffer3 [at symbol] nabersgroup [dotcom]

This blog has been viewed over 20,000 times since April, so act fast 

### Update – October 3, 2008

We have shipped out all 50 free copies. Thanks for your interest. If you are one of the 50 to receive a free copy, please feel free to come back here and give us your feedback in the comments area below.

Click that link above to read the opinion in its entirety, but here’s my summary in its most basic form:

Your plan can partner with disqualified persons in certain situations, BUT there are many possibilities for a prohibited transaction in operating the partnership.

A prohibited transaction is when a retirement plan transacts with a disqualified person. The DOL Opinion says that co-investment/partnering is not, by itself, creating a transaction between the plan and disqualified person. The opinion goes on to say that there are many other actions that could then constitute a transaction between the two, and thus a prohibited transaction. Here are a couple of notable items:

1. A prohibited transaction would occur if the entity (such as an LLC) that the plan invests in was a disqualified person at the time of the investment.
2. If the co-investment is made, even if it is not a prohibited transaction, if the interests of the plan & its accountholder diverge (with respect to the partnership) at a later time, a prohibited transaction may occur if uncorrected.
3. If disqualified persons could not have participated in the proposed investment activity without the plan’s participation, then the inclusion of the plan’s funds would be a prohibited transaction.
4. If the co-investment is made, even if it is not a prohibited transaction, anything in the future (involved in the partnership’s operation) that would create a transaction between a plan and disqualified person would be a prohibited transaction. For instance, if the partnership needed additional capital at a later time, the plan and disqualified persons could not buy or sell membership units or stock to or from each other or the partnership itself in order to raise capital for the partnership.

Many self directed IRA/401k promoters regurgitate this opinion letter to say “yes, a retirement plan can partner with disqualified persons.” In reality, the answer is “yes, a retirement plan could possibly partner with disqualified persons under certain circumstances.”

All in all, I encourage investors to stay away from partnering their IRA with disqualified persons.