*** This is Part 3 of a series about the dangers of letting an administrator act as custodian. Make sure you read Part 1 and Part 2 first to make sense of this post. ***

The illegitimate custodian test

Ask “Who should the check be payable to for the rollover contribution or transfer?”

Ask “If my IRA buys real estate and rents it out, to whom should the tenant make the rent checks payable?”

Ask “If my IRA owns real estate that needs repairs, who issues and signs the check to the repairmen?”

These questions will tell you who is actually serving as custodian. For instance, if you live in TX and unregulated company Dotrust is marketing its self-directed IRA services to you, the answer to one or more of the questions above will probably be something like Dotrust of Texas, Inc. If this is the case, ask to see its bank or trust charter – if it is an illegitimate custodian it won’t have one, and it will insist that another bank is technically the custodian. It not only matters who’s the custodian on the paperwork is; but it also matters who is acting as custodian as uncovered by the answers to the 3 questions above.

Why would somebody operate an illegitimate custodian company?

First of all, if it’s a franchise operation, the franchisee might not even know that he or she is part of an illegitimate IRA custodian scheme. Secondly, there can be a lot of profit to be made in an illegitimate IRA custodian scheme. The company can earn interest off of your IRA funds, and it may pass only some (or even none) of that interest earned on to you. It may also be able to earn higher interest rates when it collectively has custody of hundreds of millions of dollars in funds.

Surprised?

You may be thinking “This sounds like a company I’ve run into. But it promotes and and advertises and has been in the business for decades… it can’t be illegitimate, can it????”

Many high-profile schemes have been shut down. The private annuity trust scheme was promoted for over a decade before the IRS shut it down. Additionally, being in business for decades doesn’t guarantee that business is legitimate. Look at Bernie Madoff.

Madoff may be a harsh comparison. Those involved in an illegitimate IRA custodian scheme may not be knowingly harming anyone. They may even be attorneys or CPAs. They may believe they’ve merely created a loophole for themselves with the “stepped transaction” arrangement. They may be good people. But the bottom line is that there are significant risks you take in using their services, and you will pay the consequences if uncovered by the authorities. In my opinion, it never makes sense to use an illegitimate custodian because there are dozens of regulated/legitimate self-directed IRA custodians out there. There should be a balance between risk and reward. There is significant risk of using an unregulated/illegitimate custodian, and it offers no unique reward that isn’t offered by other self-directed IRA custodians.

Confused? If you have a self-directed IRA or are thinking of opening one at a custodian company, perform the illegitimate custodian test as described above.

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*** This is Part 2 of a series about the dangers of letting an administrator act as custodian. Make sure you read Part 1 first to make sense of this post. ***

Signs that your custodian may not really be a custodian

1. They sometimes call themselves an administrator. “Administrator” is an accurate label for any company who provides record keeping services. Being an “administrator” doesn’t require any regulation. These types of companies may expand their services to include asset custody without actually registering as a bank or trust company.
2. Their name contains the word “trust” attached to other letters or words. A legitimate custodian usually has the word “bank” or “trust” as a separate word included in its name. In most states, the word “trust” is a restricted word for naming companies – just like the word “bank”. This means that you can’t start a company called “ABC Bank” unless it’s registered as a bank. You also can’t start a company called “XYZ Trust Company” without being a registered trust company. An illegitimate custodian might get around this by calling themselves Trustus rather than Trust Us, Dotrust rather than Do Trust, or Safetrust rather than Safe Trust. You see, if trust is attached to another word instead of used as a separate word, then it sneakily gets around the naming restrictions.
3. They have dozens of offices all around the country. Expanding to dozens of cities across the country can get expensive for a regulated custodian. The self-directed IRA custodian business isn’t nearly as profitable as the securities business, and most legitimate custodians must operate only one or two offices in order to be able offer their services for reasonable and competitive fees.
4. They sell franchises. Franchises can be a powerful and leveraged way to build a brand, but for the IRA custodian business it is nearly impossible to expand a legitimate custodian business through franchising. If a legitimate custodian had 40 offices across the country, its overhead would be so high that its fees would be much higher than the next most expensive competitor and its services would have nothing to offer to justify the higher fees. In reality, it appears that only illegitimate custodians are able to run franchise operations, and this is made possible by not having to deal with the regulatory costs of having dozens of audited and regulated offices.
5. They hire a real bank or trust company to be the custodian, but then they fulfill custodial duties themselves. In the legal world, there is a concept known as “stepped transactions” or the use of a “strawperson”. This is basically where a step is added to a transaction to include a person or company, and this inclusion is only involved to circumvent a law. For instance a self-directed IRA can’t buy or sell assets to or from its accountholder or its family members. So let’s imagine a guy named Joe wants to sell his personal residence to his IRA – which would normally be a prohibited transaction. In an attempt to get around this prohibition, he sells his home to his friend Randy, who then sells the house to Joe’s IRA. This would easily be deemed a “stepped transaction” because Randy did not really want to buy the house; he was just trying to disconnect the real parties from transacting (Joe and his IRA) directly so that it would appear to not break any laws. This same concept can be seen with IRA custodians. An administrator may want to serve as a custodian without being a bank or trust company. So it hires a bank to serve as custodian on the paperwork. Then it gets the bank to outsource custody-related tasks (holding and controlling assets) right back to it. In this scenario, the bank is a “strawperson” and the arrangement is similar to a “stepped transaction”. To understand the legal ramification of what’s really going on, you must remove the step/strawperson. In this scenario, what’s really happening is that a non-custodian is serving as the custodian, and it is illegitimate.
6. They are opposed to the “checkbook control” IRA LLC strategy. Illegitimate custodians primarily profit by earning interest on the funds of others (like a bank) without registering themselves as a bank or trust company. In an IRA LLC structure, most of the IRA funds are invested into an LLC where the IRA/LLC accountholder puts them at any bank of their choosing – where the LLC will earn the interest on the funds. This undermines the primary goal for the illegitimate custodian (earning interest on your funds) so it usually discourages (or even disallows) you to use the IRA LLC strategy.

Coming up in Part 3 of this series: How to tell if your custodian is compliant using the illegitimate custodian test.

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To have a self-directed IRA, unlike a Solo 401k, you must have a self-directed IRA custodian… and you should stay away from unregulated companies masquerading as a custodian. A self-directed IRA custodian is one that will have less investment restrictions than the more common tradition stocks/bonds/funds brokerage-type custodian, and they usually allow investment into real estate, private companies, and other alternative assets.

An IRA is technically a trust, and a custodian is basically a trustee who performs fewer duties than a trustee usually would. As the name suggests, the sole duty is custody-holding assets and/or property on behalf of the trust.

The Internal Revenue Code says that the IRA custodian role can only be served by:

1. A bank
2. A trust company (this is the most common type of company to serve as self directed IRA custodian)
3. A company specially & specifically approved by the IRS (this is very rare)

So, essentially, in the self directed IRA market, most custodians are chartered as trust companies. A trust company is basically a bank that doesn’t lend money. Trust companies are usually audited and regulated by the same state or federal agencies that audit and regulate banks. There are a couple dozen trust companies who offer custodial services for self-directed IRAs. There is also at least one company that offers custodian services without being chartered as a bank or trust company.

The risks of hiring an illegitimate custodian

• Little to no regulation. Banks and trust companies are audited and regulated by state or federal regulators.
• Risk of failure or fraud – Unregulated companies have nothing to lose. Starting and maintaining a bank or trust company is costly. A regulated bank or trust company is usually not going to misappropriate funds or just disappear overnight. This is because it has a lot to lose: the money it took to start and maintain the company and the future profits it will enjoy if it plays by the rules and stays in business.
• Risk of failure or fraud – Unregulated companies have no minimum net worth requirements to be in business. Starting a bank or a trust company requires the owners to meet minimum net worth requirements and have a clean criminal record. An unregulated company has no such requirements – there is no capitalization requirement in most states to just register a corporation or LLC. People operating an illegitimate custodian company have gone through no regulatory approval process. They could have declared bankruptcy recently, have felony convictions, and have a net worth of less than zero dollars.
• Your IRA might be deemed to have been taxably distributed when you hired the illegitimate custodian. Because the law defines an IRA as a trust held at a trust company, one held at an illegitimate custodian is technically not an IRA at all. When you rollover your old IRA, the funds must arrive at a real custodian within 60 days. If that doesn’t happen, you owe income taxes (and possibly early distribution penalties if under age 59 1/2 at that time) on the account balance. Putting the funds at an illegitimate custodian for more than 60 days means you’ve technically distributed your IRA. If this isn’t dealt with for several years, you may be racking up interest to the IRS in addition to the taxes. As salt in the wound, the funds left over will not have any tax favorable treatment for future profits.

Coming up in Part 2 of this series: Signs that your custodian may not really be a custodian.

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• Enron
• WorldCom
• Tyco
• Subprime mortgage crisis
• Mutual fund mortgage overexposure and misreporting
• Fannie Mae & Freddie Mac accounting scandals
• Insolvency of Investment Bank Bear Stearns

…most Americans are running low on trust when it comes to financial service companies. Who can you trust?

This is an especially important question in light of my recent post about misinformation in the self directed IRA community. My answer: yourself. That is what self directed investing is all about. You have control of your assets.

With the checkbook control provided by an IRA LLC, there is no potential for fraud unless your IRA rollover is handled by someone other than a bank or trust company (aka custodian). With a Solo 401(k) you don’t even have to transfer your assets through a custodian in the first place.

Q: What should I be concerned about?

A: Prohibited transactions and tax compliance, although it is simple to address both concerns. You can search Google for “self directed IRA prohibited transactions” and “IRA UBIT tax” to learn about the basics of both topics. If a service provider claims something that doesn’t jive with your basic understanding of these core topics, that should throw up a red flag. Claims such as “your IRA can loan money to you or your company” and “your IRA can own a company that does business with you or your company” should clearly create some concerns for compliance with self dealing rules.

Good questions to ask a service provider include:

1. Are your plan documents IRS Prototypes? If yes, this means that their plan documents (for qualified plans such as a 401k) are essentially determined to meet the requirements of being a qualified plan as detailed in a blanket IRS determination letter that can be provided to you. If their answer is “no” and their plans are also not “mass submitter” documents, then there may be reason for concern.
2. Are your entity documents attorney drafted and supported? Entity documents, such as the Operating Agreement of a Special Purpose LLC, need to be regularly updated by an attorney to reflect the evolving viewpoint of the IRS and DOL. Many IRA LLC facilitators are simply reusing (without authorization) documents they purchased, but are unable to afford the legal support required to keep their services as compliant as possible. This type of intellectual property infringement can either decrease the price of the service or increase the profit margin (depending on how the unscrupulous service provider looks at it), but neither are a good deal for the individual investor who would pay the consequences in the case of legal or tax noncompliance.

Finding a company that answers the above questions favorably means that your checkbook control structure should be legitimate and compliant. This direct control eliminates potential fraud or mishandling of funds because you aren’t going to defraud yourself. This scenario may actually be able to improve your overall investment strategy. For example, my company does not accept or handle deposits or assets of any kind. For this reason, we don’t have to pass banking regulatory costs on to our customers. If it were reasonable to say that chartering a bank or trust company costs $2 million, we are excited to say that our first $2 million of reinvestable revenue can be directed towards the development of tools to help the investor rather than to protect the investor from us mishandling their funds. If maintaining a bank or trust company costs $500,000 per year in regulatory fees, that’s $500,000 of further reinvestment into tools & new services… or savings for us to pass on to our customers through lower fees.

Because the risk of prohibited transactions and fiduciaries issues are the same with or without checkbook control, the peace of mind that checkbook control offers is certainly worth a premium. The fact that it offers that peace of mind and savings (instead of a premium) is what I believe will turn this investment strategy into something that is feasible for average people.

Taking direct control of your wealth is an exciting alternative to riding the economic roller coaster, and it removes the need for you to become comfortable placing your assets into the hands of yet another smiling guy in a suit. Trust yourself.