The Internal Revenue Code does not describe what a Self Directed IRA can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibits Disqualified Persons from engaging in certain type of transactions. The purpose of these rules is to encourage the use of IRAs for accumulation of retirement savings and to prohibit those in control of IRAs from taking advantage of the tax benefits for their personal account.
When it comes to using retirement funds to invest in a hedge fund, it is important to be mindful of the IRS prohibited transaction rules under Internal Revenue Code Section 4975. In general, the IRS has restricted certain transactions between the IRA and a “disqualified person”. The definition of a “disqualified person” (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the IRA holder, any ancestors or lineal descendants of the IRA holder (i.e. parents, children, spouse, daughter-in-law, or son-in-law), and entities in which the IRA holder or a disqualified person holds a controlling or management interest. Furthermore, Internal Revenue Code Section 4975(c)(1)(D) and (E) outlines rules that relate to self-dealing or conflict of interest transactions that involves an investment that could directly or indirectly personally benefit a disqualified person. The self-dealing or conflict of interest prohibited transaction rules have the broadest application especially when it comes to hedge fund type investments.
A hedge fund is an alternative investment vehicle available only to sophisticated investors, such as institutions and individuals with significant assets. In general, retirement funds are permitted to invest in hedge funds. The prohibited transactions rules tend to become more of an issue when the person using the IRA funds or any disqualified person related to the IRA owner has a personal interest or relationship with the hedge fund investment. In other words, an IRA can generally make an investment into a hedge fund in which neither the IRA holder nor any disqualified person has any personal ownership or relationship with. The issues begin to arise from an IRS prohibited transaction standpoint when the IRA owner wishes to use retirement funds to invest in a hedge fund where her or she or a disqualified person is either an owner, employee or, in some cases, has a professional relationship with the fund in question.
In general, if structured correctly, there may be a way for one to use their retirement funds to invest in a hedge fund that one is personally involved in. The key is to make sure that the IRA investment into the hedge fund will not directly or indirectly personally benefit the IRA owners since that type of investment would likely trigger a prohibited transaction.
Generally, hedge funds are structured as limited partnerships or LLCs. In the case of a limited partnership, a general partner (“GP”) is created that tends to perform all the hedge fund management tasks. The GP generally owns a small percentage of the partnership. The investors are limited partners (“LP”) of the partnership. A typical fee structure for a hedge fund is the 2 and 20 model, which means the hedge fund manager will take a 2% management fee of all assets under management and then take 20% of the profits generated by the fund after the LP investors have received their money they invested back and, in some cases, a preferred return on the money invested is also returned to the investor.
A popular question is whether an individual who is a principal or in a management position with the hedge fund can use their retirement funds to invest in the fund. To begin with, the use of the retirement funds cannot be invested into the GP entity since that is the entity where the services are generally being performed on behalf of the hedge fund and where the management fee and carried interest are typically being directed as investing IRA funds into a company where the IRA holder has a personal ownership or is performing services as an employee would likely violate the IRS prohibited transaction rules. Therefore, the question then becomes can the IRA holder who has some personal ownership in the hedge fund use retirement funds to invest as an LP of the fund? The answer generally depends on the facts and circumstances involved in the transaction. However, in general, there are ways that one can properly structure an investment of retirement funds into a hedge fund in which the IRA holder has some personal interest. The main question that needs to be asked and answered positively is if the IRS looked at the transaction, could they argue that the IRA owner has in any way directly or indirectly personally benefited by the IRA investment. If the IRA owner cannot prove that he or she did not receive any direct or indirect personal benefit from the IRA investment into the hedge fund, then the IRS would likely argue that the investment triggered a prohibited transaction. Since the onus is always on the taxpayer to disprove a claim made by the IRS, it is crucial that the IRA owner that is seeking to make a retirement investment into a hedge fund in which he or she has some personal connection to be extremely confident that he or she can prove, if requested, that no personal benefit was derived from the retirement account investment, either directly or indirectly. Accordingly, when it comes to using retirement funds to make investments into a hedge fund in which the IRA owner has a personal relationship with, issues such as the management fee and carried interests are items that need to be taken into account when structuring the self-directed IRA hedge fund investment.
The Tax Court in Rollins v. Commissioner, a 2008 Tax Court case, offers some insight as to how the IRS looks at transactions that involve investments into entity’s where the IRA owner has a small ownership interest in. Even though the Rollins case not involve using retirement funds to invest in a hedge fund, it nevertheless offers some insight as to the IRS thoughts on the application of the IRA self-dealing and conflict of interest rules. The Rollins case is especially helpful in examining how the IRS could look at a transaction involving the use of retirement funds into a hedge fund in which the IRA owner has some personal relationship or ownership interest. Mr. Rollins was a CPA who had an ownership in several companies. One of the companies, in which he owned less than 10%, served as a director, but received no compensation, was in financial trouble and needed additional funds. Mr. Rollins decided to use his 401(k) plan funds to lend the company money at prevailing interest rates. The IRS audited the transaction and argued that the loan from Mr. Rollins 401(k) plan to the company was a prohibited transaction as the loan personally benefited him. The Tax Court agreed and basically stated that even though the company was not itself a disqualified person because Mr. Rollins owned less than 50% of the company, nonetheless he could not provide that he did not directly or indirectly personally benefit from the loan made to the company by his 401(k) plan. Clearly the Tax Court felt that Mr. Rollins personally benefited from the loan since without the loan his personal investment would have been lost. The Rollins case is a good illustration as to how the IRS could view an investment into a hedge fund by an IRA owner who has some personal interest in the hedge fund below the 50% ownership threshold.
Below are several examples that highlight the complexities involved in structuring an investment of retirement funds into a hedge fund in which the IRA owner has some personal relationship or ownership.
1. Joe is looking to start a hedge fund and needs $100,000 to begin operations. The hedge fund would be a limited partnership and Joe would be charging a traditional 2% management fee and 20% carried interest on fund profits. Joe will own 100% of the general partner of the hedge fund and is looking for investors to invest in the hedge fund. Joe wishes to use his IRA funds to invest in his hedge fund.
Issues for Joe to consider: Joe would clearly not be able to use his IRA funds to invest in the general partner since he will own 100% of that entity personally and that would likely trigger a prohibited transaction. What if Joe wanted to invest the funds as a limited partner of the fund? Unfortunately, there is no clear answer to this question as the answer is generally dependent on the facts and circumstances involved in the transaction. For example, if the only way Joe could attract investors to the fund is to show he also has invested in the fund and the only funds he had available to invest were IRA funds, the IRS could argue that the use of his IRA funds would personally benefit him since without his IRA funds being used he would not be able to attract investors to his fund and derive a personal financial return from owning the fund.
2. Ben is a 2% partner at a hedge fund that has $500 million under management. The hedge fund is set-up as a limited partnership. The hedge fund has a traditional fee model of 2% management fee and 20% carried interest. The hedge fund is looking to raise an additional $250 million and Ben is seeking to use $250,000 from his IRA to invest as a limited partner of the fund. His limited partnership interest would be 2.5% of the total fund.
Issues for Ben to consider: Ben is clearly a disqualified person because he is the IRA holder, but the hedge fund he is a partner at would likely not be since he owns just 2% of the fund, pursuant to Internal Revenue Code Section 4975(e)(2). However, the self-dealing or conflict of interest rules under Internal Revenue Code Section 4975(c)(1)(D) and (E) could treat Ben’s investment into the fund as a prohibited transaction. The question Ben must ask himself is whether he would receive any personal benefit, either directly or indirectly, from making the fund investment with his IRA funds. For example, would the fund be in financial trouble without Ben’s investment? Will Ben receive a salary bonus if he invests in the fund? Or what if, Ben is required to invest in the fund in order to maintain his position as partner of the fund? These are some of the facts that would need to be examined before determining whether Ben’s investment would rise to the level of a prohibited transaction.
3. Steve is a 99% owner of hedge fund A, which has over $750 million in assets under management. The hedge fund is set-up as a limited partnership. The hedge fund has a traditional fee model of 2% management fee and 20% carried interest. The hedge fund is looking to create fund B, which will be exclusively investing in a pool of loans. Fund B will be looking to raise $500 million from outside investors. Steve and a number of hedge fund A executives want to invest their retirement funds into fund B, but expect to own less than 5% of fund B. Fund A will be charging a management fee and carried interest on the limited partners of fund B.
Issues for Steve to consider: Since Steve owns 99% of hedge fund A and hedge fund A will be receiving a fee from the limited partners of fund B, a management fee and carried interest allocated to Steve’s IRA and potentially his executives could violate the prohibited transaction rules under Internal Revenue Code Section 4975. Fees paid by Steve’s IRA to a company he owns 99% of could be considered a prohibited transaction. What if Steve and his executives were able to have their IRAs exempted from the management fee and carried interest going to the general partner of fund A or were able to buy a different membership class of fund B, which did not have to pay any fees to hedge fund A. Because of Steve’s large ownership interest in hedge fund A, it is especially important that he focuses on the self-dealing and conflict of interest prohibited transaction rules to make sure his IRA investment into fund B could not be viewed as personally benefiting him directly or indirectly.
Unrelated Business Taxable Income
After examining the IRS prohibited transaction rules in order to determine whether an IRA investment into a hedge fund could be made, another set of IRS rules must be reviewed in order to verify whether a tax would be imposed on the income allocated to the IRA from the hedge fund investment.
In general, when it comes to using a Self Directed IRA to make investments most investments are exempt from federal income tax. This is because an IRA is exempt from tax pursuant to Internal Revenue Code 408 and Section 512 of the Internal Revenue Codes exempt most forms of investment income generated by an IRA from taxation. However, in the case of the use of margin, nonrecourse debt, or income generated from an active trade or business conducted via an LLC or partnership, a tax would be imposed on a percentage of the income generated. These rules have become known as the Unrelated Business Taxable Income rules or UBTI or UBIT. If the UBTI rules are triggered, the income generated from that activities will generally be subject to close to a 40% tax for 2017. The UBTI generally applies to the taxable income of “any unrelated trade or business…regularly carried on” by an organization subject to the tax. The regulations separately treat three aspects of the quoted words—“trade or business,” “regularly carried on,” and “unrelated.” In the case of an IRA, all active business activities will be treated as unrelated.
So why have I never heard of these rules before? The reason is that since most Americans with retirement funds invest in publicly traded stocks or mutual funds, which are often structured as a “C” Corporation, an entity subject to tax. A “C” corporation is also known as a blocker corporation. Unlike an LLC, which is treated as a passthrough entity, income from a “C” Corporation is blocked or stays in the “C” Corporation and does not flow to the shareholder. Whereas, income from an LLC passthrough the to the member/owner of the LLC – there is no entity tax with an LLC or partnership. Hence, any income allocated to an IRA via an LLC or pasthrough entity would not be subject to an entity level tax and could be subject to the UBTI tax if the LLC was engaged in an active trade or business or margin or debt was used by the LLC. In other words, if one buys stock of a “C” corporation with a retirement account, the UBTI tax rules would not apply. Whereas, if one purchased an interest in a passthrough entity, such as an LLC, with IRA funds and the LLC was engaged in an active trade or business, used margin, or acquired debt, then the income allocated to the IRA could be subject to the UBTI tax.
In the case of an IRA investment into a hedge fund, if the hedge funds activities rise to the level of a trade or business, or if margin or debt is used in the hedge funds trading activities, then even though the investment may not violate the IRS prohibited transaction rules, the income could be subject to the UBTI tax rules. Since most hedge funds are structured as passthrough entities, gaining a solid understanding of the UBTI tax rules is extremely important.
Using retirement funds to invest in a hedge fund is not on its face a prohibited transaction, however, when the IRA owner has some personal involvement with the hedge fund, the IRS prohibited transaction rules must be closely examined to make sure the investment would not trigger a prohibited transaction.
The tax professionals and CPAs of the IRA Financial Trust Company have helped hundreds of hedge fund investors use their retirement funds to make hedge fund related investments, including in their own funds, and have significant experience in this area.