Exclusive Benefit Requirement:
A basic requirement of an IRA is that it be created or organized for the exclusive benefit of the IRA holder or his or her beneficiaries. IRC §408(a). Certain types of investments may violate this requirement so as to cause the IRA to lose its tax-favored status. For example, an IRA’s interest-free loan to a friend of the IRA holder to assist the friend might be a violation of this requirement.
The Department of Labor believes that the use of the participant contributions to repay loans to the participants raises concerns under sections 403 and 404 of ERISA. Section 403(c)(1) of ERISA provides, in part, that:
The assets of a plan shall never inure to the benefit of any employer and shall be held for the exclusive purposes of providing benefits to participants in the plan and their beneficiaries and defraying reasonable expenses of administering the plan.
ERISA section 404(a)(1)(A) provides, in part, that:
A fiduciary shall discharge his [or her] duties solely in the interest of the participants and their beneficiaries and (A) for the exclusive purpose of (i) providing benefits to participants and their beneficiaries; and (ii) defraying reasonable expenses of administering the plan expenses of administering the plan.
It is the view of the Department that when the primary benefit requirement is not met, then there would also be a violation of the “exclusive purpose” and “solely in the interest” requirements of sections 403 and 404 of ERISA.
An individual setting up a self-directed IRA that owns an LLC participates as the beneficiary of their individual IRA and as the manager of the LLC. Given that the LLC is a plan asset, the manager has fiduciary duties to the IRA owner.
Thus if the manager makes decisions about the assets based on any loyalties other than for the exclusive benefit of the beneficiary the Dept. of Labor might find a violation EVEN IF ALL OF THE PLAYERS ARE THE SAME PERSON!
For example, what if the client loans money to someone who is not technically a disqualified person but is a relative such as a sibling and the client gives the borrower a good deal (rather than a fair market value deal to the benefit of the beneficiary):
The “Sibling Loans” could be considered by either the Department of Labor (DOL) or the Internal Revenue Service (IRS) to constitute a self- dealing prohibited transaction under IRC § 497S( c)( 1)(D) or (E) or the Exclusive Benefit rule. Such a determination depends on the particular facts and circumstances of each situation, and hence is difficult to predict.
The concern is based in part upon several DOL Advisory Opinions, none of which directly address a situation involving Sibling or more distant relative loans. For example, DOL Advisory Opinion 93-33A held a real estate rental transaction between an IRA owner and a school founded by the IRA owner’s daughter to constitute a IRC § 4975(c)(I)(D) or (E) prohibited transaction. DOL Advisory Opinion 88-18A also addresses the same fiduciary conflict of interest concern (proposed S500k loan to a corporation in which IRA owner had a 46.04% interest in voting power of the corporation would “likely result” in a (c)(I)(D) or (E) violation). The point of these authorities is that it is a violation of the prohibited transaction rules of IRC § 4975(c)(1),(D) or (E) if the IRA owner is placed in a position where he or she cannot exercise the fiduciary responsibilities of undivided loyalty to that person’s IRA that each IRA owner owes.
One conclusion of my research is that the exclusive benefit rule is likely not violated if all loans to individuals (who are not disqualified persons) are made for substantiated / documented fair market value.