Margin Investments

[Guest Derelict]

See PLR 8708031. The IRS appears to draw a distinction between borrowing money and buying on margin.

There are other rulings out there, and I do not pretend to be up to date on the issues.

My advice to pax is that if you are not willing to research the UBTI issues, don't do it.

I can't seem to find this PLR 8708031 anywhere, can someone provide a link or post it?

It would be greatly appreciated. I'm looking for instances in which proves that margin in an IRA isn't prohibited by the code so any other PLR's/Court Rulings would help too.

Thanks,

-D

[Kirk Maldonado]

Here are the holdings of PLR 8708031 (this is all that I have):

In summary, based on the information submitted, we rule as follows:

1. Provided that no funds are borrowed to finance the acquisition of the index futures and index stocks as described above, the income realized from the two legs of the arbitrage transactions will be excluded from UBTI under section 512(b)(5)of the Code.

2. Amounts deposited with a broker or other similar person as "margins" to secure your performance under an index futures contract will not constitute "acquisition indebtedness" under section 514©(1) of the Code, but rather are in the nature of a security deposit.

3. Whether or not amounts are borrowed to obtain the margin deposit for index futures, the index futures contract will not constitute debt-financed property under section 514(b)(1).

4. Because the index futures contract has no basis, your potential liability with regard to the performance of the contract will not enter into the computation of average adjusted basis for purposes of section 514 of the Code and the regulations thereunder. In addition, the cost of the short term securities acquired with the proceeds of your sale of index stocks will not enter into the computation of adjusted basis under section 514. Instead, the debt/basis percentage described in section 514(a)(1) will be based solely on the ratio of your average acquisition indebtedness with respect to the debt- financed index stocks to the average adjusted basis of the stocks.

5. In a fully hedged arbitrage position beginning with an overvalued contract, if the purchase of index stocks is financed with acquisition indebtedness, and if there ia gain on the index stocks in closing out the arbitrage, in computing UBTI included under section 514(a)(1) and (2) of the Code, such gain shall be offset by the loss realized on the index futures leg of the position, even though the index futures contract is not debt-financed property. Similarly, if instead there is gain on the index futures leg of the position and lose on the index stocks leg, in computing your UBTI from the arbitrage, the loss realized on the index stocks leg of the position shall only be allowed to the extent of the gain on the index futures leg of the position. Remaining gain shall be excluded from UBTI under section 512(b)(5) of the Code.

[Jon Chambers]

I concur except to note that a person is only a fiduciary under ERISA to the extent that they perform a fiduciary function under Section 3(21(A). Advisors have duty to determine if a party is a fiduciary under the law and this requires a review of the operative documents and fiduciary status cannot be based on a title such as trustee.

You may be interested in the recent (Friday) FAB from EBSA:

Federal regulators on Friday formally declared that directed trustees under the Employee Retirement Income Security Act (ERISA) are to be considered fiduciaries and are required to act prudently. The pronouncement came from the US Department of Labor's Employee Benefits Security Administration (EBSA), which released Field Assistance Bulletin (FAB) 2004-03. As they did in a legal brief filed in the Enron case, DOL officials said in the document released Friday that a directed trustee not only must carry out its duties prudently, they also must act solely in the interest of the participants and beneficiaries of employee benefit plans. The FAB did note, however, that a directed trustee may rely on the representations of the directing fiduciary unless the directed trustee knows that the representations are false. It also said that directed trustees do not have an independent obligation to determine the prudence of every transaction, nor do they have an obligation to duplicate or second-guess the work of the plan fiduciaries that have discretionary authority over the management of plan assets - though exceptions were noted in circumstances where the directed trustee had knowledge of "material non-public information." MORE at http://newsmail.plansponsor.com/cgi-bin1/D...bU10FkB0GL2N0A7 .

[jquazza]

Mbozek,

a Trustee has control over the plan assets and that makes him a fiduciary. Whether it excercises that control at the direction of another fiduciary is irrelevant. The article from the DOL published last week makes it very clear.

[mbozek]

I dont see what is significant about this notice which does not change the liabillty of the trustee who acts at the direction of a Fid. Directed trustees can require a representation from the fiduciary that the instructions are in accordance with the plan and ERISA before taking action and be indemnified for liability in acting on the instructions. The trustee is not required to perform an independent investigation of the proposed instructions or review the decisions of the plan fids.

But what is the difference between the fiduciary responsibility of a custodian and a directed trustee under ERISA?

[Jon Chambers]

In general, a custodian is not a "fiduciary" (although they may conduct themselves in a manner that makes them a fiduciary. A directed trustee is a fiduciary (albeit, with limits on their fiduciary duties). This is one of the key reasons why we generally recommend that our retirement plan clients engage a directed trustee rather than a custodian. At least historically, the cost for directed trustee services has tended to be quite low.

[mbozek]

I think that your definiton of a directed trustee and custodian is useless and confusing since it bases the difference on a conclusion, not on an analysis of the duties assumed. Under ERISA a fiducary is any person who performs a fiduciary function e.g., administers the plan, regardless of the designation. As I see it neither a custodian or a directed trustee has discretion to act without instructions from a fiduciary.

[Jon Chambers]

I guess I don't see this as all that confusing. If you are a fiduciary, you are subject to fiduciary standards. The ERISA fiduciary responsibility legal standard has been described as "the highest known to the law." [Donovan v. Bierwirth, 680 F.2d 263, 272 (2d Cit. 1982)] . If you are not a fiduciary (i.e., if you are a custodian), you are not subject to fiduciary standards. If you are a fiduciary, you can have co-fiduciary duties. If you are not a fiduciary, you don't generally have co-fiduciary duties.

Certainly a directed trustee, like a custodian, needs to take proper direction from another plan fiduciary. But since a directed trustee is a fiduciary, the directed trustee must take reasonable steps to ensure that the direction is proper (i.e., in accordance with the terms of the Plan, does not contravene ERISA, is not a prohibited transaction, etc.) If the directed trustee merely rubber stamps and executes the fiduciary's direction, they may be breaching their fiduciary duty to the Plan.

As you note, directed trustees can require a representation from the directing fiduciary that the directive is proper, and can seek indemnification from the directing fiduciary. These are reasonable steps. However, they don't eliminate the directed trustee's fiduciary liability, they merely manage it. I've been involved in litigation where a directed trustee took no steps to ensure a directive was proper, and consequently, faced liability for executing an imprudent directive. I doubt that they would have faced liability had they been serving in merely a custodial capacity.

Finally, in my opinion, it is "useful" to the plan sponsor to have a directed trustee serving in a fiduciary capacity, vs. a custodian in a non-fiduciary capacity. Of course, this is a judgment call on which reasonable people can disagree.

[mbozek]

Where does ERISA make a directed trustee a fiduicary by accepting the appointment to be subject to the direction of a fid? Under the DOL notice if the directed trustee relies on the reps of the fid that the direction is in accordance with plan terms and has no knowlegde that the reps are false then the DT has no fid liability which makes the DT's position no different than a custodian. I dont understand the relevance of the case you refer to since the DOL notice you cite states that a directed trustee has no independent duty to determine the prudence of transactions or duplicate or second guess the work of plan fids who have discretonary authority over plan assets. If the DT gets reps from the fid that the direction is in accordance with plan terms and not contrary to ERISA and has no duty to look behind the transaction how is there fid liability to the DT for following the direction of the fid? If as you claim, the DT is a fid in following the directions of a fiduciary then why be a DT because you have the same liability as the fid even though you are following the direction of a fid under ERISA and relying on their judgment?

[Jon Chambers]

ERISA makes ALL trustees fiduciaries by definition. We already established that (see 29CFR Sec. 2509.75-8). As Kirk and others noted, being a fiduciary does not mean that you have fiduciary responsibility for all plan functions, although you may have co-fiduciary duties, depending on the terms of your contract, etc.

We agree on the ability of the DT to reasonably rely on a representation from the fiduciary prior to executing a trade. The point that you didn't address was DT liability when the directing fiduciary has not made a representation. Further, under certain circumstances, the FAB notes that it may not be acceptable for the DT to rely on the fiduciary's representation. For example, the FAB provides that a directed trustee may have to question directions involving the purchase or holding of a security where there are "clear and compelling public indicators" that call into question the issuer’s viability as a going concern.

Which is exactly my point. A DT has different duties from a custodian, because a DT is a fiduciary (albeit, a limited fiduciary) while a custodian is not. Your question "Why be a DT?" is a good one. But since there are DT's in the market, I believe that my advice to clients ("Hire a DT, not a custodian") continues to be good advice.

[Kirk Maldonado]

I agree with Jon's remarks.

I think that because of their increased exposure to liability, the disparity between the fees charged by a discretionary trustee and those charged by a directed trustee will dimish. However, directed trustees don't have unlimited ability to raise their fees, because if the difference isn't that much, clients will choose a discretionary trustee to be able to shift more responsibility and potential liability to the trustee.

[BeckyMiller]

I am not entering into this fiduciary discussion. That is just too scary for a lowly little accountant like me.

I just wanted to note that if you have the CCH tax service on-line. You can get the letter ruling at http://tax.cchgroup.com/network&JA=LK&fNoS...=L&fNoLFN=TRUE&.

If you really want it and can't get it from CCH or a comparable service, e-mail me.

[mbozek]

On Feb 1, a federal judge granted summary judgment dismissing the fiduciary claims against Merrill Lynch, the directed trustee of the WorldCom 401k plan which invested in world com stock. The ct held that ML was not the fiduciary who made investment decisions regarding company stock. The ct's dismissal relied on the recent DOL bulletin on directed trustees obligations under ERISA. The World Com case was the first case to be decided in which employees tried to hold a directed trustee liable for investing in employer stock.

[CaptainObvious]

Disclaimers: I am not a lawyer, or any kind of financial expert. I am just sharing my possibly incorrect layman's understanding in the hopes that it will give others ideas to research from more authorative sources.

In a minor update to this decade old threat, I'd like a mention a more recent possibly relevant Internal Revenue Service private letter ruling, 201434024, dated May 29, 2014, released August 22, 2014, at http://www.irs.gov/pub/irs-wd/201434024.pdf, that seems to indicate that short selling stock in a trust's margin account does not itself generate UDFI tax, even if the temporarily increased cash position created from initiating the short is used to buy more stock.

One warning to keep in mind is that this private letter ruling was issued about a charitable remainder trust rather than a qualified retirement plan.

Anyhow, it seems to me that this is an example of use of a legiatimate use margin in a trust account that apparently would not generate UDFI tax.

Excerpts from pages 5-6:

"In Rev. Rul. 95-8, supra, we ruled that a short sale does not create an indebtedness for purposes of § 514 because it constitutes the borrowing of property rather than money. Rev. Rul. 95-8, supra, relies on Deputy v. duPont, 308 U.S. 488, in which the Supreme Court held that a borrowing of property does not give rise to "indebtedness." The taxpayer borrowed stock and argued that payments made to the lender constituted interest. The court held that although the taxpayer had an obligation to the lender, such obligation was not an "indebtedness," because an indebtedness arises only with respect to the borrowing of money, not the borrowing of property."

[...]

"Rulings:
1. The borrowing of stocks by a fund in entering into short positions will not result in "acquisition indebtedness" as defined in§ 514( c) so that none of the distributive share of a fund's income or gain which is derived from the fund's trading activities, to the extent attributable to the foregoing transactions, will be treated as "debt-financed property" as defined in§ 514(b).
2. The purchase of long positions in stocks in accounts at one or more affiliates of a broker using, in whole or in part, cash proceeds from short sales made through a fund's accounts at one or more affiliates of that same broker will not result in "acquisition indebtedness" as defined in § 514© so that none of the distributive share of a fund's income or gain which is derived from the fund's trading activities, to the extent attributable to the foregoing transactions, will be treated as "debt-financed property" as defined in § 514(b).
3. The use of long positions in stocks, including some or all of those purchased with short sale proceeds, as collateral to secure the performance by a fund of its obligations to deliver stock to the broker to cover its open short positions will not result in "acquisition indebtedness" as defined in§ 514© so that none of the distributive share of a fund's income or gain which is derived from the fund's trading activities, to the extent attributable to the foregoing transactions, will be treated as "debt-financed property" as defined in § 514(b).
"