Personal Guaranty Creates Prohibited Transaction?

[Guest tschotland]

Hello,

I am trying to open futures trading accounts for my IRA and profit sharing plan (single participant plan) so that they may be traded by CTAs. The brokerage says I must sign a personal guaranty on the accounts. I am concerned that this may create a prohibited transaction. The brokerage claims thousands of people have signed them. Is there an issue here? I'd appreciate any insight.

I am cross-posting this to the Investment board. I don't find a board on defined contribution plans.

Thanks,

Tom

[vebaguru]

You posted this on IRAs and Roth IRAs, leading me to believe that there are more issues than a personal guarantee:

1. What is the effect of a prohibited transaction on an IRA or a Roth IRA? Plan disqualification and immediate taxation (including penalties for premature distributions).

2. I have seen previous rulings where lending a qualified plan one's credit worthiness may be deemed a prohibited transaction.

3. Would you be doing any leveraging? While leveraging such trades is common, it creates a separate set of problems. Similar to PTs, the penalty for debt-financed unrelated business taxable income is plan disqualification.

4. When is a guarantee by the IRA holder a "personal" guarantee when the account is denominated an IRA account? My answer is that when the purpose of the guarantee is to bypass creditors and bankruptcy laws and give the brokerage firm a superior claim priority in the event of a problem.

If it were me and I was hell-bent on doing the futures trading (rather than purchasing a futures trading fund, for example), I would find another brokerage firm to deal with that did not make me go out on a limb legally to open an account with them.

[Guest mjb]

Because futures trading can have opened ended liability on trades, the broker must have a solvent party in addition to the IRA who can guarantee the payment for the amount of the futures purchased. Otherwise the broker is stuck with having to use its own funds to complete the trade if the IRA doesn have sufficient funds.

[Guest tschotland]

Hi Vebaguru,

Thanks for your reply. Can you give me a citation for the rulings on how lending a qualified plan one's creditworthiness may be deemed a prohibited transaction? I'd like to show them to the brokerage.

Futures trading is always leveraged in that you post only a fraction of the contract value as a performance bond. This amount is called margin, but it has nothing to do with margin borrowing as in an equities account. Nobody lends you any cash and no interest is paid; the leverage comes from controlling a large contract with a smaller amount of money. Crazy people leverage to the hilt and get blown up right away. Anyway, this means UBTI is not an issue.

Unfortunately I do not have the option of going with another broker. It's probably the biggest futures firm in the world, and the CTAs I want to work with all use it. By the way I am not going to trade the accounts myself, I am hiring CTAs (Commodity Trading Advisors) to do it for me. Kind of like a futures fund, except rather than handing over your money to the fund, you give the CTA authorization to trade your account for you. No risk of them running off with your money that way...

For what it's worth, the guaranty agreement only says that the guarantor will pay any debts accrued by the plan/IRA. It does not state that the guarantor must fund the plan with additional money, the guarantor is supposed to make the payment directly to the brokerage. Does that make any difference?

It's all pretty ridiculous because the CTAs have to stop trading if a retirement account declines in value by 50%. So the guaranty will never be exercised. My concern is only that somehow my plan/IRA gets disqualified someday because I signed it.

Best regards,

Tom

You posted this on IRAs and Roth IRAs, leading me to believe that there are more issues than a personal guarantee:

1. What is the effect of a prohibited transaction on an IRA or a Roth IRA? Plan disqualification and immediate taxation (including penalties for premature distributions).

2. I have seen previous rulings where lending a qualified plan one's credit worthiness may be deemed a prohibited transaction.

3. Would you be doing any leveraging? While leveraging such trades is common, it creates a separate set of problems. Similar to PTs, the penalty for debt-financed unrelated business taxable income is plan disqualification.

4. When is a guarantee by the IRA holder a "personal" guarantee when the account is denominated an IRA account? My answer is that when the purpose of the guarantee is to bypass creditors and bankruptcy laws and give the brokerage firm a superior claim priority in the event of a problem.

If it were me and I was hell-bent on doing the futures trading (rather than purchasing a futures trading fund, for example), I would find another brokerage firm to deal with that did not make me go out on a limb legally to open an account with them.

[Guest tschotland]

Hi mjb,

I understand the reason they want/need the guarantee. My only concern is that by signing it I might disqualify my plan/IRA.

Thanks,

Tom

Because futures trading can have opened ended liability on trades, the broker must have a solvent party in addition to the IRA who can guarantee the payment for the amount of the futures purchased. Otherwise the broker is stuck with having to use its own funds to complete the trade if the IRA doesn have sufficient funds.

[Guest mjb]

Hi mjb,

I understand the reason they want/need the guarantee. My only concern is that by signing it I might disqualify my plan/IRA.

Thanks,

Tom

Because futures trading can have opened ended liability on trades, the broker must have a solvent party in addition to the IRA who can guarantee the payment for the amount of the futures purchased. Otherwise the broker is stuck with having to use its own funds to complete the trade if the IRA doesn have sufficient funds.

If you guaranty the obligations of the IRA you will be extending credit to the IRA which is a PT.

[John G]

I would suggest you hire a tax attorney and/or accountant before undertaking any of these types of transactions. You can be dealing with prohibited transactions, or just getting into gray areas where the "devil is in the details".

This message board is no substitute for indepth consultation with someone who is going to ask lots of questions. It is not uncommon for folks to leave out important details, or incorrectly use industry jargon (a simple example is confusing conversions with contributions).

[Guest tschotland]

Hi John,

This is great advice. I have already discussed this matter with my ERISA attorney, he says the whole area is unclear under the law. He advised me to just go ahead and sign the guaranty and fight it out later if necessary. I also spoke to an accountant who specializes in trading and he did not know - he passed me on to an in-house attorney, who also did not know. I am sure he would happily render another opinion and another big bill if I asked him to.

In my experience, if you talk to 10 attorneys you get 10 different answers. I have spent tens of thousands of dollars over the years working with attorneys on my retirement plans and frankly I have never gotten a clearcut answer on anything, at least not when I compared what they all said. It seems there is always some level of risk. So I am trying to get a feel for the issues on my own.

I have sent an inquiry to the compliance department of the futures brokerage expressing my concerns. I'll report back with what they say (if anything).

Thanks,

Tom

I would suggest you hire a tax attorney and/or accountant before undertaking any of these types of transactions. You can be dealing with prohibited transactions, or just getting into gray areas where the "devil is in the details".

This message board is no substitute for indepth consultation with someone who is going to ask lots of questions. It is not uncommon for folks to leave out important details, or incorrectly use industry jargon (a simple example is confusing conversions with contributions).

[GBurns]

I think that you should place the burden of proof on this brokerage. If they have done so amny, the question must have come up before and the must have provided a proper answer. Bear in mind that a sale rep, by whatever name called, is still a sales rep. He or she has the main (sometime sole) function of selling you the services of the brokerage. A sales rep's opinion is not necessarily that of the brokerage. The brokerage has both a legal dept and a compliance dept. Get an official brokerage opinion in writing.

The "fact" that thousands have done something means nothing. Thousands of people do not file tax returns each year and nothing happens. That does not mean that any of us should follow suit.

JohnG suggested that you speak to a tax attorney and or accountant (I am sure that he means tax accountant). An ERISA attorney is not necessarily knowledgeable about tax issues. An accountant is not necessarily knowledgeable abou tax issues. Seeking advice from people who do not have in depth knowledge about the particular issue seems somewhat futile.

On the other hand, PT and disqualification issues are not really tax issues. So that makes the seeking of advice even more specific.

Signing then fighting it out later, could be very very expensive.............

[John G]

I also would not sign and fight it out later. If you signed something you should not, your risk of losing is too high. You don't indicate that level of assets you are talking about, but it sounds like you may be dealing with substantial funds and you don't want to put its tax shelter status at risk. If you have substantial non-tax sheltered assets as well, why not do this type of investing there and do more conventional investing in the more restricted environment?

Sure its hard to find a good tax lawyer or tax accountant (yes, that is what I meant), but its also hard to find a good plumber. Many tax professionals have no experience in some of these odd areas, so you will need to ask some hard screening questions - and you normally don't pay for advice until you find a professional qualified to help you.

I would not rely upon any tax advise from a custodian. They tell you up front that you should not rely upon them for tax advice.

In a large shop like Fidelity, Schwab or Morgan Stanley, there are layers and layers of staff. The most common layer people deal with a sales reps or "counter" help. These are generally the least trained. At a minimum, try to deal with the back office related to pension funds, retirement accounts, etc. You may have to persist to get to talk to these folks because some firms (like Etrade) try hard to keep the public out. Again, you are not asking for tax advice, but rather getting hardcopy of the firms policies and perhaps some citations of IRS regs.

[Guest tschotland]

Hi GBurns.

I'm attempting to get answers from the broker's compliance department. Thing is, can I rely on their opinion that the guaranty is okay if the IRS comes after me?

I have already spoken to an ERISA attorney, a tax attorney, and an accountant who specializes in tax issues for traders. I am burning money and not getting answers. It is very frustrating.

Thanks,

Tom

I think that you should place the burden of proof on this brokerage. If they have done so amny, the question must have come up before and the must have provided a proper answer. Bear in mind that a sale rep, by whatever name called, is still a sales rep. He or she has the main (sometime sole) function of selling you the services of the brokerage. A sales rep's opinion is not necessarily that of the brokerage. The brokerage has both a legal dept and a compliance dept. Get an official brokerage opinion in writing.

The "fact" that thousands have done something means nothing. Thousands of people do not file tax returns each year and nothing happens. That does not mean that any of us should follow suit.

JohnG suggested that you speak to a tax attorney and or accountant (I am sure that he means tax accountant). An ERISA attorney is not necessarily knowledgeable about tax issues. An accountant is not necessarily knowledgeable abou tax issues. Seeking advice from people who do not have in depth knowledge about the particular issue seems somewhat futile.

On the other hand, PT and disqualification issues are not really tax issues. So that makes the seeking of advice even more specific.

Signing then fighting it out later, could be very very expensive.............

[Kimberly S]

I'm attempting to get answers from the broker's compliance department. Thing is, can I rely on their opinion that the guaranty is okay if the IRS comes after me?

Ask them that question too! My guess is they will say no.

[Guest Sieve]

Didn't mjb already give you the answer? In mjb's view--and in mine--a personal guaranty of IRA obligations is a prohibited transaction.

If you think you've been burning money without getting answers, then here you will not burn money but you still will not be able to get full agreement on a difficult issue (but of course, here you will not get legal advice, either).

[Guest tschotland]

Hi John,

Having already talked to three professionals I am a little wary of going on a fishing expedition. My ERISA attorney is actually one of the top guys in the country. However if I did want to screen for someone new, can you suggest the most hardball questions I should ask before hiring them? My issues are the personal guaranty, and whether if I short stock in my plan or IRA I will be doing anything prohibited or even be subject to UBTI.

You and GBurns have suggested getting an official broker opinon - is there any boilerplate for that so I can know that what they are giving me is what I need?

Could I try getting a PLR ruling on this?

Thanks,

Tom

I also would not sign and fight it out later. If you signed something you should not, your risk of losing is too high. You don't indicate that level of assets you are talking about, but it sounds like you may be dealing with substantial funds and you don't want to put its tax shelter status at risk. If you have substantial non-tax sheltered assets as well, why not do this type of investing there and do more conventional investing in the more restricted environment?

Sure its hard to find a good tax lawyer or tax accountant (yes, that is what I meant), but its also hard to find a good plumber. Many tax professionals have no experience in some of these odd areas, so you will need to ask some hard screening questions - and you normally don't pay for advice until you find a professional qualified to help you.

I would not rely upon any tax advise from a custodian. They tell you up front that you should not rely upon them for tax advice.

In a large shop like Fidelity, Schwab or Morgan Stanley, there are layers and layers of staff. The most common layer people deal with a sales reps or "counter" help. These are generally the least trained. At a minimum, try to deal with the back office related to pension funds, retirement accounts, etc. You may have to persist to get to talk to these folks because some firms (like Etrade) try hard to keep the public out. Again, you are not asking for tax advice, but rather getting hardcopy of the firms policies and perhaps some citations of IRS regs.

[GBurns]

John G makes a good point that " Many tax professionals have no experience in some of these odd areas, so you will need to ask some hard screening questions - and you normally don't pay for advice until you find a professional qualified to help you."

The "screening questions" should have established knowledge and ability.

So I do not understand how you could be "burning money".

[Guest tschotland]

Hi Larry,

I appreciate the opinions offered by you and mjb, it's just that I am not clear on why it is a PT (though I am worried that it is). I would not be loaning money to the plan/IRA, nor making a deposit to it. I would be agreeing to pay off the broker if the plan/IRA went into debt. I would not get any tax deferred benefits from doing that - it's not like I would be putting extra money into the plan and seeing it grow. I couldn't claim it as a tax loss outside the plan either. And guaranty or not I would always be free to make contributions to a new plan/IRA in future years, so it's not as though the guaranty enables me to avoid having to make up the losses with only tax-deffered money. From the standpoint of the IRS getting their cut it seems like the guaranty is a non-event. Am I missing something?

Vebaguru said there have been cases where a personal guarantee was treated as a PT. I'd like to see those and understand why. If you guys have citations please let me see them.

Thanks,

Tom

Didn't mjb already give you the answer? In mjb's view--and in mine--a personal guaranty of IRA obligations is a prohibited transaction.

If you think you've been burning money without getting answers, then here you will not burn money but you still will not be able to get full agreement on a difficult issue (but of course, here you will not get legal advice, either).

[Guest tschotland]

> The "screening questions" should have established knowledge and ability.

> So I do not understand how you could be "burning money".

I have been with my ERISA attorney for years, so I didn't screen him. I just called him up and discovered that it was going to be a fishing expedition. The tax accountant and his in-house tax attorney have written numerous books and articles on all aspects of taxation for traders and use of retirement vehicles for trading. They came highly recommended by numerous traders. I had no problem starting to pay for their time just on that basis. It was after we burned an hour that I realized that on these particular issues, which are highly specific to be sure, they were also going to have to go on a fishing expedition...

If you could suggest some really hard-ball questions to ask to avoid paying to learn there is going to be a fishing expedition, I would love to hear them.

Thanks,

Tom

[Jim Norman]

Tom,

See Internal Revenue Code Section 4975©(1)(B) under the list of prohibited transactions. You will find "lending of money or other extension of credit between the plan and a disqualified person".

You are a disqualified person with respect to your IRA. Can it seriously be argued that a personal guaranty is NOT an "extension of credit" to the IRA? What is an "other extension of credit"?

How much are you willing to risk to make this argument? The penalty for an IRA engaging in a prohibited transaction is full and immediate taxation of the entire IRA account. If the IRS audits and finds this it will be 2-3 years down the road from 2008, so you would have a 3 year old 2008 tax deficiency with accumulated interest and penalties due to the IRS. Sure, you can fight it later if and when the issue arises, but at what cost?

[jpod]

There is no question that a guarantee is a pt. That is the reason (or at least one of the reasons) why there is a statutory exemption for ESOP loans: the exemption is necessary in order for the employer to guarantee the loan.

I don't think I'm sticking out my neck to say that this is "ERISA 101." This is the type of question to which we can provide a direct answer on this message board, but if you don't accept it as an answer we're not going to argue with you.

[Belgarath]

See if you can find the text of Janpol v. Commissioner, 101 T.C. 518 (1993) which may illuminate the subject a bit. I don't have a link to the actual case.

[Guest tschotland]

I'm sorry if this is all ERISA 101 stuff. Here is my confusion: I understand that if I actually fund my IRA/plan with extra money that is a prohibted transaction. This is very clear. What is not clear to me is, does the mere promise to pay a debt accrued by the IRA/plan should the need arise create a prohibited transaction? Please note, this hypothetical payment of debt would NOT occur by funding the plan with additional money, it would be a direct payment from myself to the broker. Moreover this payment will never actually occur, since if the account declines in value by even 50% the CTA must stop trading, and I would have him stop long before that point anyway.

I cannot find the text of Janpol v. Commissioner. However I did find a document that references it in connection with a case that was ruled on similarly. In that case, a private foundation deposited its assets in a futures margin account to secure the performance of futures trading by the director of the foundation and his family. So money actually was deposited somewhere, not just a mere promise to do so maybe someday.

Thanks,

Tom

[Jim Norman]

does the mere promise to pay a debt accrued by the IRA/plan should the need arise create a prohibited transaction?

If the mere promise to pay is an "extension of credit", then YES, it does create a PT. Is such a promise an extension of credit? IMO yes, it is.

Much like a company may have a credit line with a bank. The bank is extending credit to the company even if the company does not actually draw against the line. Having the line allows the company to tie up its cash in ways that it would not otherwise be possible if it could not rely on the credit line as a backup. Your personal guarantee on behalf of the IRA allows the IRA to make investments it would not be able to make if the guarantee was not there.

The question is, how much risk do you want to take, and how much do you want to spend in legal fees to fight the IRS over the definition of an extension of credit, knowing that it is more likely than not that you would lose the case anyway?

[Guest Sieve]

When you decide if you want to take a chance on this transaction in spite of the strong feeling of this group that your loan guarantee is a PT, remember that the consequences of an IRA entering into a PT generally are much more severe than for a qualified plan. For an IRA, the IRA ceases to be an IRA as of the first day of the taxable year in which the PT occurs, and all amounts are treated as distributed as of that date (and the 15% PT excise tax does not apply). For a qualified plan, the excise tax applies for each year that a PT continues to exist, and the transaction must be undone (which may be difficult for this transaction).

[Guest tschotland]

Okay, you guys have put the fear in me...

Here's another approach: I am 1/3 owner of one of my businesses. If that business signs as guarantor it would not be a prohibited transaction because I do not own a controlling interest in it. Is that correct?

Thanks,

Tom

[GBurns]

For clarification :

What type of business entity is it?

Are you an employee?

Are you an officer ?

Are you a Director/Board member ?

Is this business part of a controlled group or otherwise related to the other businesses ?