Short Selling in IRA / Profit Sharing Plan

[Guest tschotland]

Hello,

I am trying to understand why it is that all the brokers I talk to will not permit short selling in an IRA nor in a profit sharing plan. They claim there are IRS and SEC regulations prohibiting it but cannot supply specific citations. Meanwhile I have located a revenue ruling (95-8) and PLRs in which the IRS has held that borrowing stock does not create acquisition indebtedness and UBTI. There is also a DOL class exemption (Prohibited Transaction Exemption PTE 75-1) that permits short selling. Can anyone tell me where in the law it states that short selling is prohibited?

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

Thanks,

Tom

[John G]

I will throw out a few reasons that come to mind:

1. Your account is essentially "borrowing" stocks that you don't hold - and there are prohibitions against borrowing.

2. Custodians aim for the common demoninator because its easier and because the vast majority of the accounts are there. Lots of custodians impose greater restrictions than the IRS. I don't recall any custodian going out of business because they turned down unusual investments in any of the shelter accounts. There is no prohibition against a custodian imposing greater restrictions. A simple example of this is will a custodian allow you to participate in: IPOs, stocks on foreign exchanges, pink sheet stocks, etc.

3. When you short a stock, you can expose yourself to more than entire assets of the account. For example, shorting 2,000 shares of Google at various times this year could expose you to $1.5 million in possible loss. Even if you have mega assets outside of the IRA...how can you make good on a problem? There are limits to how much you can contribute. Not everyone can qualify for a conversion......

[Guest tschotland]

Hi John,

> 1. Your account is essentially "borrowing" stocks that you don't hold - and there are prohibitions against borrowing.

There's a body of case law and PLRs that distinguish borrowing money from shorting stock. Also, as I understand it, an IRA and a profit sharing plan are both permitted to borrow money (e.g. for real estate transactions). You may face taxation on UBTI, but borrowing is not a prohibited transaction.

> 2. [...] There is no prohibition against a custodian imposing greater restrictions.

I think that's what is going on.

> 3. When you short a stock, you can expose yourself to more than entire assets of the account.

Definitely so. The peculiar thing is that it is permitted to trade futures in an IRA or qualified plan, and the exposure beyond plan assets for futures is MUCH worse than for shorting a stock. If I short a stock I have to put up the proceeds of the short sale + 50% more in cash or other securities. That's 150% of the present stock value. In order for that to take out my account I would have to sleep through a 50% rise in the stock, even more if I have beyond the additional 50% in my account (in my strategy I have on average 100%, it is a balanced market neutral approach). Contrast that with futures, where I am permitted to plunk down a few thousand bucks and trade a $140,000 crude oil contract long or short - if I did that I could blow my account in a heartbeat and owe extra money. It makes no sense to me that futures are permitted while shorting is not.

Thanks,

Tom

[Guest tschotland]

Here is some new information. It applies to my profit sharing plan, not my IRA.

I have consulted my plan and trust documents. I am using the DATAIR Mass-Submitter Prototype Defined Contribution Trust. This is an IRS-approved prototype plan. Section 4.2(d) reads as follows:

(d) The Trustee may buy and sell put and call options, covered or uncovered, engage in

spreads, straddles, ratio writing and other forms of options trading, including sales of options

against convertible bonds, and sales of Standard & Poor futures contracts, and trade in and

maintain a brokerage account on a cash or margin basis.

The key phrases here are "put and call options, covered and uncovered", and "trade in and maintain a brokerage account on a cash or margin basis". You need a margin account to do short sales (although you do not need to take a margin loan to do it). And uncovered options have such unlimited risk they make short selling look like buying a CD. So it looks like short selling is okay by the IRS, at least in a defined contribution plan. Or is someone going to tell me that I can't rely on the trust document even if it's IRS approved?

Now assuming it's okay in the plan, what does that say about doing it in an IRA?

Thanks,

Tom

[Guest tschotland]

With regard to short selling in an IRA, I found the following sentence and reference in the article "You Want to Do What With Your IRA?" (John N. Singletary Jr., ABA Trust & Investment, May/June 2006 pp 6-17):

"For instance, the Department of Labor has determined that IRAs can be margined [11];"

The reference was to DOL Opinion Letter 86-12A. I cannot locate this, does anyone have it?

Thanks,

Tom

[masteff]

Now assuming it's okay in the plan, what does that say about doing it in an IRA?

It says absolutely nothing about IRAs because while QPs and IRAs have similarities, they do not share certain enabling and controlling IRS Code sections (eg, 401 vs 408).

That does not say that some items are not in common... however you'd be well advised to not make an error of extrapolation from a qualified plan to an IRA (or vice versa).

[Guest tschotland]

> The reference was to DOL Opinion Letter 86-12A. I cannot locate this, does anyone have it?

Never mind, found it.

[Guest mjb]

Now assuming it's okay in the plan, what does that say about doing it in an IRA?

It says absolutely nothing about IRAs because while QPs and IRAs have similarities, they do not share certain enabling and controlling IRS Code sections (eg, 401 vs 408).

That does not say that some items are not in common... however you'd be well advised to not make an error of extrapolation from a qualified plan to an IRA (or vice versa).

IRC 408(e)(1) provides that IRAs are subject to the rules for UBIT under IRC 511. As for imposition of UBIT tax, IRS publication 598, P15 on short sales states "Short Sales. Acquisition indebtedness does not include the "borrowing" of stock from a broker to sell the stock short. Although a short sale creates an obligation, it does not create debt."

PLR 9703027 permitted a short sale of stock by a qualified plan as not being from debt financed property.

However a broker can refuse to allow short selling by a customer.