The Internal Revenue Code (“Code”) does not describe what type of investments are permitted to be made with a Self-Directed IRA, only the categories of investments that are not permitted. In general, Code section 408 and 4975 identify three categories of investments that are prohibited for Self-Directed IRA investors: (i) life insurance, (ii) collectibles, and (iii) a transaction involving the IRA and a disqualified person that does not exclusively benefit the IRA.
For purposes of Code Section 4975, a disqualified person is defined to includes the IRA holder, any ancestors or lineal descendants of the IRA holder, and entities in which the IRA holder holds a controlling equity or management interest.
- Internal Revenue Code 408 describes what a Self-Directed IRA cannot invest in.
- Collectibles, such as art and stamps, are prohibited by the IRS.
- Is an investment fund containing collectibles allowed?
What is a Collectible?
Code Section 408(m) states that an IRA is not permitted to invest in any collectible. Investing in a collectible would trigger a taxable distribution to the IRA holder. A collectible is defined as the following, per the IRS:
(B) any rug or antique,
(D) any stamp or coin,
(E) any alcoholic beverage, or
(F) any other tangible personal property specified by the Secretary for purposes of this subsection.
IRC 408(m) also includes an exemption to the definition of collectible for IRS-approved precious metals, such as gold, silver, or palladium bullion, as well as American Eagle, state minted, and bullion coins.
Therefore, according to the Code, a Self-Directed IRA may not invest in art, diamond, antiques, or any other defined collectible. However, there is technically an indirect way for an IRA to invest in collectibles.
Collectibles via an Investment Fund
Over the last several years, there has been an emergence of crowdfunding-type investment funds that allow investors to own a fractional interest in art, antiques, and other types of collectibles. The question then arises, can a Self-Directed IRA invest in a fund that owns an interest in a collectible, such as a piece of art? The plan asset rules offer some guidance.
The Plan Asset Rules
The purpose of the Plan Asset Regulation is to enforce fiduciary obligations under the Employee Retirement Income Security Act of 1974 (ERISA) in situations where an ERISA plan investor (plan or IRA) invests in a business entity or investment fund. The Plan Asset Regulation describes the circumstances when the assets of the separate entity (i.e. investment fund holding collectibles) are deemed to be “plan assets” of the plan (i.e., the look-through rule).
Below is the primary exception to the application of the plan asset rules:
- Publicly Offered Securities Exception
- Operating Companies Exception, and
- Significant Participation Exception (Also Known as the 25% Test)
Look-through Rule Exception
The look-through rule is only applicable to “equity interests.” The Plan Asset Regulation defines an equity interest as “any interest in an entity other than an instrument that is treated as indebtedness under applicable local law and which has no substantial equity features.”
Hedge funds and private equity funds that issue common shares or limited partnership interests are clearly issuing equity interests.
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Significant Participation Exception (Also Known as the 25% Test)
The final exception to the Plan Asset Regulation’s look-through rule is the significant participation safe harbor, also known as the 25% Test.
In drafting the Plan Asset Regulation, the DOL concluded that if “benefit plan investors” hold less than 25% of the equity interests of a separate entity, it is unlikely that the entity specifically solicited plan investors or that plan investors had an expectation that the entity would be managed in furtherance of their particular investment objectives.
The argument goes that if a Self-Directed IRA owns less than 25% of an investment fund that holds collectibles, the IRA would not be deemed to own the underlying collectibles directly since the plan asset look-through rules would not apply. Note – this is one position.
On the other hand, an argument can also be made that any IRA that owns an equity interest in a pass-through fund holding collectibles is deemed to indirectly own a collectible in violation of Code Section 408, which does not differentiate between a direct and indirect investment in collectibles and simply refers to the acquisition of any collectible.
The validity of using a Self-Directed IRA to invest in a pass-through investment fund owning collectibles is still somewhat murky. On one hand, a fund that is owned less than 25% by retirement accounts will not trigger the plan asset look-through rules and the IRA is not acquiring a collectible directly, but simply investing in an investment fund. On the flip side, an argument can be made that any ownership of a collectible, either directly or indirectly, could violate 408(m).
Conclusion About Collectibles in an IRA
IRC 408(m) is clear that a Self-Directed IRA is not permitted to acquire a collectible. The plan asset rules determine whether the investment of a plan or IRA will cause the manager of the fund to be subject to the ERISA fiduciary rules based on the look-through rules. Even though the plan asset rules are not designed to determine whether an IRA investor is deemed to own the underlying assets of the fund (i.e., the collectibles), many tax professionals believe the IRS could use the plan asset look-through rules to make the argument that an IRA investment into a fund would deem the IRA to own the underlying assets of the fund directly.
However, if the fund is owned less than 25% by retirement accounts, the plan asset look-through rules would not apply. Nevertheless, the validity of investing in art and other collectibles via an investment fund using a Self-Directed IRA is still somewhat foggy. As always, you should consult with a financial planner before making an investment you are unsure about.
