Financial Adviser's Control over Taxpayers' Self-Directed IRA Proves Costly.
(Parker Tax Publishing January 2014)

Self-directed IRAs have become increasingly popular in recent years because they allow an IRA owner to have more control over the type of investments that will be held in the IRA. For example, the owner of a self-directed IRA may choose from a range of investments permitted for IRAs - including real estate, limited partnerships, mortgages, notes, franchise businesses, etc. - rather than being limited to the typical investments offered by IRA custodians and trustees (stocks, bonds, mutual funds, etc.). This higher degree of flexibility in choosing IRA investments allows the IRA owner to invest in assets with greater wealth-building potential. According to a 2011 report by the Investment Company Institute, U.S. investors held approximately $4.7 trillion in IRAs. Estimates from various sources approximate that investors' hold 2 percent, or $94 billion, of IRA retirement funds in self-directed IRAs.

The large amount of money held in self-directed IRAs makes them attractive targets for fraud promoters. A self-directed IRA can be costly if the IRA owner does not properly manage the investments and leaves that task to someone else. Such was the case in Berks v. Comm'r, T.C. Summary 2014-2 (12/30/13), where a couple rolled over the funds from their IRA to a self-directed IRA after being advised to do so by their financial adviser. The financial adviser invested the couple's self-directed IRA in five real estate partnerships that, after several years, went belly up. Because the couple never received the proper documentation from the adviser regarding notes issued to the self-directed IRA by the partnerships, and could not properly document their losses, they were hit with tax deficiencies and penalties relating to the depletion of their IRA assets.

Background

In the late 1990s, Bernard and Claire Berks' financial adviser, J. Richard Blazer, presented them with a proposal to invest in various real estate partnerships. Mr. Blazer was the president of a venture capital firm. The Berks had known Mr. Blazer since the mid-1980s and considered him a friend. The Berkses decided to invest and, with Mr. Blazer's help, they rolled over money from preexisting IRAs into separate self-directed IRA accounts that they opened with a firm called TCA. Mr. Blazer recommended TCA to the Berkses because it would accept promissory notes in IRA accounts for which it served as custodian and he had a good working relationship with the firm. TCA recognized Mr. Blazer as the Berkses' authorized representative.

The Berkses transferred approximately $91,000 to their TCA accounts and those funds in turn were transferred to five different partnerships in exchange for promissory notes. Mr. Blazer was a general partner in each partnership. The promissory notes purportedly matured five years from the date of issuance and provided for relatively high interest rates (10 percent to 12 percent per year), which would accrue and would be paid only if and when the underlying properties were developed or sold. Between 2001 and 2006, all of the partnerships failed for various reasons, and the promissory notes held in the Berkses' IRA accounts become worthless. Mr. Blazer provided TCA with the original promissory notes and related private placement memoranda for the Berkses' investments.

Bernard testified that Mr. Blazer informed him in early 2007 that the promissory notes held in his and his wife's IRA accounts had become worthless. Mr. Blazer sent the letters to TCA under the cover of his own letter stating that the IRA accounts should be terminated because the partnerships that issued the promissory notes were no longer in business. TCA declined to close or terminate the accounts based on Mr. Blazer's letter and sent a letter to the Berkses asking for a written explanation of the current status of the assets within their accounts. After receiving nothing from the Berkses, TCA issued Form 1099-R to the Berkses, reporting a taxable distribution of the IRA funds in 2009. The Berkses did not include those distributions in their income, and the IRS issued a deficiency notice. The case subsequently ended up in the Tax Court.

Tax Court Decision

In testimony before the Tax Court, Bernard could not recall any details regarding the nature or location of the real estate that the partnerships owned or ever receiving any documentation regarding the properties. Mr. Blazer testified that the investments he had presented to the Berkses were speculative and that he counseled them to sprinkle their investments among several partnerships to minimize the risk of loss. He also testified that a partner in one of the partnerships defrauded the other partners by surreptitiously taking mortgage loans on the partnership's property. The mortgage on the property subsequently was foreclosed when that partner failed to repay the loans and filed for bankruptcy. In another instance, Mr. Blazer testified that the partnership owned 50 percent of the subject property and that he (as the general partner) had decided to "let the property go" or simply revert to the individual holding the other 50 percent ownership interest in the property because development costs were too high.

Mr. Blazer testified that the remaining partnerships failed and that the properties invested in were lost in foreclosure proceedings.

As the promissory notes in the Berkses' IRA accounts matured, TCA had inquired whether the notes would be renewed. Mr. Blazer testified that he had numerous telephone conversations with TCA representatives informing them that the partnerships "were no longer in business" and that the promissory notes in the Berkses' accounts had become worthless and would not be renewed.

The Tax Court concluded that the Berkses failed to meet their initial burden of producing credible evidence and/or presenting a reasonable dispute in respect of the Forms 1099-R TCA issued. As a result, the Tax Court upheld the IRS's deficiency determination. The Tax Court noted that it was not obliged to accept the Berkses' self-serving testimony without objective, corroborating evidence.

SEC Fraud Alert

The Securities Exchange Commission (SEC) has issued an Investor Alert to warn investors of the potential risks associated with investing through self-directed IRAs. As the number of self-directed IRAs has increased, so have the reports of fraudulent investment schemes.

According to the SEC, state securities regulators have investigated numerous cases where a self-directed IRA was used in an attempt to lend credibility to a fraudulent scheme. Similarly, the SEC has brought numerous cases in which promoters of fraudulent schemes steered investors to self-directed IRAs. As the SEC noted, while self-directed IRAs may offer investors access to an array of private investment opportunities that are not available through other IRA providers, investments in these kinds of assets may have unique risks that investors should consider. Those risks can include a lack of disclosure and liquidity -- as well as the risk of fraud.

In particular, fraud promoters who want to engage in Ponzi-type schemes or other fraudulent conduct may exploit self-directed IRAs because they permit investors to hold unregistered securities, and the custodians or trustees of these accounts likely have not investigated the securities or the background of the promoter. There are several ways fraud promoters may use these weaknesses and misperceptions to perpetrate a fraud on unsuspecting investors.

First, fraud promoters can misrepresent the responsibilities of self-directed IRA custodians to deceive investors into believing that their investments are legitimate or protected against losses. Fraud promoters often explicitly state or suggest that self-directed IRA custodians investigate and validate any investment in a self-directed IRA. However, self-directed IRA custodians are responsible only for holding and administering the assets in a self-directed IRA; self-directed IRA custodians generally do not evaluate the quality or legitimacy of any investment in the self-directed IRA or its promoters. Further, most custodial agreements between a self-directed IRA custodian and an investor explicitly state that the self-directed IRA custodian has no responsibility for investment performance.

Second, self-directed IRAs carry a financial penalty for prematurely withdrawing money before a certain age. This financial penalty may induce self-directed IRA investors to keep funds in a fraudulent scheme longer than those investors who invest through other means. Also, the prospect of an early withdrawal penalty could encourage an investor to become passive with a lesser degree of oversight than a managed account might receive, allowing a fraud promoter to perpetrate his fraud longer.

Finally, as discussed above, self-directed IRAs usually allow investors to hold alternative investments such as real estate, mortgages, tax liens, precious metals, and private placement securities. Unlike publicly traded securities, financial and other information necessary to make a prudent investment decision may not be as readily available for these alternative investments. Even when financial information for these alternative investments is available, it may not be audited. Further, self-directed IRA custodians usually do not investigate the accuracy of this financial information. This lack of available information for alternative investments makes them a popular tool for fraud promoters' schemes.

Conclusion

Taxpayers with self-directed IRAs need to be wary of fraudulent investment schemes that utilize a self-directed IRA as a key feature. Practitioners with clients that have such IRAs or that are considering such IRAs should discuss with their clients the potential for fraud and the fact that the available information for alternative investments in the IRAs makes them a popular tool for fraud promoters' schemes. (Staff Contributor Parker Tax Publishing)

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