Executive Summary
Many readers of this blog contact me directly with questions and comments. While often the responses are very specific to a particular circumstance, occasionally the subject matter is general enough that it might be of interest to others as well. Accordingly, I occasionally post a new "MailBag" article, presenting the question or comment (on a strictly anonymous basis, of course!) and my response, in the hopes that the discussion may be useful food for thought.
In this week's MailBag, we look at the problem with trying to swap a highly appreciating private company investment from your personal assets into your Roth IRA (and the "prohibited transaction" rules that prevent it), and also the challenges for advisors in a broker-dealer who are trying to get their compliance department to loosen the reins and allow them to adopt social media.
Prohibited Transactions And Using A Roth IRA To Buy A Personal Investment
Question/Comment: My client invested into a private company (purchased equity) using personal funds. The company is performing well. Can the client use funds from their self-directed Roth IRA to purchase the allotted equity and return capital to their personal account?
I can certainly appreciate the client’s goal here – now that the investment into the company is working out, the client wants to get all future growth inside of a tax-free Roth IRA. Unfortunately, this strategy won’t work, due to the Prohibited Transaction rules.
If you’re not familiar, the Prohibited Transaction rules under IRC Section 4975 stipulate that a retirement account owner (or other fiduciary, or certain families members, all of which are called “disqualified persons”) cannot engage in transactions with his/her own IRA (or other retirement account). Buying/selling/exchanging property between the retirement account and its owner/fiduciary is a prohibited transaction, along with lending money (in either direction). Rendering services to or on behalf of your retirement account is also a prohibited transaction – this is why people who buy real estate inside of a self-directed IRA get in trouble if they do any fixer-upper remodeling work themselves.
In this case, selling an investment from your personal/brokerage assets to the Roth IRA in exchange for cash would be a pretty straightforward prohibited transaction – a purchase/sale of property between the IRA account and the IRA owner. Notably, it doesn’t even matter if the transaction occurs at an objective fair market value; the fact that it occurs at all between the parties makes it a prohibited transaction.
And it’s worth noting that the penalty taxes for a prohibited transaction are to be avoided at all costs, as they are quite draconian. The initial penalty tax is 15% of the dollar amounts involved, and if the prohibited transaction is not corrected in a timely manner, the penalty tax elevates to being 100% of the entire amount involved, essentially forfeiting to the IRS the whole value of the dollars involved in the prohibited transaction!
Bear in mind that these rules are only about doing deals between the retirement account owner and the account itself. It is permissible for retirement accounts to invest into and own private businesses (though still bear in mind the related prohibited transaction rules on not rendering services to the business in the IRA). But the workaround would have been to invest in the business with the Roth IRA dollars in the first place; there’s no good way to unring the bell at this point.
Financial Advisor Adoption Of Social Media In A Broker-Dealer
Question/Comment: We have just started utilizing Social Media for our firm. The frustrating thing (as I’m sure you have heard many places) is Broker Dealer policies hampering efficient use of the platforms. Our B/D states that ALL original Status Updates or Tweets must be Pre-Reviewed (I know this is not a FINRA rule). The only thing that is Post-Review are comments to existing posts or retweets. I think this especially hampers efficient use. Essentially if we don’t post something by 11am PST it probably won’t show up until the next day (or if it’s Friday, then until Monday).
I was wondering if you have run across anyone who has effectively persuaded their compliance departments that previously had a similar stance to allow them to do all Post-Review? Or any information you have that I could use to help persuade them? What are the primary guidelines you follow? We are currently the largest advisor at our B/D so that should help but I want to approach the issue fully equipped.
As you note, social media status updates and tweets aren’t necessarily required to be pre-reviewed under FINRA rules (though anything that would be bona fide advertising material is). Though statements that may be deemed as advertising, or false or otherwise misleading, can still be problematic, which is why compliance departments want to at least have a systematic process for post-review.
The reason why so many broker-dealer compliance departments seem to want to do pre-review of everything, though, essentially comes down to the sad reality that most compliance departments do not trust their advisors in the first place. Instead, the advisors are treated as though they’re going to do something bad and abusive – as though it’s just a matter of time – and accordingly the compliance team basically creates compliance rules to protect against what the “lowest common denominator” of the firm might do.
In other words, if you’re in charge of the compliance department, and you don’t want to get fired or disciplined yourself based on what the one most idiotic broker in your entire firm MIGHT do, you make highly restrictive rules to limit what even that one person might do … and in the process, end out with rules that are excessively and arguably unnecessarily restrictive to the average and especially the best advisors in the firm.
Indirectly, this is the primary reason that social media and blogging adoption seems to have occurred more quickly in the RIA environment in recent years; it's not actually about the differences in compliance regulations between FINRA and the SEC, but the fact that smaller RIA firms (and even large RIAs are "tiny" by broker-dealer standards) are closer knit with fewer degrees of separation between compliance and the firm's advisors. There's a decent chance that an RIA's Chief Compliance Officer has a direct and personal relationship with every advisor in the firm (which might just be 1, 2, half a dozen, or a dozen advisors), which means there's a higher degree of trust and an opportunity to make the compliance less burdensome on the basis of that trust.
Since in the broker-dealer context this basically comes down to an issue of trust in the broker-dealer’s advisors from its compliance department, for some broker-dealers the way they’ve managed to this challenge is to have an ‘experimental’ or 'pilot' group of advisors to be their social media pioneers. That group of early-social-media-adopters are deliberately carved from the broker-dealer’s premium/top advisors (who, presumably, are more trustworthy), and that group is allowed to do their social media activity on a post-review basis than pre-review (and only the bona fide advertising materials, like blog posts, that must be pre-reviewed, are handled that way).
If your broker-dealer doesn’t already have a strategy like this for social media adoption, you might propose pursuing with your broker-dealer, especially if you actually are the top firm/branch in your broker-dealer. You will likely need to reach out to the higher-ups in the firm who would make such a decision (as realistically it needs to be decided by senior leadership and handed TO the compliance department – they won’t likely do it on their own), but again if you’re a top advisor in the broker-dealer, you may (hopefully?) already have that kind of access to the leadership.
In essence, you’d be asking them if a group of top advisors – including you – can get more favorable post-review treatment on the basis that you really ARE one of the more trustworthy advisors, as demonstrated by your track record and production with the firm. You won't be avoiding compliance oversight altogether, but hopefully a more post-review-oriented approach will make it easier for you to get started - and notably, some technology platforms today like Hearsay Social effectively allow a "real-time-review" approach that is also an appealing alternative for some compliance departments. And giving the broker-dealer a little nudge that it’s time to come into the 21st century probably wouldn’t hurt, either! 🙂
In the meantime, you might want to check out this article for some further thoughts on social media implementation strategies and some of my own 'lessons learned', and if you're going to be doing more social media in the future (hopefully!) there's an upcoming Advisor Symposium on Social Media and Blogging you may be interested in as well!
