Know the Risks and Responsibilities Before Offering Hard-to-Value Investments
Your financial organization may often look for ways to gain a competitive edge within the IRA market. Offering alternative investment options may be one way to attract and retain clients with large balances. But be sure to balance a desire to remain competitive with your duty to maintain compliance. If your organization does offer alternative investments, either directly or through an outplacement relationship, it may face challenges in accommodating your clients’ hard-to-value assets. Unless all parties clearly understand what is involved with holding hard-to-value assets in an IRA, confusion and conflict are likely to result. Not to mention compliance failures, which can lead to embarrassment at best, and penalties at worst.
What Is a Hard-to-Value Asset?
Determining what is considered a hard-to-value asset can be confusing. Investments in time deposits, bonds, government securities, mutual funds, and publicly-traded stock (i.e., traded on a stock exchange) have readily available fair market values (FMVs). But other investments that do not have easily determined FMVs, such as non-publicly traded stock, limited partnerships, and real estate, may find their way into self-directed IRAs.
Nonpublicly Traded Stock
For assets that are not publicly traded (e.g., stock from a privately held company not traded on a stock exchange), it can be difficult to determine the FMV. If your financial organization permits IRA owners to select investments that are not publicly traded, it must make sure there is a way to determine and report a FMV each year.
Limited Partnerships
Your financial organization may face challenges in determining the FMV of limited partnership interests. As a “rule of thumb,” the general partners in such an entity are advised to have its value appraised by an independent appraiser at least once every three to five years. In intervening years, the general partners are expected to exercise good faith in determining the partnership’s FMV, or use an independent appraiser. IRA custodians should establish and follow a policy regarding when they will require a valuation by an independent appraiser—one with experience in valuing limited partnerships—and when they will accept valuations provided by the partnership.
Real Estate
Valuing real estate may not be as difficult as some other alternative investments. Financial organizations often require that IRA real estate investments be valued annually by independent appraisers. If the value of the property is readily obtainable by another means, such as value used for property tax purposes, some financial organizations will not mandate an annual valuation by an independent appraiser. Because tax assessment values may lag behind market value, your financial organization should exercise caution when relying solely on the value used for property taxes.
What Are Your Responsibilities?
As an IRA administrator, your organization must report an IRA’s FMV to both the IRS and the IRA owner every year. Your organization must also be able to ascertain the FMV of an IRA investment that is distributed in-kind (i.e., a distribution of assets rather than cash). These requirements are not waived because an investment is hard to value.
Because the IRS provides no guidance on how to value these assets, your financial organization should consult with its legal counsel to establish procedures for obtaining the required FMV. These procedures should include the time frame for obtaining an independent valuation, the circumstances for when to use a non-independent valuation, and the steps to take when a valuation is not judged to be reasonable.
If your financial organization uses an independent appraiser or broker, it still has a duty to evaluate and monitor the appraiser or broker—as it would for any other professional service used. Because the burden of producing a reasonable valuation is ultimately on your financial organization, it should ensure that it can demonstrate a good faith effort in selecting, directing, and monitoring the appraiser or broker, in part by keeping process documentation.
An agreement with the IRA owner—whether contained within the IRA document itself, or in a separate agreement— should clearly list each party’s duties, including how valuations are obtained, how often, and who pays for them. The cost of appraisals is generally paid from the IRA, though some circumstances could justify a fee being paid directly by the IRA owner. Disputes may arise if these logistics are not communicated up front. And, unfortunately, your financial organization cannot escape liability just because it failed to account for the cost of generating the proper reporting.
What Are the Risks?
When deciding whether to offer certain hard-to-value investments, your organization must evaluate its compliance responsibilities and which investments it can feasibly service.
IRS penalties – Failure to provide an accurate and timely FMV statement (IRS Form 5498, IRA Contribution Information) is $50 per failure.
IRS scrutiny – You may not consider IRS penalties alone as much of a risk, but the likelihood for increased IRS scrutiny—especially if the violations are frequent and extensive—should be cause for concern.
Lawsuits – If an IRA owner is accused by the IRS of underreporting income because of undervalued assets, the IRA owner may seek to shift blame and initiate legal action against your financial organization. Even if your organization ultimately prevails in court, through a settlement, or by dismissal, the financial cost could be considerable.
Reputational damage – While your organization may pay IRS penalties, survive an IRS audit, and settle or win any lawsuits, the damage to your organization’s reputation may be the most significant consequence of missteps in the administration of IRAs that hold hard to value assets.
Be sure your financial organization has determined how it will meet the FMV reporting requirements on hard-to-value assets before deciding whether permitting such IRA investments is in the organization’s best interest.
