This article is supposed to serve two purposes: (1) to argue that it is reasonable for an investment adviser in most instances to receive investment advisory fees from rendering investment advice to their family member’s individual retirement account (“IRA”), and (2) to make you second guess the advice you receive from your compliance consultant.
Be wary before you trust a compliance consultant who is providing you advice on complex legal issues, such as ERISA or the Internal Revenue Code (the “Code”). While many compliance consultants add value, you must understand their limitations. One of those limitations is that they do not have years of highly relevant legal education that focuses on reading a statute, analyzing regulations and seeking out interpretive guidance.
I came across a perfect example of a compliance consultant making an egregious mistake the other day. A prospective client received a mass email from their consultant that identified a potentially problematic business practice for them. They brought it to our attention for a second impression. The email stated:
We wanted to bring to your attention an IRS regulation that impacts IRA accounts. It relates to ensuring compliance with [the Code] Section 4975 and related Internal Revenue Service (IRS) self-dealing and prohibited transaction considerations. Under IRC Section 4975, certain family members of a Retirement Account holder are deemed “Disqualified Persons.” Disqualified Persons may not engage in acts of self-dealing. Self-dealing considerations are implicated where certain family members are hired as Advisors and receive compensation from a family member’s Retirement Account. As such, if an Adviser is receiving compensation from a family member to manage the family members’ IRA account, it is a prohibited transaction. Unless an exemption applies, the IRS has enforcement authority which can range from assessing a 15% excise penalty to disqualifying the IRA.
As a result of this rule, we encourage you to review your existing accounts and ensure the firm is not being compensated for management of family members’ IRAs. This IRS regulation is not currently included in your Compliance Policies and Procedures Manual and we are taking the approach that it is optional. If you wish to include the information in your compliance manual, please let us know.
This communication showed that the compliance consultant identified a law, analyzed it and concluded that a certain practice was in violation of the law, and implicitly that there was no relevant exemption for this practice. The consultant’s advised that the prospective client must forego revenues, because the consultant believed that providing services to a family member was a non-exempt prohibited transaction under the Section 4975 of the Code. This appeared wrong to me on so many levels.
Interpreting the Code isn’t an easy task—the Code is a labyrinth. Also, this area of the Code is especially complicated as it has a unique interplay with the Employee Retirement Income Security Act of 1974—otherwise known as ERISA. Reading the relevant paragraphs of Section 4975 would have only been the first step of this exercise. However, there are also regulations that accompany the Code. Then there is a unique industry understanding that can only be held by a person uniquely familiar with ERISA. This consultant clearly did not have a clear grasp of the regulations or the industry experience to opine on this issue.
Second, the consultant could have been found to have been involved in the unauthorized practice of law or accounting. I won’t touch on this issue, because it is beyond the scope of this article.