Individual Retirement Accounts: Formalizing Labor's and IRS's Collaborative Efforts Could Strengthen Oversight of Prohibited Transactions
Released: 2019-07-08T00:00:00

Letter

Background

IRA owners are not permitted to engage in certain prohibited transactions involving IRA assets. Prohibited transactions generally fall into two categories:

Transaction involving disqualified persons. An IRA is prohibited from engaging in a transaction with disqualified persons, such as members of the IRA owner’s family or an IRA fiduciary.

Transaction involving self-dealing. An IRA owner who is a fiduciary is prohibited from engaging in a transaction with the IRA where the IRA owner personally benefits (other than through the receipt of a distribution).

We previously reported that prohibited transactions are more likely to arise when IRA owners make unconventional IRA investments. Unlike conventional IRA investments in publicly traded stocks, bonds, and mutual funds, unconventional investments in real estate, virtual currency, or private equity are more likely to involve the IRA owner, disqualified family members, or other disqualified persons. For example, an IRA invested in rental real estate can leave IRA owners susceptible to a number of prohibited transactions, such as renting to family or paying for repairs with personal funds.

IRA owners may face adverse and potentially severe tax consequences if they are found to have engaged in a prohibited transaction. Specifically, the IRA could lose its tax-favored status. The account would then be treated as distributing all its assets to the IRA owner at the fair market value on the first day of the year in which the prohibited transaction occurred. The IRA owner may be subject to additional income taxes because of any early distribution from an IRA. The prohibited transaction may also be subject to excise taxes.

The Employee Retirement Income Security Act of 1974 (ERISA), which established IRAs and rules prohibiting certain IRA transactions, assigned IRA oversight roles to both DOL and IRS. To avoid confusion over dual jurisdiction, a 1978 Executive Order further clarified the agencies’ roles and responsibilities regarding prohibited transactions. As a result, the authority to interpret the prohibited transaction rules and grant exemptions to those rules was transferred to DOL. The transfer did not affect IRS’ ability to enforce the excise tax provisions or the tax consequences for IRA owners who are found to have engaged in a prohibited transaction. However, in enforcing such tax consequences, IRS is bound by the regulations, rulings, opinions, and exemptions issued by DOL.

DOL has the authority to grant administrative exemptions to the prohibited transaction rules on either an individual or a class basis. DOL can grant prospective exemptions for a transaction that an IRA is considering, as well as retroactive exemptions for transactions that have already occurred.

DOL Has Not Sufficiently Documented Internal Policies and Procedures for Reviewing Prohibited IRA Transaction Exemption Applications

To grant an exemption from prohibited IRA transaction rules, DOL evaluates applications using statutory criteria, and follows administrative procedures codified in regulations. Generally, DOL may not grant an exemption unless it finds the exemption to be: in the interest of the plan and its participants and beneficiaries, and protective of the rights of plan participants and beneficiaries.

Before granting an exemption, DOL generally must publish a notice of proposed exemption in the Federal Register inviting interested parties to comment on the proposed exemption.

DOL Has a Process to Grant Administrative Exemptions for Otherwise Prohibited IRA Transactions

DOL regulations lay out the process for filing and processing prohibited transaction exemptions applications. Among other things, the regulations explain: who may apply, what information must be included with an application, when a conference with DOL can be requested, when a request for reconsideration of a DOL decision can be made, how DOL and the applicant will notify interested persons if DOL decides a tentative approval is warranted.

DOL also publishes a booklet that provides an explanation of the regulations and applicable laws, and includes additional information for applicants like examples of common types of exemption requests.

IRA owners or their fiduciaries file applications for exemptions with DOL’s Office of Exemption Determinations which is part of EBSA. Applicants can research information about past exemptions granted by the agency on EBSA’s website. As explained in the DOL booklet describing the application requirements, applicants have the burden of demonstrating that they should be granted an exemption.

If DOL tentatively denies an application, applicants have options for requesting that the denial be reconsidered. Within 20 days of the tentative denial, applicants can request a conference with DOL, or notify DOL of their intent to submit additional information. If, after a conference has been convened, DOL issues a final denial of the application, DOL will entertain one request for reconsideration if the applicant presents significant new facts or arguments, which, for good reason, could not have been submitted earlier.

After DOL publishes a notice of proposed exemption in the Federal Register that describes the pending application, the applicant must notify interested persons of the pending exemption. Often, the contents of the information sent to all interested persons, the manner in which it is sent, and any associated deadlines will have previously been agreed to by DOL and the applicant. DOL may also hold public hearings during the comment period. For example, if the transaction involves potential fiduciary self-dealing or conflicts of interest, any individual potentially adversely affected by the exemption may submit a request for a public hearing to DOL. If granted, DOL publishes information about the exemption in the Federal Register and on its website. Figure 1 provides an overview of the exemption application process.

The regulations describe circumstances in which DOL will ordinarily not consider an application. For example, DOL generally will not consider an individual application if DOL already has under consideration a class exemption relating to the same type of transaction. DOL will also not consider an application for transactions subject to DOL or IRS investigations. DOL requires applicants to disclose in their applications whether exemption transactions are, or have been, subject to an investigation or enforcement action by DOL or IRS. In addition, if the applicant or any other party in interest becomes the subject of an investigation or enforcement action, the applicant is required to promptly notify DOL.

If applicants find that their prospective transaction is substantially similar to other transactions for which the agency has previously granted exemptions, they can follow an expedited process by submitting an “EXPRO” application. EXPRO applications are required to cite prior exemptions granted by DOL to demonstrate that the proposed IRA transaction is substantially similar to other IRA transactions for which DOL has previously provided an exemption. Specifically, EXPRO applicants must cite as substantially similar, either (1) two individual exemptions granted by DOL within the previous 5 years, or (2) one individual exemption granted within the past 10 years, and one transaction authorized pursuant to the EXPRO class exemption within the past 5 years. The applicant must give notice to all interested persons, and the applicant must resolve all substantive adverse comments provided by interested persons before DOL will grant final approval.

The time to complete the exemption process can range from a few months to more than a year. DOL officials told us that the process generally takes about 1 year for an individual IRA application that is relatively simple or routine. EXPRO applications have been processed in as few as 78 days. According to DOL officials, the process can start before an applicant submits a formal application because applicants can, and do, request informal consultations and conferences with DOL. DOL officials explained that sometimes potential applicants decide not to file an application after an informal conference because applicants realize that their application would likely be denied.

DOL officials explained that during the review process, they first confirm their understanding and characterization of the proposed exemption through correspondence with the applicants. Then, in response, DOL often sets conditions under which relief from the prohibited transaction rules is contingent, such as on the applicant taking additional actions and remaining in compliance with those conditions. For example, if an applicant wants to sell or purchase an asset in what would be an otherwise prohibited IRA transaction, DOL may stipulate that the applicant first obtain an independent appraisal or valuation assessment to determine a fair-market value of that asset.

After applications are formally submitted, many IRA applicants withdraw during DOL’s review process. Over an 11-year period, we found that of the 124 IRA applications, applicants withdrew roughly half (56) before the review process was completed (see table 1). Of the remaining 68 applications that continued with the review process, DOL granted 48, denied 16, and closed four application cases for administrative or other reasons. DOL officials did not dispute the results of our analysis, but they said that it would be misleading to conclude that DOL is more likely to grant than deny applications. Rather, they said that their practice of encouraging applicants to consult with DOL in advance leads some potential applicants to decide not to pursue an exemption.

In our review of processed applications, we found that most of the applications involved the sale of IRA assets. We found that 88 of the 124 applications were for transactions involving the sale of IRA assets. Most of these were sales of securities or real property (see appendix I for additional information). The next most common type of transaction was for the purchase of assets (21 applications), and most of those also involved securities or real property. The remaining applications involved other transactions, including leases, loans, and extensions of credit.

DOL Lacks Documented Policies and Procedures to Manage Its Reviews and Data

DOL has not sufficiently documented internal policies and procedures to manage and help ensure effective internal controls of its prohibited transactions exemption process. While DOL regulations and guidance detail the requirements for applicants, DOL generally lacks internal documentation of the steps and actions DOL officials are to follow when processing applications, and the roles and responsibilities of agency officials.

DOL officials told us that they use a case tracking system to record and track applications. When an application is received by DOL, the division chief of EBSA’s Office of Exemption Determinations (OED) reviews the application and assigns it to an OED supervisor. Either the division chief or the supervisor enters preliminary information from the application into the system, and classifies the transaction by applying one or multiple subject matter codes. The supervisor then reviews the information in the applicant’s case file and assigns the case to an OED analyst. DOL officials told us that any interim data, such as the publication date for a proposed exemption, is entered by the supervisor in the system. If an application is withdrawn by an applicant, denied, or granted, the supervisor records this information in the system, including the dates of these actions. When a case is closed, the analyst completes a close-out index form and submits it to the supervisor for review, and the supervisor enters a closing code in the system. DOL officials told us that they can use the system to generate management reports, such as on the number of applications filed and the amount of time to process cases.

Neither the process described above, nor the different roles and responsibilities of the OED division chief, supervisors, and analysts in that process, were documented in the internal documents that DOL provided. A system reference guide included instructions to system users for how to input and modify case records, generate reports, and add or modify users. The reference guide also included screen prints indicating which fields are required by the system to process a case. However, the reference guide did not contain information about responsibilities and duties for these data entry activities, and how those duties are assigned. The documentation provided is unclear regarding who within OED is ultimately responsible for making final decisions on applications.

According to Standards for Internal Control in the Federal Government, documentation of an agency’s policies and procedures is a necessary part of an effective internal control system. Such documentation can appear, for example, in management directives or operating manuals, and it should be readily available for examination. Policies and procedures can also help document internal control responsibilities within the agency.

DOL officials told us that OED is a small and compact organization, and as such, its policies and procedures can easily be communicated “person to person” and through onsite training. DOL officials also said that the process for entering data is not difficult, and there are few opportunities for error because nearly all data on applications is prepopulated.

The principles of internal control, however, apply to both large and small organizations. The level and nature of documentation may vary based on the size of the organization and the complexity of the processes the organization performs, but documentation is still necessary. By documenting policies and procedures, management will be better positioned to monitor whether the organization’s activities are aligned with those policies and procedures, and assess whether the organization is achieving its objectives. Documenting procedures also would provide greater transparency about how applications are handled, and can reduce the risk of employees carrying out their duties inconsistently. For a small organization like OED, documentation of policies and procedures provides a means to retain organizational knowledge, and can help ensure continuity of and consistency in operations if key personnel leave the organization unexpectedly.

DOL and IRS Currently Share Some Information on Exemption Applications, but More Formalized Collaboration Could Improve Their Oversight Efforts

Some information sharing takes place between DOL and IRS on applications for IRA prohibited transaction exemptions, but no formal mechanism exists to help guide collaboration between the two agencies. As previously discussed, DOL and IRS share oversight responsibility for prohibited IRA transactions. Based on our review of applications and DOL data as well as interviews with agency officials, we found that interactions between DOL and IRS regarding applications for prohibited transaction exemptions are infrequent and limited in scope. Of the 124 applications we reviewed, only eight were coded in OED’s Case Tracking System as having “external contact with IRS,” and DOL officials confirmed that this accurately reflects the level of interagency coordination. DOL officials stated that they sometimes contact IRS about exemption applications, and IRS officials confirmed to us that they periodically receive communications from DOL. IRS officials also told us that they occasionally contact DOL.

Both agencies described to us how their current interaction occurs. DOL officials told us that they coordinate with IRS in the following ways: If, during the application review process, OED staff identify applications that may warrant further review or investigation for tax violations, they refer the case to EBSA’s Office of Enforcement, which may then coordinate or refer the case to IRS.

DOL officials said that OED staff review the IRS “Dirty Dozen” list of potentially abusive tax scams and schemes.

IRS officials said that when possible prohibited transactions arise during an examination that might require DOL input, IRS examiners reach out to DOL to ensure that IRS understands DOL decisions on those transactions.

DOL officials said that, in their view, most requested prohibited IRA transaction exemptions do not require extensive interaction with IRS. They questioned the potential usefulness of information about denied or withdrawn applications that might be shared with IRS, but said that IRS could certainly obtain this information if IRS requested it.

IRS officials, however, told us that more information from DOL about prohibited IRA transactions and requested exemptions could be useful in carrying out IRS’s oversight responsibilities. For example, DOL does not share information on denied or withdrawn applications with IRS, information that IRS officials told us would be helpful to them. We found that denial information could be useful to IRS as illustrative examples of prohibited transactions for examiner training and educational outreach to IRA owners. Information about the types of transactions in withdrawn applications could also help IRS identify emerging issues or trends in potential prohibited transactions marketed to IRA owners.

Although some limited collaboration between DOL and IRS exists, the agencies have not applied to their oversight of prohibited transactions some key practices we have identified in prior reviews of interagency collaboration. Specifically, developing a mechanism to formalize the sharing of information between DOL and IRS could help support current collaboration activities, and could be useful in helping the agencies identify opportunities for greater collaboration going forward. Furthermore, documentation is a necessary part of an effective internal control system. Documenting the procedures for interagency collaboration would improve internal control over the agencies’ activities. A formal agreement, such as a memorandum of understanding (MOU) or other mechanism, can further help agencies monitor, evaluate, and update interagency collaboration.

For example, DOL and IRS have previously formalized their collaboration regarding oversight of a different type of retirement savings vehicle— employer-sponsored retirement plans. DOL and IRS have oversight responsibilities for employer-sponsored retirement plans, such as pensions, and in 2003, DOL and IRS completed an MOU to implement collaboration between the two agencies with regards to investigations of and litigation involving employer-sponsored retirement plans. The employer retirement plan MOU and the implementing guidance contain some features of interagency collaboration mechanisms that we have identified in prior work. For example:

The responsibilities of each agency are documented, and responsible agency components and officials are identified.

The agencies use collaboration tools (checklists) for determining whether issues presented in an examination or investigation by one agency should be referred to the other.

A system and process exists to track referrals, and the agencies reconcile their data about referrals (including pending referrals) quarterly.

The employer retirement plan MOU also established a process to periodically monitor its effectiveness, and the MOU was last updated in 2013. Developing a similar mechanism to formalize the sharing of information between DOL and IRS regarding IRA prohibited transaction exemptions could help the agencies better support their current coordination efforts and identify additional opportunities for greater collaboration.

Conclusions

IRAs are a key vehicle for individuals to save for retirement. IRA owners’ decisions to invest in unconventional assets can expand their role and responsibilities substantially. The consequences for account owners who make a mistake can be severe.

When IRA owners request an exemption from rules on prohibited transactions, DOL evaluates applications using statutory criteria, and follows administrative procedures codified in regulations. However, DOL has not sufficiently documented internal policies and procedures for how to manage its process for granting exemptions. Such documentation is a necessary part of an agency’s effective internal control system.

DOL and IRS share oversight responsibility of prohibited IRA transactions. While the two agencies do share some information, they do not have a formal mechanism to guide and monitor their collaboration. By formalizing interagency collaboration, such as through an MOU or other mechanism, DOL and IRS could help reinforce their current information sharing and potentially identify new opportunities to improve their oversight efforts through greater collaboration. Documenting procedures for DOL and IRS collaboration on prohibited IRA transactions would also help introduce better internal control over these activities.

Recommendations for Executive Action

We are making a total of three recommendations, including two to DOL and one to IRS.

The Secretary of Labor should document internal policies and procedures for managing the IRA prohibited transaction exemption process. (Recommendation 1)

The Secretary of Labor, in consultation with the Commissioner of Internal Revenue, should establish a formal means, such as a memorandum of understanding or other mechanism, to support and guide DOL’s and IRS’s collaborative efforts to oversee IRA prohibited transaction exemptions. (Recommendation 2)

The Commissioner of Internal Revenue, in consultation with the Secretary of Labor, should establish a formal means, such as a memorandum of understanding or other mechanism, to support and guide DOL’s and IRS’s collaborative efforts to oversee IRA prohibited transaction exemptions. (Recommendation 3)

Agency Comments

We provided a draft of this report to the Secretary of Labor, the Commissioner of Internal Revenue, and the Secretary of the Treasury for review and comment.

In its comments, reproduced in appendix II, DOL generally agreed with our two recommendations directed to it. For recommendation 1, DOL plans to create an internal procedure manual formalizing OED’s administrative case processing procedures to help in passing along institutional knowledge. For recommendation 2, DOL agreed to periodically discuss all IRA exemption cases with IRS and did not elaborate on the formal means for this information sharing. DOL also provided technical comments which we incorporated as appropriate.

In its comments, reproduced in appendix III, IRS generally agreed with our recommendation directed to it. For recommendation 3, IRS said it is committed to discussing an appropriate mechanism, including periodic meetings, to formalize collaboration on IRA prohibited transaction exemptions. IRS plans to consider expanding its formal collaboration with DOL as part of the next periodic update of the existing employer plan MOU. IRS also provided technical comments which we incorporated as appropriate.

The Department of the Treasury provided technical comments which we incorporated as appropriate.

As agreed with your office, unless you publicly announce the contents of this report earlier, we plan no further distribution until 30 days from the report date. At that time, we will send copies to the appropriate congressional committees, the Secretary of Labor, the Secretary of the Treasury, and the Commissioner of Internal Revenue. In addition, the report will be available at no charge on the GAO website at http://www.gao.gov.

If you or your staff have any questions about this report, please contact James R. McTigue, Jr. at (202) 512-9110 or Charles A. Jeszeck at (202) 512-7215. You may also reach us by email at mctiguej@gao.gov or jeszeckc@gao.gov. GAO staff making key contributions to this report are listed in appendix IV.

Appendix I: Applications for Individual Retirement Account Exempted Transactions by Type

Appendix II: Comments from the Department of Labor

Appendix III: Comments from the Internal Revenue Service

Appendix IV: GAO Contact and Staff Acknowledgments

GAO Contacts

Staff Acknowledgments

In addition to the contacts named above, MaryLynn Sergent and David Lehrer (Assistant Directors), Ted Burik, Susan Chin, Steven Flint, Emily Gruenwald, Mark Kehoe, Jungjin Park, and David Reed made key contributions to this report. James Bennett, Amy Bowser, Jacqueline Chapin, Edward J. Nannenhorn, Andrew J. Stephens, Walter Vance, and Adam Wendel also provided support.