Self-Directed IRAs are ideal fraud targets

Most Americans are familiar with the various retirement plans available to them for their long-term futures. Perhaps you're one of the fortunate few who still have a pension with your employer that will pay benefits to you based on a specific formula determined by that benefit plan. Or maybe your company offers a contribution plan such as a 401(k) and may even offer an employer match. Still others may utilize Individual Retirement Accounts (IRA) such as the traditional version or Roth. However, I've left one out one lesser-known retirement vehicle: the Self-Directed IRA (SDIRA), which poses potential major fraud risks. 

Self-directed IRA players

Larry and Eleanor Kotula, nearing retirement age, were well on their way to living out their golden years. (This case is fictitious but, sadly, all too accurate.) They did everything right. They raised two children and paid for their college educations, lived modestly and saved aggressively for retirement. They’d amassed more than $1 million in Larry’s employer-sponsored 401(k) plan and had paid for their home worth $250,000. Everything was looking well until the 2008 stock market plunge. Like many investors, they lost a significant sum of their nest egg and soured on the prospects of the financial markets. They began looking to find sources of more promising investment returns other than the stock market. They met Ron, a financial advisor and investment promoter, who steered them to an SDIRA.

SDIRAs offer wider array of investments

Time for a short SDIRA primer. SDIRAs are tax-deferred IRAs that require their owners to make their own investment decisions and direct the purchases or sales of assets within their accounts. Investors in SDIRAs are generally able to purchase a greater array of investment assets, including real estate, precious metals and promissory notes. In other words, SDIRAs are constructed to invest in alternative investments outside of firm-approved stocks, bonds or mutual funds that would be typically offered by brokerage companies. Now back to the Kotulas.

Self-directed IRA fraud?

So, Ron identified investments and business ventures in which the Kotulas could invest their rolled-over 401(k) funds and assisted them in setting up an SDIRA. Ron first helped them create a limited liability company (LLC) that would be the owner of the SDIRA. In most cases, the SDIRA is the 100 percent owner or member of the LLC. Now the LLC, in turn, would be the legal owner of any assets for which money is invested. (See Self-directed IRAs: A tax compliance black hole, by Warren Baker, Journal of Accountancy, October 2013.) This is known as a "checkbook IRA" because the LLC has a bank account for which investors can write checks. Of course, in our scenario above, Ron made himself the manager of the Kotulas’ LLC and gave himself sole signature authority on the bank account set-up for the LLC. (You see where this is going.)

After Ron began the LLC and helped open the bank account, he created an account for the Kotulas at a "trust custodian." The U.S. Internal Revenue Service requires that custodians and/or trust banks administer tax reporting and keep records on SDIRA assets but nothing more. Though these custodians don’t have to meet the same regulatory requirements as traditional brokerage firms, they have limited responsibilities and typically aren’t responsible for evaluating the quality or legitimacy of the underlying asset placed in an SDIRA. (See Rule with self-directed IRAs: Investor really beware, by Ilyce Clink and Samuel J. Tamkin, Sept. 29, 2012, Chicago Tribune.)

Because custodians are in charge of record keeping, they must account for investment purchases or sales and any gains or losses during their year-end valuations of SDIRA investments. The custodian sends quarterly account statements to the investors. However, any information the custodian provides the investors is solely based on numbers from the LLC, which in our example would be Ron. In other words, the custodian does no due diligence on behalf of the investor as to the value of the investments or legitimacy of the quarterly account statements.

In the Kotulas’ case, this is where things started to go wrong. They completely relied on Ron’s promotion of a particular business venture. After the Kotulas rolled their money from the 401(k) into the custodian account, Ron withdrew those amounts to the LLC bank account by providing an investment certificate to the custodian for record keeping. Unfortunately, the investment certificate was fake, and no business venture existed. Ron was then able to divert money from the LLC bank account for his own purposes.

Over the next several years, the custodian continued to hold the fake investment certificate and provided quarterly account statements to the Kotulas based on values that Ron provided. Because the Kotulas’ custodian provided them quarterly statements that showed increasing values, they assumed their investments were performing well. Years later, the Kotulas accessed their retirement savings and realized they were fraud victims.

Of course, not all SDIRAs are fraudulent. However, numerous risks make them particularly vulnerable to fraud.

SDIRA fraud risk and prevention

According to the Investment Company Institute (ICI), as of Dec. 31, 2013, approximately US$23 trillion was invested in retirement savings, which represented 34 percent of U.S. household financial assets. (See Retirement Assets Total $23.0 Trillion in Fourth Quarter 2013.)

The large amount of money held in retirement accounts might make them more susceptible to fraudsters. Also, as investors become more savvy they might be enticed to identify other alternative types of investments outside the traditional types of investments (i.e. stocks, bonds, mutual funds). A potential growing trend for SDIRA investments and opportunity for fraudsters might exist in the crowd-funding phenomenon. Below are five helpful tips to prevent and avoid SDIRA fraud from the U.S. Securities and Exchange Commission. I’ve added tip No. 5. (See the SEC Investor Alert, Self-Directed IRAs and the Risk of Fraud.)

1. Verify information in SDIRA account statements. Because LLC managers report investment values to custodians, it’s important that investors take extra care to understand the underlying investments. For example, if investors are directing their investments into real estate they should verify the existence of the real estate. Investment promoters should be willing to provide sound evidence of how the investments were valued.
2. Perform some due diligence. Verify that the person offering the investment is licensed. This may provide some security because any credible investment advisor typically has to go through a series of regulatory steps to become licensed. Also, obtain references of the person offering the investment.
3. Ask questions. This is probably the most important step you can perform when investing in any product. If you don’t understand the investment or process well enough so you can explain it to others, then it probably isn’t something you should be investing in.
4. Be mindful of guaranteed returns. If it is too good to be true then it probably is. It’s a cliché, but do I need to say more? Rarely do any investments have guaranteed returns. Just remember this simple saying: The higher the risk, the higher the reward. And the lower the risk the lower the reward.
5. Seek counsel. Seek the advice of friends who aren’t professional attorneys or CPAs. You might be surprised at how intuitive they can be in gauging your investment opportunity.

Retiring baby boomers and ambitious millennials

In the next decade, fraud risks associated with SDIRAs will grow with the large number of baby boomers entering retirement age and the huge pool of assets available to fraudsters. Also, younger generations may seek investment opportunities outside of the traditional stock markets, such as technology and start-up ventures. As anti-fraud professionals, we need to be aware of new and sophisticated ways investors may be defrauded.

L. Christopher Knight, CFE, CPA, is a forensic accountant in Indianapolis, Indiana, and an adjunct instructor at Indiana University-East in Richmond, where he teaches courses in support of the minor in financial forensic investigations.

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