Potential fallout from the US Department of Labor’s (DOL’s) fiduciary rule affects the status of Individual Retirement Account (IRA) custodians and trustees that have been approved by the IRS to act as nonbank custodians and trustees. These nonbank custodians and trustees must satisfy a laundry list of requirements under the US Department of the Treasury’s (Treasury’s) regulations. One such requirement is that the nonbank custodians or trustees must periodically satisfy the “net-worth” test. The net-worth test generally requires that a nonbank custodian or trustee’s net worth be at least equal to a specified percentage of all of the assets it holds as a nonbank custodian or trustee. If the nonbank custodian or trustee holds the assets as a “passive” nonbank custodian or trustee, less net worth is required to pass the test.

The Treasury regulations generally define a “passive” nonbank custodian or trustee as one that does not have the discretion to direct the investment of the assets it holds – so far so good. What gives us pause is language in the IRS Non-Bank Trustee Investigation Procedures that defines “passive” on a controlled group basis and in terms of not providing “any investment advice,” which could arguably include nondiscretionary investment advice. Although Investigation Procedures may not be cited as authority, they do provide insight into what the IRS is thinking and are the basis used by the IRS in conducting its periodic nonbank custodian and trustee investigations.

The concern is that the IRS may be thinking that “passive” is the same as not being a “fiduciary” under the Tax Code for purposes of the prohibited transaction rules. This interpretation works under the current Tax Code definition of “fiduciary” because investment advice may be given without triggering fiduciary status if certain requirements are met. Under the new DOL fiduciary rule, however, this would generally not be the case. If nonbank custodians and trustees that are currently passive are considered nonpassive, they would need a higher net worth to pass the net-worth test, which could trigger related adverse economic consequences. Because the nonbank custodian Treasury regulations define a “passive” nonbank custodian or trustee as one without investment discretion, it would appear that the Treasury regulation would need to be amended before the new DOL fiduciary rule could be applied to the definition of “passive,” but it is unclear what the IRS is thinking.

To read part one, click here -  More DOL Final Fiduciary Rule Fallout: Some Potential IRS Pitfalls for IRA Custodians and Trustees (Part 1 of 2)