A path to investment capital

QUESTION: Why would any of the people with a collective $90 billion in self-directed Investment Retirement Accounts (IRAs) decide to purchase alternative investments sponsored by energy companies?

ANSWER: Because they can if they want to!

The complete answer to this question is not quite so simple, but it does explain the rationale behind the growing number of alternative investments, including those sponsored by energy companies being purchased for self-directed IRAs.

Since these IRAs were introduced in 1974, the people who open them have been allowed to purchase alternative investments that meet the tax-deferred guidelines set out by the Internal Revenue Service. These include private stocks, limited partnerships, promissory notes, and similar products that aren't traded on an organized public exchange and require special expertise to establish their value. Their attraction, typically, is a high potential return on retirement investments.

The competition among all types of alternative investment sponsors for a piece of this investment capital is intense. But oil, gas, and energy companies seeking funds for exploration, recovery, transportation and distribution, and the financial advisory firms that assist them are becoming more aggressive in sponsoring alternative investments with these IRAs in mind.

It should be noted that many people purchase alternatives for segments of their investment portfolio other than IRAs and some purchase them for both current investments and retirement. This article aims to focus attention on the process and parties involved when an alternative investment is to become part of a self-directed IRA account.

Companies planning to promote alternative investments to this market will need to become familiar with a group of financial service firms that can become their allies in the process. They are known as custodians and their importance lies in the fact that all self-directed IRAs must be established with a custodian such as a bank, credit union, brokerage firm, savings and loan association or trust company that has been approved by a Federal and/or state agency to provide asset custody services to individual investors and financial advisors.

Investors may learn about energy alternatives from financial advisors, through research, or from sponsors directly. However it happens, if they want to purchase a specific alternative for their self-directed IRA account, the relationship between the sponsor, the investor and a custodian is soon to follow. It is at this point that sponsors and individuals learn that some custodians readily offer to administer retirement accounts with alternatives while others choose not to do so.

Those without a self-directed IRA who wish to buy an oil or gas alternative investment for retirement must contact a custodian that accepts these investments to open one. These new accounts can be funded from any source. Investors who already have such an account can use those funds to make the purchase assuming the custodian is agreeable. If not, funds must be transferred to a new account with a custodian that does.

When an alternative is of interest to an IRA account holder, the first step for the custodian is to review the investment to confirm its IRS suitability. Energy companies may wish to reach out to custodians to perform a preliminary review of their investment product. Favorable results may encourage the sponsor to refer prospective IRA investors and their advisors to these custodians to speed up the investment process. However, investors can open self-directed IRAs or add new alternatives to an existing IRA administered by any firm willing to service them, thus, sponsors may find themselves working with a number of custodians.

Once an investment's IRS compliance is confirmed and the IRA is opened and funded, the account holder will sign the offering documents provided by the sponsor. While the decision to make the purchase is the investor's, it is the custodian that makes the purchase in the account's name using funds in the client's IRA. This initiates the ongoing relationship between the sponsor, the IRA account holder, and the custodian for the life of the investment. The sponsor will forward to the custodian all revenue originating from the alternative which will be recorded and deposited in the client's account. If payments of any type are due the sponsor, the custodian will issue them. The custodian will also be responsible for selling, liquidating, or closing out the investment in the manner described in the subscription or offering memorandum.

As part of the administrative services, custodians issue regular reports to account holders and their financial advisors as well as to the IRS. At the time of purchase, the custodian and the account holder agree on an independent third party that will annually establish the value of the investment for the account holder to be reported to the IRS. Equally important, the custodian will monitor business or financial transactions related to the investment by the account holder and sponsor to guard against prohibited transactions that would result in a financial penalty imposed on the IRA by the IRS.

It bears mentioning that while custodians are active participants in the IRS suitability determination and the ongoing IRA administration, they do not offer clients any investment, financial, or legal advice related to the investments nor do they offer any opinion to the sponsor as to whether a client has sufficient wealth to be considered an accredited investor which is often a sponsor's requirement.

While a basic understanding of the role custodians play in the self-directed IRA market is important, energy sponsors should realize that like any other group of businesses, there are differences in business models and experience. Sponsors may benefit from learning as much as possible about custodians they might recommend to potential IRA investors or about other custodians an investor might choose. Research not only provides an overview of the custodian's approach to the alternatives and IRAs, but will help develop specific discussion points. Key points to consider:

1. How long has the firm been serving self-directed IRA clients who have invested in alternatives?
2. How many IRA accounts with alternative investment does the firm have?
3. How many different types of alternative investments do its clients hold?
4. What is its specific experience with energy-related alternatives?
5. Through its website or other means, does it provide educational information to prospects, clients and advisors about alternatives?
6. What website, online, and communications technology does it use to open and administer accounts, accept transferred funds, and report to clients, advisors, the IRS and sponsors about the investments in IRA accounts?
7. How does it handle telephone and e-mail inquiries and questions from prospects, clients and advisors?
8. What fees does it charge to open and administer self-directed IRAs?
9. Do investment community and industry trade media and associations look to the firm as a source of self-directed IRA information?

Energy investment sponsors that study the world of self-directed IRA custodians will conclude that their primary role is to assist sponsors and clients who want to make their own retirement financing decision using IRS-approved investments.

About the author

John Johnson is president of GoldStar Trust Company. GoldStar has more than 20 years of experience as a selfdirected IRA custodian and serves more than 37,000 IRA accounts with assets of more than $2.2 billion, as of March 31, 2013.