Entrust New Direction Blog

The self-directed IRA is a wonderful vehicle for diversifying IRA or other qualified funds into ‘alternative’ assets like real estate, private placements, notes, precious metals, and more. The whole structure of a truly self-directed plan is different than what most people are accustomed to with their current bank or brokerage company. Most people are more familiar with working with an advisor or appointed financial representative. With that structure, the advisor/representative helps the client determine what the IRA is going to invest in and when. With a truly self-directed IRA there is no advisor or representative. You take on that responsibility as the ‘self’ in the self-directed IRA.

You are the one in control of everything that happens with your IRA. We need your initiative to do anything with the account. We can’t (and won’t) do anything without your direct, written authorization. We are here and accessible to do whatever you need us to do. However, in order to ensure the full security of your account, we do not take any action except upon receiving your direct written request.

As a general rule, if you are a client and you are thinking to yourself: “I wonder who is doing such and such?”—the answer is probably YOU! You decide what your IRA is going to invest in. You put together the details of the investment. You provide us with the investment direction forms, and you approve everything before we process it.

The great thing about working with a local company like Entrust New Direction is that we are available when you need to reach someone. We always answer the phone when you call, and you are able speak with a representative in the appropriate department to help with whatever you need.  Additionally we have a wealth of really good information on our website.

I am a visual person and I like analogies, so here’s an analogy for the self-directed IRA structure: Think of the IRA as a bus. You are the driver of the bus and Entrust New Direction serves as the wheels and sometimes the brakes. A bus without wheels is not going anywhere (you need a self-directed IRA administrator to provide recordkeeping and administration for the IRA), and a bus without brakes is extremely dangerous. Thus, our two roles are essential to the IRA. We will move when you direct the steering wheel of the bus in a particular direction and hit the gas. If you are clearly going the wrong way (i.e. towards a prohibited transaction) we will stop you. 

If you are not an Entrust New Direction IRA client and are working with another self-directed IRA company that doesn’t utilize their brakes, you may want to ‘trade in’ for a better bus. If you find a company that blindly does whatever you ask, without requesting documents or asking basic questions, you may want to separate yourself from that company. Unfortunately there are companies in our industry that operate without ever utilizing their brake system.

It is important to note that, at the end of the day, you are responsible for your self-directed IRA. Entrust does not approve or endorse any investments. We are capable of telling you what the rules are, however when it comes down to it, it’s your IRA and you are responsible for it. We’ve been doing this a long time and we are very knowledgeable of the rules for self-directed IRAs.

We can’t give advice or ‘approve’ your investments, however, if you are forthcoming and honest with all the information and you have a general question about whether something that you are looking to do is a prohibited transaction or not, we can generally answer your questions (or at least direct you to the appropriate section of the Code to research the issue). If we happen to see that the investment you are trying to make is clearly a prohibited transaction, then we won’t fund that transaction (i.e. we will use our brakes). We don’t want our clients to get into trouble with the IRS, that’s not good for anyone. We don’t want ‘bad assets’ in our system, and we certainly don’t want our clients getting into trouble and telling their friends what a terrible experience they had with one of those ‘self-directed IRAs.’

Our goal is to provide our self-directed IRA clients with the broadest spectrum of investment options while at the same time helping them stay out of trouble and maintain their IRA’s tax deferred status. If you know what you want to do with your IRA, and need an administrator that will allow for the flexibility to do it, give us a call. We would love to work with you. 

Photo Courtesy of Bill Ward.

We field quite a few calls from ‘creative' investors scheming to get around the IRS rules for self-directed IRA investing. As somebody that takes a lot of these calls, I am often surprised by the lack of respect that the IRS gets from the average US tax payer. I understand that very few people have ‘warm and fuzzy' feelings about the IRS; I mean it is pretty rare that a surprise contact by the IRS is a good thing! So I understand the distaste with the IRS, however I think people should be careful not to confuse dislike with a lack of respect.

("tax collector" photo by eflon)  

The fact is, the IRS is pretty darn good at what they do once they open an audit. IRS audits are extremely thorough. If you break a rule and your IRA is audited you are probably going to get busted and the penalties can be extremely damaging to your IRA. On top of that, unlike within our Judicial System, the accused is guilty until proven innocent - not the other way around. The burden of proving innocence falls on the accused taxpayer.

The IRA prohibited transaction rules can be found section 4975 of the IRS code. In respect to buying real estate within an IRA the rules are you (and your direct lineal relatives) cannot use the asset that your IRA owns. Additionally, your IRA cannot have transactions (buy/sell) with you or your direct lineal relatives. These rules are pretty cut and dry and there is no legitimate way to get around them. If your IRA owns a property, there is no way for you to use the property or benefit from the property in any capacity. Likewise, if you own an asset personally there is no way to move it into your tax-deferred IRA.

We know these rules well because we remind people every day.  We want all IRA owners - clients, prospective clients and otherwise, to know the rules so they never have to dread the call from the IRS.  Our number 1 job is education because we want every single person we speak with to know the rules.  While we do not take legal or fiscal responsibility for the self-directed IRA, we do feel a personal responsibility for your education. 

We like to think of ourselves as the angel on your shoulder when you make an investment decision.  You, of course, make your own decision.  But we try to whisper in your ear, "Prohibited Transaction", and "Self-dealing, don't do it".  We want you to have as much money as you can legally acquire when you're ready to retire.

And of course, you want that too.  We often get asked the question "how would the IRS know if I use the property?" As an administrator of self-directed IRAs, we don't get involved with how likely it is that someone gets caught in a prohibited transaction; we are focused on not allowing clients to get their IRA involved in a prohibited transaction in the first place. Granted, there are not IRS police spying on your IRA-owned property trying to catch you in the act of using the property. However, if you or your IRA gets audited there is a very high likelihood of getting caught if you did in fact break the rules.

Another unique thing about the IRS that you should understand is they don't just look at the transaction itself, they also look at the circumstances involved. We've had prospective clients propose structured arrangements to get around the rules. We've heard things like "what if I sell my personally owned property to my friend and then buy it back with may IRA.... how would the IRS ever know?" The fact is, it would take the IRS all of about 2 minutes to see what you've done and to declare the arrangement as a prohibited transaction. Buying the property with your IRA from your friend is not directly a prohibited transaction; however, the arrangement of selling something you own to the friend and then buying back with the IRA is most definitely a prohibited transaction. Additionally, not only did you break a rule, but you intentionally created a scheme to get around the rules....The IRS is not going to take this lightly.

Other investors suggest using an LLC to get around the IRS rules. LLCs can sometimes be useful in structuring real estate investment.  However, they are not magical entities that make all the rules disappear. If your IRA invests in an LLC, then the rules apply to the IRA now apply to the LLC as well.

The penalties for prohibited transactions can be extremely harsh. The IRS does not tie their hands down by telling you exactly what will happen if your IRA takes part in a prohibited transaction. Each case is judged on a case by case basis. You will almost certainly lose your IRA tax-deferred status (the IRA would be immediately distributed to you personally). This can create an unexpected tax liability as well as penalties if you are under the age of 59.5. On top of that, they will most likely impose a 15% prohibited transaction penalty. There have been extreme cases when the prohibited transaction resulted in 100% loss of the IRA. Prohibited transactions are not to be taken lightly.

The bottom line is this: your IRA receives special tax treatment from the IRS.  IRAs have built in tax-deferred growth. In order to maintain that treatment, it is important that the IRA investments are just that...investments. If you want to use the IRA funds or benefit from the IRA funds then you should take a distribution, pay the tax and then do whatever you like with the funds. However, while they remain in the IRA you (and your direct lineal family members) should not benefit from what the IRA is doing. So next time you are trying to think of a creative way around the IRS rules, STOP!.... there is no legitimate way to get around the IRS rules.

When the first King levied the first tax on the first farmer, humanity began our hate/hate relationship with taxes and, in some cases, tax collectors.  I can imagine that the biggest and meanest person would be tax collector, and this object of dread would take just about everything the farmer didn't already use.  Thankfully, these days, we are able to work a little magic with IRAs, HSAs and other tax-deferred and tax-free options. 

Of course it's not magic, but it sure can seem that way unless you're a CPA in title or experience level.  We here at Entrust New Direction have had so many questions about UBIT, taxes on IRAs and taxes on other retirement accounts,  we decided to open an accounting firm, IRA Tax Services, Inc. - specifically to help people with these types of accounts.

However, as education is really our #1 priority, we want to share some answers with you in a couple different FAQ blog posts.

Question: My Roth IRA purchased a rental property, funding it with 10% from the IRA and 90% from a bank loan. The net income is $3,000 a year. Is all the net income from this property tax-free? Or is $2,700 taxable and only $300 is tax-free?

Answer: The bank loan part is subject to UBIT. You referred to net income. If your calculated net income is $3,000, after all expenses (including depreciation), then roughly 90%, or $2,700 is taxable to the IRA. The IRA's first $1,000 would be tax-free, thus, it would pay tax on $1,700 (around $255). If you didn't calculate net income (Unrelated Business Taxable Income) with all allowable expenses and depreciation, then go back and do so. We often find that IRAs, like other real estate investors, find that they have positive cash flow but a tax loss. It is important to file the 990-T to report the loss and thus carry it forward to future years. Also note the debt-financed percentage is recalculated each year.

Question A Wall Street Journal Article that I found says ". . . any leveraged property in an IRA can trigger the Unrelated Business Income Tax. When mortgaged investments post a profit of over $1,000 in any year, the gain beyond $1,000 is taxed at anywhere from 15% to 40%. IRA investors can get around the tax by applying excess profit to the loan principal. Once the loan is paid, the UBIT no longer applies to any profit, and if the property is held for an additional 12 months in the IRA, eventual sale profits won't be subject to the tax either."

The quote above states "IRA investors can get around the tax by applying excess profit to the loan principal." Is it true that applying the excess profit from rents to principal pay down will avoid UBIT? Thank you.

Answer: What the article should say is not "get around that tax", but instead that paying down the debt balance will reduce the taxable portion of the income. The intent of the article is to highlight that by paying off the loan as soon as possible (and then have a 0 loan balance for a 12 month period), the IRA can reduce to 0 the debt-financed percentage and thus have no UBIT. The profits from the investment, plus any other available cash can be used to pay down the loan. Note that this strategy limits your IRA's other investment options since the money is going to the bank instead of buying new investments. Run the numbers to see what makes the most sense in your situation.

Question  Let's just say my self-directed IRA purchases a 5% interest in an LLC that buys a shopping center for cash. In the first year, the LLC has net income of $100,000 and distributes $5,000 to the IRA. The following year, the LLC obtains a non-recourse loan of $1,000,000. The LLC uses $100,000 of the loan proceeds to hire an unrelated contractor to make improvements to the property, and distributes $900,000 of the proceeds.  $45,000 of this $900,000 is distributed to the LLC. After the debt is added, net income remains the same, and thus $5,000 of net income is distributed to the IRA in year two. Is there now unrelated business income, and if so, how much?

Answer The amount of UBIT is determined on the percentage of the amount of total indebtedness from the acquisition of the property. Depending on the business activity of the LLC, it may be that the LLC is operating a business, and thus all of its earnings may be subject to UBIT as a result.

Assuming in your example that the LLC is just a passive rental operation, then you need to calculate the debt financed portion of the property. Using the property for security for a loan does not make the property debt-financed unless the money is used on the property. In your case, $100,000 of the loan which was used to improve the property is debt-financed, and income generated by the overall debt-financed portion is subject to tax (avg debt/average depreciated basis of the property plus improvements).  The other $900,000 was not used to acquire any asset, other than the cash, and that is not generating income as it has been distributed. It does not enter into the UBIT calculation.

Confused?  Have more questions?  You can always use IRA Tax Services and ask your own question. Or, like some of our clients, just drop off a truckload of documents duct-taped together in a big ball and hope for the best.

Just Kidding.   Please keep your documents organized.

Everyone's favorite government organization, the Internal Revenue Service, recently released their annual "'Dirty Dozen' Tax Scams", and some aspects of retirement arrangements did not slip by un-noticed. In this case, the IRS is looking out for your (and your IRA's) best interest.

To summarize and generalize, this quote is from IRS Commissioner Doug Shulman: "Taxpayers should be wary of scams to avoid paying taxes that seem too good to be true, especially during these challenging economic times. There is no secret trick that can eliminate a person's tax obligations."

The IRS is paying attention to IRAs, and is learning more and more about cheaters each year. The 2007 and 2008 Dirty Dozen both mentioned retirement arrangements; specifically, "Taxpayers should be wary of advisers who encourage them to shift appreciated assets into Roth IRAs or companies owned by their Roth IRAs at less than fair market value. In one variation of the scheme, a promoter has the taxpayer move a highly appreciated asset into a Roth IRA at cost value, which is below annual contribution limits even though the fair market value far exceeds the amount allowed."

This year's list includes a specific reference to LLCs.

Abusive Retirement Plans
The IRS continues to uncover abuses in retirement plan arrangements, including Roth Individual Retirement Arrangements (IRAs). The IRS is looking for transactions that taxpayers are using to avoid the limitations on contributions to IRAs as well as transactions that are not properly reported as early distributions. Taxpayers should be wary of advisers who encourage them to shift appreciated assets into IRAs or companies owned by their IRAs at less than fair market value to circumvent annual contribution limits. Other variations have included the use of limited liability companies to engage in activity which is considered prohibited. (emphasis mine)

If you are considering an IRA LLC, please be aware of the legality and limitations. Don't trust just anyone you find on the internet (including us). Call the company, see how much they know about IRAs, the IRS, IRA LLCs.

For more information on the care and feeding of an IRA LLC (Checkbook Control IRA).

View full list on IRS website.

In some cases these rules appear intentionally broad and cryptic. Frequently, we look to tax court decisions, private letter rulings, and the pondering of experts to guide us in the quest to find the best investment offering the most control over the outcome while still steering clear of Prohibited Transaction pitfalls.

The recent court case Joseph R. Rollins vs. The Tax Commissioner – 11/15/2004 offers self-directed investors some clarification with regards to prohibited transactions and further clarification of the definition of “disqualified persons” with regards to one’s retirement plan investments. Briefly stated, the Rollins decision was based on the following set of circumstances:

Rollins was the administrator for his own 401(k) plan. He also owned less than a controlling interest in three legal entities. Each of these entities borrowed money and executed a promissory note with Rollin’s retirement plan at terms that would be considered fair market. Mr. Rollins acted as treasurer for these entities and was the signer on the promissory notes on behalf of the entities as well as directing the plan to fund the loans.

Definition of “Disqualified Persons”

A “disqualified person,” in most cases, includes the IRA holder, lineal ascendants and descendants of the IRA holder, as well as any entity where the aggregate ownership share of disqualified persons constitutes a controlling interest. For example, if the son and daughter of an IRA holder owned 50% of CrazyPants LLC, the IRA could not do business with CrazyPants LLC, regardless of the fairness of the terms of the transaction. Using these rules, it seemed permissible for Mr. Rollins’ plan to loan money to entities that were not “disqualified” as he did not own 50% of any of them.

While the definition covers employers, employee organizations such as collective bargaining units and other employer and family relationships, it is our experience that it is the IRA holder and his family members who are most often involved when deals are put together. The IRS has provided definitions of when transactions with these individuals will run afoul of the prohibited transaction rules. As a result, transactions are often designed with those definitions in mind in order to avoid a prohibited transaction issue. Mr. Rollins did exactly that in designing the plan loans. He acknowledged that he personally was disqualified but the transactions were with entities that were not. Yet the court determined that the loans gave him an indirect personal benefit and thus were prohibited transactions.

Disqualified Persons and The Rollins Decision

The Rollins Decisions caught some of us off guard because of the “controlling interest” definition we have carried around for so long. The resulting refinement of this definition has taught investors to look further into the structure of a transaction and examine: 1) Who is negotiating for each entity? 2) Who is responsible for carrying out the terms of the agreement/note? 3) Under what circumstances could the “use of” or “investment of” plan assets indirectly (or directly) benefit the interest of a disqualified person?
Judicial Observations:

Rollins, “the petitioner,” owned from 9% to 33% interest in the three entities involved. Although he did not hold a controlling interest of “50% or greater,” the judge made the following observations after ruling against the petitioner:

The petitioner was the single largest shareholder by a significant margin in all three entities. The comparison between his share and the shares of other shareholders was a focus of this decision.

The petitioner held the positions of president, secretary, and treasurer, as well as being the registered agent of all of the entities.

The treasurer, Rollins, was the signer on all the notes securing the indebtedness.

The notes were at higher than market value and there was no default. Mr. Rollins’ Plan benefited from the security and the income of the investment.

Mr. Rollins had the burden of proving that he did not use the plan assets for his own benefit. The court determined that Mr. Rollins failed to carry this burden, noting specifically the sparse evidence presented.

It is clear from this case that the substance of the transaction, “Was it a good or bad investment?” had no bearing on the ruling against Rollins. Simplistically defining “controlling interest” as a percentage owned by a disqualified person was not looking deep enough into the issue of whether or not there is self-dealing in the transaction. Disqualified persons involved in a transaction who are deemed to be receiving an indirect personal benefit, or “self-dealing,” results in the transaction being a prohibited transaction.

Self-directed plan investors planning investments where disqualified persons or entities are involved, even in a less than controlling status, should realize that the IRS Tax commissioner can, and obviously will, look deeper than the broad percentage guidelines. He will look for, among other things, convincing evidence that there is NO personal benefit derived from the transaction, directly or indirectly, by those disqualified. Furthermore, investors must recognize that decisions with regard to prohibited transactions will not be decided solely on the merits of the investment itself. Prohibited transactions are just that – prohibited. As stated by the judge and worth noting by all of us when structuring investments for our IRAs or Qualified Plans: “Good intentions and a pure heart are no defense”.

The Roth IRA is quite possibly the best deal the federal government has ever offered tax payers.  But until 2010, this fabulous deal was only offered to people earning less than (approximately) $100,000.  Not so in 2010.  The federal government has announced a suspension of the rules for 2010.

The Roth IRA is like the pot of gold at the end of the rainbow. You can rollover any amount of money from a traditional IRA or 401(k) into a Roth IRA, and every dollar you earn with that money is TAX FREE.

The federal government really wants people to convert to Roth IRAs in 2010. There is one more reason to convert - you can pay the taxes from the conversion in equal amounts in 2011 and 2012. This means you get a no-interest loan for 2 years.

Besides earning tax-free dollars for you, the Roth IRA is one of the best vehicles for passing money to your heir.

See more information and sign up for an email list which we'll use to remind you to open a Roth IRA in 2010. 

Securities brokers and some accountants will be the first to tell you that you don't want leveraged property in either a Traditional or a Roth IRA because you will have to pay taxes in the form of "UBIT". The motivations of the anti-UBIT crowd speak for themselves, but, in nearly all decisions related to leveraging an IRA property or not are about doing the numbers. There is some feeling that UBIT is actually wrong, or a penalty for doing something you shouldn't, in fact, it is part of the tax law that usually pertains to non profit organizations and has been around for a long time.

Non Profits and UBIT

This is how UBIT and non profits are related: A Homeowners' Association "Dairy Glen", a non-profit corporation, has installed a pool and tennis courts for the residents. These facilities are supported by the HOA dues, paid by the residents of that neighborhood. At some point the HOA board decides that they are going to open the recreation facilities to the public and charge admission or offer memberships, all funds going back to the HOA accounts.

Down the road is "Muscle World, Inc." a gym that offers similar facilities to their members. Muscle World pays taxes like any other corporation but has a tough time competing with Dairy Glen because they have to pay taxes. This is where UBIT enters. The government, in order to force fair competition levies UBIT on Dairy Glen because they are now in a business that is unrelated to the original business of maintaining neighborhood facilities. How does this relate to the IRA?

IRAs and UBIT and Leverage in Real Estate

The amount of money you can shelter within an IRA is limited by the annual contribution limits and by how much an employer is allowed to put into your 401k which you may ultimately roll over to an IRA. They really don't want to give you unlimited ability to contribute to a tax-advantaged plan. If you bring additional funds into the IRA in the form of a mortgage, you are increasing the size of your IRA.

The government is willing to give you tax-deferred status on the income generated by whatever you have in the IRA initially but is not willing to shelter the profits of the net income generated by the extra funds brought into the account in the form of a loan. The IRA is treated like a non-profit but the additional funds brought in are not. Thus UBIT enters the picture.

Some Quick Facts

• When calculating UBIT from rental income it is only the NET income generated by the debt leveraged portion, after the deduction of operating expenses, interest and depreciation.
• LLCs will not protect you from UBIT, it still applies
• The IRA pays the tax, not you.
• The IRA has its own tax return and this return affects neither you nor your tax return
• For most leveraged real estate deals an IRA does not pay UBIT until somewhere between years 4 to 8 because of depreciation.
• Losses carry forward so file from inception

UBIT is generated by an IRA in three ways:

1. Net income generated by leveraged portion of an investment @ trust rate
2. Proceeds of a sale taxed based on balance of debt at time of sale @ capital gains rate (if 1 year or more after purchase, short term gains taxed at the trust rate
3. The IRA owns an operating business such as providing goods or services. Tax is on 100% of the net income using the trust rate. This situation is not covered in this article.

UBIT Illustrated

The best way to look at UBIT is not a snapshot but across several years. As mentioned earlier, most leveraged IRA properties don't generate UBIT until between years 4 and 8. This illustration shows year 1, the second looks at year 8.

Summary of key points on calculating UBIT:

• Taxed on Net Operating Income * Debt Financed %
• Taxed on Capital Gains at sale * Debt Financed %
• Debt Financed portion is recalculated each year.
• Tax is only a percentage of Debt Financed net income.
• Calculation of debt-leveraged % is actually the loan balance/depreciated basis of the property

John's Uncle IRA buys an investment property using a non-recourse loan*:

First Full Year of Operation

• Cost of property: $500,000
• IRA investment: $200,000
• Non-recourse Loan: $300,000
• Leverage: 60%
• Mortgage Pmt: $1,600/month
• Taxes & Insurance: $400/month

Other information:

• Rent: $2,500 per month
• Utilities: paid by tenant
• Net Cash Flow: $490/mo = $5,874/yr
• Depreciation: $14,545/yr.
• Principal Payments $4,474
• Interest Expense: $14,720 (4.95%)
• Net Loss Year One ($4,265)
• Annual Appreciation 2.5%

No UBIT is paid.

Year 8

• Rent: $2,951 per month T&I $475
• Utilities: paid by tenant
• Net Cash Flow: $876/mo = $10,512/yr
• Depreciation: $14,545/yr.
• Principal Payments $6,318
• Interest Expense: $12,876
• Net Income Year Eight $2,296

Calculation of UBIT:

Debt Balance/Depreciated Basis:

• 263,835/398,182 = 66.26%
• Net Income * 66.26% = $1,521
• UBI = $1,521- $1,000 = $521
• Tax ~ $104

Year 8

• Sale Price $609,201
• Costs of sale 3% - $18,276
• Net Proceeds = $590,925
• Current year Debt Financed % - 66.26%
• Capital Gain ($590,925-$426,587)=$ 164,338
• (Note $426,587 = depreciated basis)
• UBI portion $108,757

UBIT: $23,655
Gain: $164,338 - 23,655 = $140,683

A good exercise is to take the same size IRA and calculate the gain on a property with zero leverage. It would be difficult to determine the income generated by rental operations but, at the end of year 8, with the same appreciation would be $36,370 after deducting the cost of selling of 3%.

Before someone talks you out of leveraging a property within an IRA, do the numbers and decide for yourself. It may or may not made sense to use a mortgage but at least YOU will understand the decisions you make when investing your IRA money. A self-directed IRA is the only way you can purchase real estate AND have a mortgage on it. The flexibility of the self-directed IRA can provide you a world of choices regardless of which way the numbers go.

Catherine Wynne is a Principal in Entrust New Direction IRA, Inc. a self-directed IRA administrator. She is also a Principal in IRA Tax Services, Inc. A tax service company devoted entirely to IRA tax filings for Unrelated Business Income Tax ( UBIT or UBTI). 

1. They rely entirely on the Swanson Case to justify the legality of the IRA/LLC arrangement
2. They capitalize on the IRA owners’ desire for complete control of IRA funds and disenchantment with the securities industry.
3. They promise “checkbook control” of these funds without the “interference” of an IRA custodian.
   

WHAT DID SWANSON DO?

Mr. Swanson caused a corporation called “Worldwide” to be created and his IRA purchased 100% of the outstanding shares of that corporation. After funding the IRA share purchase, Mr. Swanson was appointed president of the corporation which, in turn, did business with Swanson’s company, “Swanson Tool”. Swanson Tool paid sales commissions to Worldwide. Note: Worldwide had no employees. The Swanson case attracted attention primarily because a) it was a single member entity where the IRA owned all shares; b) Mr. Swanson was appointed the president with complete control over all monies of the corporation; and c) Worldwide made lots of money in this arrangement.

WHAT WAS THE SWANSON DECISION?

Very few understand what the Swanson Decision addressed. Many think that this was a decisive case that certified the legality of the single member LLC for IRAs. It was not.

The facts are:

The Swansons sought to recover legal fees from the IRS after a settlement with the IRS on a number of tax issues. The question put forth in this case was whether or not the IRS was overzealous in pursuing the Swansons during the negotiation and settlement process in resolution of these tax issues.

The entity purchased by the IRA was not an LLC at all but a foreign sales corporation.

The case was decided at the administrative or lowest tax court level and was not appealed by the IRS.

The IRS behaved badly in this case by misapplying the prohibited transaction rules and choosing to pursue the Swansons in spite of (The IRS admitted) hazy understanding of the facts of the case and application of the rules.

The IRS confined the defense of their actions to only three potential prohibited transaction areas. They chose wrong.

WHAT WAS DECIDED?

Only one issue was decided: the Swansons were entitled to monetary relief for excessive legal fees resulting from the long, entrenched battle with the IRS. The issues viewed as “key” to the advocates of “checkbook control” rest on the three arguments the IRS chose to pursue in defense of their actions during the settlement process.

The IRS believed that these three actions by Swanson constituted prohibited transactions under IRC 4975. These issues were:

Was the purchase of shares in the corporation by the IRA a prohibited transaction?

Was the appointment of Mr. Swanson as president/director of the entity a prohibited transaction?

Was the payment of dividends by Worldwide back to the IRA account a prohibited transaction?

The court decided that none of these three areas constituted a prohibited transaction.

WHAT WAS NOT REVEALED BY SWANSON

The following issues, which directly impact the operation of the IRA-owned entity, did not come up in the Swanson Case but are of importance to anyone attempting to operate an IRA-owned LLC:

Subsequent funding of entity following initial funding:

There appears to be no question that funding the LLC after the IRA’s initial purchase of shares constitutes a prohibited transaction because the LLC becomes a disqualified entity after funding.

IRA holder as manager: What can an IRA holder do as the manager of the LLC? This was not addressed in Swanson and still is not defined. The extent to which an IRA holder can work on behalf of the entity is still in question.

Arrangements: The IRS more recently has looked at entities set up specifically to avoid application of certain tests, such as fiduciary responsibility, and setting up entities as part of a pre-arrangement to avoid a prohibited transaction, as being invalid (C.F.R. § 2509.75-2(c)). What does the IRS view as an “arrangement”? What about circumvention of the custodian requirement set forth in IRC 408?

Arrangements: The IRS more recently has looked at entities set up specifically to avoid application of certain tests, such as fiduciary responsibility, and setting up entities as part of a pre-arrangement to avoid a prohibited transaction, as being invalid (C.F.R. § 2509.75-2(c)). What does the IRS view as an “arrangement”? What about circumvention of the custodian requirement set forth in IRC 408?

The IRA holder as manager and signer on the entity account can take money out of and put money into the entity and thus take distributions and make contributions to the IRA without the custodian reporting either of these activities to the IRS. The prohibited transaction rules, such as no personal use, no guaranteeing of credit, and no use of the IRA’s asset for the IRA holders benefit: all of these can happen without custodial involvement because they happen within the created entity.

WHAT CAN BE TAKEN FROM SWANSON

One thing we can rely on with regards to the Swanson Case is that the IRS is not going to make the same mistake twice. IRA investment in closely held or “checkbook control” LLCs, because of their high profile, will loom large as an IRS target. When (not if) the IRS decides to challenge “checkbook control” IRAs, they will be ready. The questions not answered by the Swanson Case will most likely be the focus of any future IRS court case.

Lastly, there is a limited understanding of prohibited transaction rules across the spectrum of IRA owners in self-directed investments. There is much inexperience with regards to the use and operation of business entities such as LLCs which may, in turn, result in inadvertent prohibited transactions because of confusion in the relationship between the individual, the LLC and the IRA member as three distinct entities.

In summary, the Swanson Case may only be the start of IRS scrutiny of self-directed IRA investments and single member LLCs in particular. Anyone entering into this type of IRA investment must understand the basis in law on which this type of investment structure is built, what the rules are with regards to both prohibited transactions and how to operate a registered business entity.

Lastly, everyone needs to know what the Swanson Case did not do for us!

Want to know more? Register for our webinar on single member LLCs.

Catherine Wynne is a principal in Entrust New Direction IRA, Inc., a licensee of The Entrust Group (TEG). TEG has been, since 1981, the leader in self-directed IRA, Roth, SEP and 401(k) administration. New Direction, in Lafayette, Colorado, provides administration services as well as continuing education for tax and investment professionals and the general public. Website: NewDirectionIRA.com.

The modern day gold rush is ON! Commercials, neighbors and famous financial advisors tell you to buy gold. Especially in the past six months, many clients and prospective clients have asked us if they can use their retirement funds to buy gold and other metals. The answer is YES, if you have a self-directed retirement plan, your IRA may invest in precious metals. Part 1 and Part 2 of "How to Buy Gold and Other Precious Metals in your (Self-Directed) IRA" will help you answer the next question- what kind of gold and what other metals?

With so many coins and metal choices on the market, making a decision can be confusing. Following is a simple step-by-step way to determine if the metal of your choice is acceptable for an IRA investment. Note that whatever your choice, the IRS will not allow you to hold the metal personally. The IRA custodian or depository will hold the metals for your IRA.

Let's get the basics out of the way first. Your self-directed IRA can only invest in Gold, Silver, Platinum and Palladium. Note that the key word here is invest. Your IRA cannot buy collectibles - your IRA is only investing in the metal itself, not rare or attractive coins. The metal must be in a certain form (usually coins or bars) and/or of a certain purity. The purity or fineness of the metal is how the quality of the metal will be measured for your IRA.

When most of us hear about gold investment we picture the 400 ounce gold bars we have seen in movies. Extremely heavy (25 pounds), those bars are also very expensive items, particularly with the recent price increases in gold. IRAs are often priced out of the gold bar market, but, fortunately, other options exist. One option is smaller units of bullion, provided they meet the fineness, or purity level, requirement. Another option is coins.

We will provide more detail on specific coins in Part II.

Welcome to the nitty gritty details of investing in gold and other precious metals with your self-directed IRA. If you missed Part 1, check it out first.

First, some history. The IRS initially said that all coins are collectible and therefore, not a legal IRA investment. In the mid 1990’s, after realizing that a 400 ounce gold bullion bar would be too expensive for most IRAs, Congress allowed certain coins in addition to bullion.

Generally these IRA allowable coins fall into two categories:

1.Coins specifically listed in the Internal Revenue Code and minted by the US. . These include:

2. Some coins meet the minimum fineness requirements but are not rare enough to receive collector attention.

* Gold Coins - .995+
* Silver Coins - .999+
* Platinum - .9995+
* Palladium - .9995+

In addition to these American options, there are some coins issued by mints of other nations that do meet the fineness requirements. See more detail on specific coins in our coin report. If you’re not sure about the fineness, ask your self-directed IRA custodian or metals dealer.

Coins that were issued for commerce are not going to qualify for IRAs. Also, coins issued for special occasions like Olympic games or national celebrations, and those issued in small quantities, are desired by collectors and their price is generally higher than the value of the raw metal. They are not allowed in IRAs.

When you are researching a particular coin, check two things:

1) Make sure the fineness of the coin meets the required amount from the table above. If not, then it does not qualify.

2) Compare the price of the coin to that of an equivalent weight coin of the same metal and to global spot price of the metal. If you find the price for your coin of choice significantly higher than one or both of the other prices, pass it up for your IRA, as it is likely a collectible.

Your IRA’s investment in gold is just an investment in the raw metal; attractiveness of the coin should not come into play in your investment decision. In other words, consider the value of the coin melted down – not as art.

Also remember that you will not be holding the coins personally when your IRA invests. The IRA custodian will require the coins be held in a depository and you will likely never see them unless you take them as a distribution when you retire.

Now that you’re armed with good information on what kinds of precious metals your retirement account can invest in, you can join the gold rush. Thankfully, you won’t need to climb mountains with a pick and shovel and freeze your knees in mountain streams to diversify your retirement portfolio with precious metals.

For more information, check out our Precious Metals page or our page on some specific coins.