Entrust New Direction Blog

We have many prospective clients who call to ask about a ‘checkbook control
IRA-LLC'. When these people call, we generally spend quite a bit of time with them explaining what a self-directed IRA is and what a ‘checkbook control or single member IRA-LLC' is -- because there is a difference. If you want to invest in alternative assets like real estate, private stock, notes, gold, etc - you don't need an LLC. Some of our clients do elect to invest their IRA into a LLC. However, the vast majority of our clients hold their IRA investments directly in their IRA.

There are many companies which push the LLC structure; some will even go so far as to say you need an LLC. The fact is, your IRA is fully capable of holding alternative assets directly without the addition of an entity like an LLC. If a company tells you that you need the LLC, chances are that company is making money from some aspect of the sale of the single-member LLC. The structure is known by various names - the Checkbook Control IRA, the single-member LLC, the IRA-LLC - but they're all the same structure.

1) The IRA-LLC may not even be legal.

Many companies will try to convince the investor that an LLC makes investing simpler and easier. We've found that in some cases, the LLC involvement actually complicates matters. It is still unclear if it is even permissible to own an LLC with your IRA AND control that LLC personally (as the manager of the LLC).

There have been court cases and private rulings that somewhat cover the issue of funding a new entity with an IRA. However, none of these cases clarified what (if anything) the IRA holder can do as manager of the IRA-owned LLC.  For this reason, self-directed IRA companies require an independent attorney opinion letter specifically stating that this arrangement is not a prohibited transaction before they will fund the investment. The issue is a grey area at best.

We at Entrust New Direction IRA, Inc are not advocates of the IRA-owned single-member LLC structure, and won't be until the Department of Labor or the IRS come out and specifically state that the structure is permissible. Like I said it is grey... and we don't like to work in grey areas.

2) Checkbook Control IRA Costs more money to open.

And then there is an issue with costs. I've heard the argument that our IRA administration fee is too expensive and that the SMLLC structure somehow saves the clients money. Let's examine the details. Our annual administration fee is $250 per asset, per year. Most companies that push the ‘checkbook control IRA-LLC' charge a sizable up-front fee to open the LLC. These fees can be anywhere from $2,500-$5,000, before any investment is made.

Let's take the low end of the LLC startup costs - $2500. That means without an LLC, your IRA can purchase 10 different assets before you equal just opening the LLC.

3) More difficult to find a custodian.

It is important to note that even with a SMLLC, the client still needs a self-directed IRA company to provide custodianship of the IRA that holds the LLC. We've found recently that fewer and fewer companies are willing to provide custodianship to IRA LLCs. The ones that are still willing to hold them are charging higher fees because these investments are considered ‘high risk' investments and the banks don't like holding assets that don't have clearly established values.

4)Annual Valuation can be expensive and annoying.

That brings us to another huge issue...valuing SMLLC investment. The custodial bank that holds your IRA is responsible for getting an annual valuation of the assets your self-directed IRA holds. We've found that banks are requiring more and more information from clients; particularly clients that have single member LLCs in their IRA. We will elaborate more on this issue in a future blog so stay tuned (hint: you are probably going to have to pay someone to appraise the LLC every year).

5)You might as well become a CPA.

If you elect to structure your investments through a SMLLC then you (as the manager) are 100% responsible for making sure every aspect of the company is handled appropriately. Don't underestimate the responsibilities that come with managing a company (particularly when you consider the company is owned by a tax-deferred or tax-free IRA). It is extremely important that you keep the IRA/LLC assets separate from your personal assets. You must understand that the rules which apply to the IRA also apply to the LLC.

A violation of the prohibited transaction rules can result in huge penalties to your IRA, or a complete distribution with the associated tax hit.  A self-directed IRA client working directly with Entrust New Direction IRA, Inc (no LLC involved) has the benefit of working with our asset acquisitions department when making investments. We see thousands of transactions a year and can assist in explaining what the IRS guidelines are for self-directed IRA investing.

The bottom line:

If you are an expert in self-directed IRAs AND you know how to manage the recordkeeping for a business AND are capable of keeping IRA/LLC assets separate from personal assets AND you've talked to your attorney and they are willing to provide an opinion letter specifically stating the entire thing is okay AND you want to pay 10X the starting costs.... then you might want to consider the ‘checkbook control IRA-LLC'. Anything short of that and you are most likely better offer working with the experts here at Entrust New Direction IRA, Inc. We've been doing this a long time and we can help you better understand the rules and protect your IRA's tax-deferred status.

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.

Entrust New Direction has never recommended an investment nor provided investment advice, and we never will.  What we try to do sometimes is describe what some of our clients are doing - we provide examples and options.  Usually we deliver positive examples, such as the client whose self directed IRA bought a tractor and rented it out hourly, daily, weekly, monthly - enlarging his retirement account after every rental.  We love to share the good examples and will continue to do so.

This week, however, we're providing some cautionary tales.  Such as the story of the retirement investment vehicle stuck in the mud.

We've described how to care for your single-member LLC (AKA the checkbook control IRA).   We've described this in detail because there are many many details, many hoops for the retirement investor to jump through when investing in a single-member LLC.  Some of the hoops are extremely flammable.

Our president shared her point of view on Swanson, a case which many people use to justify single-member LLCs/checkbook control IRAs.

We've also described that the IRS may be firing a warning shot over the bow of those who invest retirement funds into their own businesses.  Frequently, these two gray areas are combined, and this situation describes our first horror story.

The Horror Stories

Early one morning, a man called as soon as we enabled the phone system, his voice trembling, "I think I may be in very big trouble", he said.  He took some money from his LLC and spent it on his own personal company without tracking it, not realizing that this was a taxable, penalizable occurrence.  "It was my LLC," he said, "I always thought I could do what I wanted with it.  Nobody told me different."  He was the client of another firm, a firm that specializes in single-member LLCs, and they wouldn't call him back.  We are still doing our best to help him.

Another man sold a real estate asset from within the LLC and used his own Social Security number on all closing documents.  Consequently, he received a 1099 and owed taxes on the proceeds of the sale, which severely cramped his personal finances.  If some folks, myself included, happened to do the same, we would have to declare bankruptcy.

A woman with property in Honduras sold the property, which was held in her "checkbook control" IRA, and she put the proceeds into her personal bank account without our knowledge.  She used these proceeds to purchase commercial property in her own name. The purchase had to be reported as a prohibited
transaction. We don't know the end of this story as she's out of the country. This could end up as a criminal matter.

• Fines. 
  
• Penalties. 
  
• Forced distribution of assets.
  
• Gargantuan tax bills. 
  
• Jail time.

These are a few of our least favorite things.

As stated up top, we do not and will not advise our clients on investments, unless they're trying to perform a prohibited transaction.  We give as much information as the client will take, and hope for the best.  We want our clients and potential clients to know their options - by no means is a single-member LLC the best or only option for self-directed IRA investment. And by no means is Entrust New Direction one of the many firms who will push you into a checkbook control IRA. What we do provide is expertise in the rules, an experienced sounding board for you and your investment ideas.

We now resume our regularly scheduled stories of successful and happy investors.

Photo courtesy of phototram.

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.

Field Service Advisories, in the hierarchy of “credible or useful” falls well below the Swanson Case, decided at the administrative (lowest) tax court level.  Private Letter Rulings, Internal IRS Memorandums and DOL Opinion Letters are much more useful than a field service advisory for gaining clarification of an IRS position.  This is clearly stated in the subject line of the Advisory, I quote “In accordance with I.R.C. § 6110(k)(3), this Chief Counsel Advice should not be cited as a precedent”. 

If you read through the Advisory it addresses the question of whether or not a corporation, created by a father for his and his three minor children’s IRAs, and his active involvement in that corporation, constituted an indirect circumvention of the rules on taxable gifts to the children.  Although the Swanson Case is quoted in great detail within this document, it has little relevance to the question asked regarding the taxable gift laws. The only portion of Swanson that was of any relevance was the reference to the payment of dividends to the IRAs from the Corporation.   The tangential visit to the prohibited transaction rules and inclusion of Swanson does not impact the gift tax issue.

The reference in the Advisory of the IRS conceding the issue of whether or not a prohibited transaction occurred in the Swanson case with regards to the interaction between Worldwide and Swanson was based, not on prohibited transaction rules, but on the IRS’s relentless pursuit of Swanson for the purpose in order to stall for time in the hope that the IRS agents could learn more about prohibited transactions in order to “find something” they could use against him. 

Reading the transcript of the Swanson Case (not a summary of the Swanson Case) reveals that the IRS internal memos submitted as evidence supported that from IRS internal memos that the IRS was absolutely at fault.  It doesn’t take a lot of thought to conclude that the IRS was not going to appeal this one. 

Just because the Swanson Case was liberally quoted in the Advisory does not serve as a validation of the “Checkbook Control IRA”.  Using it as a tool to support this structure is irresponsible.    

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.