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.

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.