Entrust New Direction Blog

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”.

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.    

The basics:

Health Savings Account (HSA) is a savings account you can fill tax-free. You can use the account to partner with your self-directed IRA to invest, earning tax-free funds, which you can use to pay for future medical expenses tax-free.

Why I love my HSA:

1) tax shelter (up to $5,000 for family in 2009)

2) can be invested like a self-directed IRA

3) earnings are tax-free

4) never expires (can reimburse you for medical expenses from the moment you open the account until the day you expire).

5) can be filled with a one-time IRA rollover

An HSA can only be used with a High-Deductible Health Care Plan (HDHP), which is also referred to as a catastrophic plan. To me, that's what health insurance is for - catastrophes. Of course, like car or life insurance, the higher deductible, the lower the premium. This can be a good thing, depending on your situation.

The anecdotal evidence:

When I was covered by a standard health insurance plan by my old employer, I paid my $300 every month and my family's $20 doctor visit copays and my family's $20 prescriptions. We went to the doctor with almost every cough and rash and throat ache; we filled and took the prescriptions.

Then, I changed jobs and began the HSA/HDHP plan. At first, I was very unhappy about the change. I thought about how much the doctor costs, how much our numerous monthly prescriptions cost, and I was not happy.

But as the first year as a so-called "under-insured family" progressed, we began to notice a change. We went to the doctor less. We discovered in a couple cases that our medical problems could be solved by nutrition and habit changes. We started to feel better than we had before. We still visited the doctor when we wanted to, we still had monthly prescriptions, but less in both cases.

Slowly, as we examined the bills, we noticed another change. We were actually paying less for health care than with the standard health insurance! Plus, the money in our HSA, combined with our self-directed IRA, was growing steadily, which helps my worried mind.

You probably don't get a health care tax deduction

One more reason to consider an HSA-  you cannot deduct health
costs from your income unless 

    1) health care is 7.5% of total income and

    2) you itemize all your health care expenses

HSA works for us, it may work for you.  For more information, read What is an HSA?

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. 

Greenwashing is a new term in the American lexicon, sprouted up thanks to the relatively recent enviro-happy-environment. A mashup of the words green and whitewashing, greenwashing refers to the act of companies exaggerating or fabricating environmental or earth-friendly aspects of the business. This spin tactic is used in the automobile industry, the travel industry, with cleaning products - just about everywhere in the marketplace, including investments.

According to Time magazine, sales of organic food alone (no other green or greenwashed products or services) doubled to $20 billion from 1997 to 2007. $10 billion can buy a lot of green paint. Of course, using spin in marketing is not exactly a new phenomenon, but people who care about how their actions and inactions affect the earth want to know the truth.

And this is where the self-directed IRA pops up. The self-directed IRA leaves the investment decision up to you. If you contribute to a 401(k), you cannot choose which stocks your retirement funds buy. Same with a standard IRA. But with a self-directed IRA, you can be as green as you want to be, and still make money.

One example is the start-up alternative energy (or alternative packaging or alternative transportation) company. Your self-directed IRA can buy private stock in the company, but before you decide, you can visit the factory, meet the workers and learn about the processes. Verify the green-ness yourself.

Your IRA could loan money to individuals in third world nations via various microloan companies. Your IRA could buy an electric car and rent it out. The possibilities are self-limiting. That is the beauty of self-direction.

See some examples of truly green and socially responsible retirement investing.

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). 

Behold the lever, first described in 260 B.C. (or so the historians say) by Greek mathemetician Archimedes.

The lever has helped people accomplish more than they thought possible. I imagine the first time a lever was used, it seemed magical.

Behold the lever, 2009:

Using a self-directed IRA, you can more than double your buying power if you use leverage to purchase real estate. More and more banks are learning about self-directed IRAs and offering loans for purchasing real estate. Because the loans are non-recourse (only secured by the asset), a loan to a self-directed IRA is the most secure option for a bank (and for the IRA).

Of course, some restrictions apply:

1) The loan must be non-recourse, which means your personal credit, and the rest of your IRA does not apply to the value of the loan - only the property does.  In the case of defaulting on the loan, the bank takes over the real estate.

2) In most cases, the property must be income-producing.

The down payment is usually in the neighborhood of 40% of the value of the property.  This means you more than double your buying power, which means you could increase the value of your retirement money (or make up for stock losses) faster.

Contact us if you have questions or view this helpful FAQ.  

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 Denver Post reports that Denver metro foreclosures are down 46% in the first quarter 2009 compared to first quarter 2008.

This is good news and bad news for the savvy investor.  Good news if you have real estate already in your self-directed IRA or HSA since this likely indicates that prices are on the upswing.  The bad news is for those of you who wanted to pick up a (or another) foreclosure property - the pickings are slimming!

The Post article is based on a report released by RealtyTrac which details foreclosure rates around the country.   The front range Colorado is besting the national average by far - national rate is up 23%.

Boulder area is down 20%, Greeley down 23%.  Colorado Springs and Fort Collins had slight increases, but overall the front range seems to be standing strong.