5 reasons to stay away from a Checkbook Control IRA

If you want to invest in alternative assets like real estate, private stock, notes, gold, etc., you don’t need an LLC although some investors choose that structure.

There are many companies that 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.

Here are some concerns to consider when you think about the Checkbook IRA or LLC structure.

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

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.

2) Checkbook Control IRA Costs more money to open.

Many people are quick to think the Checkbook Control/LLC structure somehow saves money. Let’s examine the details. For instance, our New Direction 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.

3) More difficult to find a custodian.

It is important to note that even with a Checkbook Control IRA/LLC, the client still needs a self-directed IRA company to provide custodianship of the IRA that holds the LLC. 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 by the IRS and the banks don’t like holding assets that don’t have clearly established values.

4) Annual Valuation can be expensive and annoying.

The custodial bank that holds your IRA is responsible for getting an annual valuation of the assets your self-directed IRA holds. Banks are requiring more and more information from clients; particularly clients that have single member LLCs in their IRA.

5) You might as well become a CPA.

If you elect to structure your investments through a Checkbook Control IRA/LLC 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 of the assets.

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 are willing to pay extra for starting costs, then you might want to consider the checkbook control IRA-LLC. Anything short of that and you are most likely better offer using a self-directed IRA to purchase assets without an LLC.

Inviting IRS curiosity with the Checkbook LLC arrangement

There are some compelling logistical advantages to having the financial control that a single member LLC (a.k.a. “checkbook” LLC) can create, but these conveniences are only realized by venturing close to certain IRS prohibitions. In some cases, it is easy to characterize a particular asset or transaction in an IRA as allowed or not, but with a checkbook LLC the parameters are less clear. The question about how to use a single member LLC within the IRS rules for IRAs comes down to interpretation and risk tolerance. Let’s talk a little more about the Single Member LLC IRA disadvantages.

In order to realize the tax benefits for retirement accounts, the IRS has certain guidelines that are designed to benefit the retirement account without benefiting the owner of the account prior to retirement. Amongst other things, the IRS requires a buffer for IRAs. This buffer entity or custodian is required so that the interest of the account is not compromised by the immediate interests of the owner. Having an IRA invest in a single member LLC that is then managed (directly or indirectly) by the holder of the IRA is a way that this custodial arrangement can be subverted. That does not mean that the IRA owner/LLC manger will not act in the best interest of the IRA and within the IRS guidelines, but because of the opportunity implicit in this arrangement, the IRA holder/LLC manager could be inviting IRS curiosity that might be hard to satisfy.

Single member LLCs funded by an IRA are an attractive option for those who need liquidity to run their investment operation. For example, an IRA holder that wants to fix and flip houses as a retirement investment might feel limited by having to pay contractors via the administrator of their IRA, as this process can take some time. Tax liens are another investment type where having the ability to disburse funds quickly is desirable. For these investors, having a checking account that handles IRA funds can seem like a necessity.

Another reason why an IRA holder might want an LLC in his account is that the IRA incurs fees every time it writes a check. So, if your IRA’s assets require a constant flow of outgoing checks, it can save money for the IRA to not have to pay the administrator for every check. The consideration here is the cost of setting up and maintaining an LLC measured against the per check charge. This situation can also be impacted by the IRA having a non-disqualified intermediary (such as a property manager for real estate) be right there, but that costs money as well.

There are some apparent advantages of having a single member LLC in an IRA, what is the downside of setting up an IRA up this way? To put it bluntly, the downside is if the IRS gets interested in the way an IRA and its LLC are operating, they can enforce some substantial financial penalties. Here are some salient points to consider regarding the “allowability” of the checkbook LLC arrangement.

It is considered self-dealing, and therefore prohibited, for an IRA to invest in a company that is more than 50% owned by or controlled by the IRA holder (or close family member). The IRA’s initial investment in an LLC may seem to not conflict with this rule since most LLCs are set up without the IRA holders name attached to it. However, if control of the LLC resides with the IRA holder, there is a fine line to be walked. Philosophically speaking, a self directed IRA involves the owner providing strategy on the IRA’s investments. So theoretically, the LLC could also be directed by the owner as long as that direction is not producing benefits for the owner prior to retirement. The IRS’s interest in this fine line is that it doesn’t allow “sweat equity” to be put into IRA assets. This sweat equity would be seen as an illegal contribution, and is pretty easily identified if we are talking about the IRA holder painting a house or something of a physical nature. However, the line between directing strategy for an LLC and controlling the LLC (which would result in a self-dealing scenario) has a little more opinion in it. Certain things, like being the named manager of the LLC or being a signer on the bank accounts for the LLC would be more indicative of control than not.

An additional factor in the scenario is that by forming an LLC, the burden of record-keeping switches from the IRA custodian to the manager of the LLC. If the manager of the LLC does not perform this function appropriately, the IRS has the power to exercise its authority. So even if the LLC is operating in the best interest of the IRA, if the documentation is not up to par, there could be unwanted consequences for the account.

When it comes to having an IRA invest in an LLC which the IRA holder controls, the investor is stepping into a gray area. Situations such as the IRA holder being on record as the manager of the LLC and/or the IRA holder being a signer on the LLC’s checking account are evocative of self-dealing whether there is any malfeasance occurring or not. Unfortunately, those situations are also at the heart of the convenience of the “checkbook” LLC. Because this is a “gray” area, it would not be surprising if the IRS decided to make it more black and white in the not-too-distant future. In the mean-time, the prospective retirement investor must wade through a myriad of interpretations and measure their own risk tolerance in order to arrive at a strategy when it comes to having their IRA acquire an LLC.