Self-Directed IRA Loans vs. Equity: Which is better for you?

One of the advantages of self-directed IRAs is that they provide more than one way to invest in any given asset. Let’s look at an example to see how.

Say there’s a local pizza place that is looking to open a new location across town. They approach you to invest but unfortunately all your personal investment funds are tied up at the moment. However, you have a pool of $300,000 in cash in your IRA ready to be invested.

You have several ways to invest in the pizza place. You can issue a loan—you and the borrower will determine the interest rate and the term of the loan. Or you can buy equity in the pizza company and receive either stock or a percentage ownership. Your return may not be as cut and dried as the loan but your opportunity for profit could be greater if the new location prospers.

Determining which route to go could make a difference. Let’s look at loans and equity investments for IRAs.

Loans – In this structure, you and the company you’re investing in will determine the amount and terms of the loan and sign a promissory note together. Your IRA earns money on the interest rate and points you assign to the loan. This is an advantage unique to notes as you will have a fixed return in an agreed upon amount of time. Your borrowers can be companies and/or people with whom you feel comfortable.

Note that the company you invest your IRA in cannot be owned or controlled by a disqualified person (including lineal ascendants and descendants, spouse and certain fiduciaries).

One advantage of loans is that you will typically not be subject to Unrelated Business Income Tax, or UBIT, which could be assessed on an equity share of an entity by an IRA.

Private Equity/Stock – Some companies elicit investment capital by offering equity or stock. Via these private placements, your IRA can invest in private companies and earn a percentage of their profits based on how much equity you have. Equity can be expressed as either shares of a company or an ownership percentage.

The advantage of private equity is that the return on the investment can be directly tied to the performance of the company.

As mentioned above, equity ownership may incur UBIT. This is a business tax that some tax advantaged entities pay when they have revenue-producing operations. For an IRA, business tax can paid by the company before profits are paid to the IRA and in that case, UBIT would not be assessed to the IRA. Or, the company can pay profits to the IRA before business taxes, and the IRA would be subject to calculating UBIT, which would be assessed at trust rates if tax was due.

If you have any questions, give us a call at New Direction IRA or visit us at www.ndira.com.






   

How Technology can eliminate the Checkbook IRA

The biggest appeal of Checkbook IRAs (IRAs that invest in LLCs created by the IRA owner) is that they allow the IRA, by extension, to purchase things quickly.

However, the Checkbook IRA structure is currently under intense scrutiny by the IRS and sets up a situation where unscrupulous account holders can make mistakes and put themselves at risk of penalties, taxes and forced distributions.

New Direction IRA, however, has put in the resources over the last several years to develop and implement an industry-best technology system that makes self-directed IRAs easier to manage and invest with.

Their technology allows investors to open accounts online, contribute money to their accounts, send funds to closings, collect rent checks, view transaction history and much more is in the works. Investors can also speak on the phone or chat online with client representatives and asset experts for instant information.

So for instance, where it might take other SDIRA providers days to process transactions, NDIRA can get it done within 24 hours. And the better the technology they develop gets, the quicker those transactions can occur and the less need for Checkbook IRAs and all the risks they present.

Remember that Checkbook IRAs are not flexible and often cost more than a SDIRA administered by New Direction IRA. With a New Direction IRA investment in real estate or any other asset type, you can direct us to send funds, leave the paperwork to us, have rent checks sent to your account and you can manage and oversee everything online.

For more information about self-directed IRA technology or NDIRA, visit www.newdirectionira.com.

What’s In Your IRA? The IRS Wants to Know.

Self-directed IRA administrators/custodians are now forced to provide current values for all IRA assets for IRS reporting purposes.  IRA holders have always been required to provide a valuation of their account assets, but the request has become a requirement due to the changes in the banking industry.  Some IRA account holders are not happy about this.

The FDIC, as a result of its increased diligence in auditing all banks, has lately focused on those banks acting as custodians for self-directed IRAs.  The audits are examining the risk assumed by banks while servicing both consumers and businesses.  The audits include IRAs, which are insured up to $250,000 per account. 

It is not surprising that the FDIC is looking at self-directed IRA bank custodians. When the IRA is self-directed, the IRA holder is responsible for following IRS rules. Investments such as “checkbook control” IRAs, real estate and some private placements can create questions regarding observance of the Prohibited Transaction rules. These types of investments also may complicate tasks such as asset valuation for the purpose of annual reporting, Roth conversions and “in-kind” distributions from the IRA.

The IRS, in conjunction with the increased level of FDIC scrutiny, has made no mistake about their efforts to  step up their audit efforts of self-directed custodians and specifically Checkbook IRAs.  Among the list of audit items, the valuation of the IRA assets is prominent.  IRA custodians will be holding their IRA account holders to higher levels of diligence in providing asset valuation and documentation.  Several self-directed IRA industry leaders have already requested these valuations from account holders but have also gone the extra step of freezing or terminating custodial services to account holders that do not comply.

The “checkbook control” IRA is notorious for being the most vulnerable to abuse.  This is primarily due to the direct control of the IRA funds by the IRA holder but also due to the inability of some IRA holders to provide supportable documentation as to the value of the LLC.  It has been revealed that many IRA holders with “checkbook control” IRAs lack the experience for proper management of a legal entity and scant knowledge of the Prohibited Transaction rules.

Self-directed IRAs will continue to come under IRS scrutiny due to the FDIC’s increased custodial bank audits .In the end, the question will not be:  Will certain self-directed IRA investments remain legal? The question will be:  Is the self-directed IRA owner held to the same standards applied to the securities industry?  And more specifically, Is the IRA owner providing  fair market value for the asset? as well as Is the IRA holder benefiting from the IRA investment prior to distribution and taxation?

Tax Court’s Broad Application of Prohibited Transaction Rules May Hit Owners of Checkbook IRAs

Owners/managers of IRA-owned LLCs (also known as IRA LLCs or Checkbook IRAs) could be hit with taxes and penalties if they provide “prohibited services” to their IRA and the LLC it owns. In a recent ruling, the U.S. Tax Court clarified that it will base decisions regarding prohibited transactions on a broad reading of the tax code.

So what does this mean for IRA owners?

First, let’s look at the decision. The U.S. Tax Court ruled that two individuals who set up an IRA-owned closely held corporation and provided it with personal loan guarantees violated Section 4975. The tax court emphasized that the “broad language” used by Congress in the prohibited transaction laws is intentional and aimed to prohibit a wider variety of acts than would be prohibited without it.

In specifically addressing a loan guarantee—which the two mean illegally provided—the court said:

“The language of section 4975(c)(1)(B), (lending of money or other extension of credit between a plan and a disqualified person) when given its obvious and intended meaning, prohibited the taxpayers from making loans … either directly or indirectly to their IRAs by the way of the entity owned by the IRAs.”

The ruling has ramifications for all IRA owners. Managers of IRA-owned structures, usually LLCs, may suffer similar treatment under a similar broad application of 4975(c)(1)(C). That clause prohibits “furnishing of goods, services, or facilities between a plan and a disqualified person.” 

Most IRA LLC advocates point to the Swanson v. Commissioner, 106 T.C. 76 (1996) tax court ruling as the decision that allows an IRA owner to be the President of an IRA-owned entity.  While the case indicates that being the President is not prohibited, neither the IRS code nor the Swanson case addresses what “services,” if any, that President/Manager can provide to the entity. This creates an ambiguity of which IRA/LLC owners should take notice.

There is little doubt that decision-making is always the responsibility of the IRA account holder, but far more than just decision-making is required for the operation of a business. 

Thus, this Court ruling raises serious concerns that day to day running of the LLC business, including such things as recordkeeping, accounting, and financial reporting, as well as operational and administrative functions, could be prohibited under a broad definition provision of “services.”  All of these services are typically provided to a business at a cost.

IRA owners who are actively managing an IRA/LLC may want to explore having the LLC engaging outside providers of active “services” to avoid potential tax/penalty consequences.

Should I own a Checkbook Control IRA?

When researching Checkbook Control IRAs, it is a good idea to look into the drawbacks as well as the benefits before moving forward. There are responsibilities the IRA holder must understand. You might want to ask yourself, “Do I really want this much control of my retirement funds?” Ask the following questions before proceeding:

Q1: An LLC/Checkbook Control IRA sounds appealing, what are the drawbacks of this type of investment?

There are a couple of drawbacks and some out-right dangers. For Checkbook Control, you must have an entity created. In most cases, that entity is an LLC. The LLC is a company for which someone must be responsible. In order to manage the entity, you must know all the rules of both running an entity and all the IRS rules about the IRA itself. Educating yourself on both sets of rules can take a fair amount of time to grasp. Although many of them are not hard, if you don’t stay current, you may forget or miss something important. Remember, IRS rules regarding prohibited transactions don’t always make sense. Applying logic doesn’t always get you to the right answer. And the consequences for the IRA of breaking IRS rules can be significant taxes and penalties.

Q2: What are my responsibilities as the owner of an LLC and Checkbook Control IRA?

The Checkbook Control IRA-LLC is a company. The company is authorized by whatever state you worked with originally. The things you will be responsible for can vary widely. For instance, following is a list of some items suggested by the state of Colorado. Of course this is only a partial list, and due to the limited activity in most Checkbook IRA-LLCs, some of these might not apply. Check your state's rules and regulations.

• Establish a corporate bank account.
• What officers are authorized to sign checks?
• Trade name – Are you going to do business under a name other than corporate name? If so, contact the Office of the Secretary of State.
• Business plan, budget, cash flow projections, working capital needs – Can you cover payroll, operating expenses, taxes, etc. for a 6 month period? Books and accounts – Contact your accountant. Do you understand the tax implication of the entity you are using for your business?
• Obtain your federal tax identification number from the IRS.
• Obtain your state tax identification number from the Colorado Department of Revenue.
• Do you have all of the federal, state and local tax information and forms?
• Federal withholding
• Federal unemployment
• State withholding
• State Workmen’s Compensation
• State & Local Sales Tax – Contact City Hall
• Zoning – Is local zoning appropriate for your business use?
• City/County business licenses – Contact City Hall or County Offices.
• Special licenses for certain kinds of business – Contact City Hall.
• Liability
• Fire and Premises
• Business Interruption
• Crime
• Officer and Director liability

Again, this list is partial and specific to Colorado. Be aware of the requirements of owning a company.

Q3: Fees for this service vary from a couple of hundred dollars to thousands of dollars. What services am I getting for the fee I pay?

The services vary widely based on the vendor you select to set up the LLC, but usually what you are buying is assistance in creating the entity itself. Most companies charge you up-front to start-up then leave you alone. For on-going running of the business and maintaining the viability of the entity, you will have to arrange for that yourself.

Q4: What happens to me and my IRA if I don’t follow the rules?

Entering into a prohibited transaction, such as providing goods or services to your IRA- owned LLC or making loans, advances or other transactions with your IRA-owned asset, will result in your IRA being distributed to you as of January 1^st of that year. Distribution results in you having to pay income tax and/or penalties and interest on the amount distributed. The penalties and interest can potentially go back multiple years.

Q5: Even if I am following the rules, can I still get in trouble with the IRS?

The rules and laws don’t specifically cover all details of these types of arrangements. Some activities that the IRA-LLC promoters encourage have not been fully tested by the courts nor formally allowed by the Internal Revenue Code or Department of Labor. In the future, the courts or federal authorities could declare that these activities are not allowed. And that could easily put you in the position of having committed a prohibited transaction even though you thought you were following the rules.

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.