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.
