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.