Do the details matter? Absolutely, and do not let anyone convince you otherwise. When it comes to asset protection, planning for the unexpected is key to any successful strategy. How all the pieces fit together and the correct order can not be understated. I cringe every time a real estate investor questions why I recommend specific steps be taken to protect assets. There are those who question because they wish to understand while others, I think, assume I am only trying to sell them on my services, and the structure they created with XYZ Company is just fine. In some respects this second group is correct; in those instances when a lawsuit is brought their limited liability company or corporation will probably protect them when faced with a frontal assault. However, a creative attorney who understands business entities will use an indirect attack to achieve the desired result, dismantling all of your protection in less time.
In a recent bankruptcy decision involving Bruce Bernard Nolte, such an indirect assault was made against an LLC owned by a self-directed IRA. Here are the facts: Mr. Nolte established a self-directed IRA with Davenport Trust Company to hold his rollover IRAs. After the account had been funded, Mr. Nolte directed Davenport to invest a portion of his IRA in an LLC that Mr. Nolte came to control as one of its managers. In 2014, Mr. Nolte filed for bankruptcy and listed his self-directed IRA as an exempt asset. The bankruptcy trustee did not agree and sought to disqualify the IRA’s exempt status on the grounds Mr. Nolte engaged in a prohibited transaction when his self-directed IRA invested into an LLC controlled by Mr. Nolte.
Knowing a direct attack against the IRA would ultimately fail because it is an exempt asset, he sought to strip the IRA’s protections by asserting Mr. Nolte committed a prohibited transaction. If this indirect attack by the bankruptcy trustee were successful, then the IRA assets would be available for Mr. Nolte’s creditors. Unfortunately for the bankruptcy trustee, this was not to be.
The Court concluded that a self-directed IRA owner does not engage in a prohibited transaction when he directs his IRA custodian to invest his IRA funds into an LLC controlled by the IRA owner. The Court analyzed Internal Revenue Code § 4975(c)(1) which defines a prohibited transaction as follows:
For purposes of this section, the term “prohibited transaction” means any direct or indirect—
(A) sale or exchange, or leasing, of any property between a plan and a disqualified person;
(B) lending of money or other extension of credit between a plan and a disqualified person;
(C) furnishing of goods, services, or facilities between a plan and a disqualified person;
(D) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;
(E) act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interests or for his own account; or
(F) receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.
The court reasoned that even though Mr. Nolte is a disqualified person vis-à-vis his IRA, the mere investing into a LLC controlled by Mr. Nolte does not give rise to one of the prohibited transactions enumerated in Internal Revenue Code § 4975(c)(1).
The takeaway from this case is two-fold:
- How you set up and operate your plan is very important lest you give a potential creditor an indirect avenue of attack to dismantle the protection you built; and
- Setting up an LLC owned by your IRA does not constitute a prohibited transaction (unless of course – you set it up wrong, i.e., see #1).