I have discussed retirement planning investing in self directed IRAs and/or pensions (solo 401k or profit sharing plans) in previous blog posts. If you read these, you may recall a few of the issues associated with using retirement assets for investments outside of the typical securities market. Many of these outside investments typically include real estate, closely held business entities, i.e., LLC, private lending and any other investment that is not specifically prohibited by federal law—literally anything other than life insurance, S-Corporations and collectibles can be held in a Self-Directed IRA.
Most SDIRA investments are structured one of two ways. The SDIRA owner can either instruct the SDIRA custodian to make the investment directly on behalf of the SDIRA, in which case the SDIRA becomes the legal owner of the investment, or the SDIRA owner can have his SDIRA create an LLC and subsequently invest all of the SDIRA’s assets into the LLC. In the LLC situation, the SDIRA is the 100% owner of the LLC and the SDIRA owner is the manager. Both forms of investing through a SDIRA are permissible under the Internal Revenue Code, however, it is after the investment is made where the trouble usually begins. In the case of setting up the LLC, it can begin earlier. The following examples are real life client scenarios, which illustrate the tax issues surrounding SDIRA investing.
Example #1: SDIRA invests into a LLC established by SDIRA owner
Scenario: Alan rolled his existing ROTH IRA to a new custodian (whom I will refer to as ABC Trust). ABC Trust is a self directed IRA custodian. Upon completion of the rollover, ABC Trust told Alan to create a LLC with a bank and they will wire his SDIRA funds into the new company so Alan can personally direct his investments.
Alan set up his company through Legal Zoom paying for the entity setup himself. Further, Alan used his home address as the business address and he served as the LLC’s registered agent. Once the entity was registered with the state and Alan received his LLC operating agreement from Legal Zoom, he signed it and directed ABC Trust to initiate the transfer.
Tax Issue: Alan’s mistake was in setting up his company through Legal Zoom and not using an attorney familiar with custom drafting an LLC operating agreement for SDIRA investing. IF Alan had used an attorney, then the following would have changed with the setup:
Alan’s SDIRA would have paid to set up the LLC – When Alan paid to set up the LLC and subsequently contributed this interest to his SDIRA, he committed a prohibited transaction. IRC 219(e) only permits cash contributions to IRAs.
Alan would not use his home address as the business address nor would he serve as the LLCs registered agent – Alan is providing services to his SDIRA by using his home address as the business address and serving as the resident agent. A third party for the SDIRA should handle both of these and be paid for by the SDIRA e.g., a PO Box is opened for the LLC and the attorney is hired as the resident agent. IRC 4975 does not permit the furnishing of services or facilities between an IRA and the IRA owner.
Alan’s operating agreement is not compliant with IRC 4975 prohibited transaction requirements – Alan’s operating agreement permits Alan to pay himself a management fee, loan himself money, run an active business through the company, invest in insurance or collectibles, etc. A LLC operating agreement established by a SDIRA and managed by the SDIRA owner should contain restrictions preventing self dealing or prohibited transactions.
Alan should not have signed the operating agreement – Alan’s SDIRA is the LLC member. ABC Trust company should have signed the LLC operating agreement on behalf of Alan’s SDIRA.
Example #2: SDIRA invests in real estate with a non-recourse loan
Scenario: Susan directed her SDIRA custodian to purchase a rental house in California for $300,000. Susan’s SDIRA contained $200,000, so she obtained a loan via her SDIRA from a 3rd party for the $100,000 difference. The loan is non-recourse meaning Susan is not liable to the lender in the event of default. Susan’s SDIRA has been collecting $2,000 a month rent for the past five years and has not missed one loan payment.
Tax Issue: Susan did not create any problems for herself with the way she structured this transaction. Susan’s problem is IRC 514, which imposes a tax on the portion of income earned by the IRA attributed to debt. One third of Susan’s annual rental income is attributed to debt financing ($100k / $300k = 1/3). Over the five year period, Susan’s SDIRA failed to pay over $9,000 in federal taxes.
Susan’s problems stem from a lack of guidance from her SDIRA custodian. SDIRA custodians typically refuse to take any responsibility for the investments they are directed to make by the account holder. Most of the SDIRA agreements I have reviewed contain language stating that all legal and tax consequences of the SDIRA’s investments are the IRA account holder’s sole responsibility.
The problem for Susan is that most SDIRA custodians will avoid providing any guidance for a transaction and instead tell the SDIRA owner to seek independent counsel, but these same custodians promote the idea of investing in the very transaction – giving rise to the tax or legal issue. Further, most attorneys or CPAs are unfamiliar with IRA tax reporting so these problems go unnoticed for many years until the IRA is audited.
Example #3: SDIRA sets up LLC to fix and flip property
Scenario: Mark, with the assistance of an attorney, established his SDIRA owned LLC and funded it via his SDIRA custodian. After his structure was complete, Mark began purchasing single family homes in his LLC. Mark, aware of the prohibited transaction rules, hires contractors to perform all of the rehab work. Mark is buying and selling 12 to 15 homes a year in his SDIRA owned LLC and is ecstatic all of the income is tax-free.
Tax Issue: Mark’s potential issue is very common amongst real estate investors who buy and sell. The IRS could argue the buying and selling of real estate not held for investment is considered an active trade or business. IRC 512 imposes a tax on income earned by an IRA engaged in a trade or business. The tax is 39.6% on any amounts over $11,950. If Mark’s SDIRA is audited, he could owe hundreds of thousands of dollars in income tax, penalties and interest, potentially wiping out all of his gains.
You are probably wondering if there is a workaround to Mark’s dilemma. Unfortunately there is not and the active trade or business issue is a facts and circumstances test for the IRS. I typically find people like Mark are also engaged in flipping activities outside of their SDIRA. Most of these investors are running this as an active business, i.e., taking deductions against their income from flipping activities. Therein lies the problem. If the flipping of homes is an active business outside of the SDIRA, how does one argue it changes when run through a SDIRA? With a wink and a nod.
Example #4: Husband and wife each have a SDIRA and together they invest through an LLC
Scenario: Steve and Pam each directed their SDIRA custodian to invest in a jointly owned LLC. Their SDIRA custodian set up the LLC so Steve and Pam could pool their SDIRA funds. Both Steve and Pam are co-managers of the LLC. Steve and Pam’s SDIRAs have $400k and $200k respectively. When the LLC ownership is divided it is split 50/50. Steve and Pam buy three properties in their SDIRA LLC.
Legal Issue: Steve and Pam’s mistake was in dividing their ownership 50/50 between the SDIRAs. Steve and Pam should have allocated the ownership of their LLC 66% to Steve and 34% Pam. This allocation is based on their respective contributions.
Steve and Pam have created an LLC taxed as a partnership, i.e., more than one owner. As a result their LLC must file a tax return each year and issue K-1s to each of their LLCs. Neither Steve nor Pam should be completing this return. Their IRAs or the LLC must pay a third party to prepare the return or else the IRS could assert Steve or Pam made an impermissible contribution of services to their IRAs.
Example #5: SDIRA partners with SDIRA owner’s parents to buy real estate
Scenario: Kevin would like to engage in larger real estate transactions with his SDIRA. Short on the necessary capital, he approaches his father, Frank, to partner with him on his real estate deals. Kevin’s attorney creates an LLC to be owned 60% by Kevin’s SDIRA and 40% by Frank. The ownership reflects the amount contributed by each party.
After the LLC is funded the company acquires its first deal. Due to unanticipated rehab expenses, the LLC runs short on cash and Kevin asks Frank if he could contribute an additional $15k to bring the project to completion. Frank makes the contribution.
After the property is sold, the LLC distributes the profits back to each party and the LLC searches for a new investment. In short order, a new deal is struck and both parties contribute a portion of the profits from deal #1 to acquire deal #2.
Legal Issue: IRC 4975(c)(1) disallows certain interactions between an IRA and people that are “related” to the IRA account holder. Under the code, the “related” people are called disqualified people. The term “disqualified person” is defined in Section 4975(e)(2) and includes (but is not limited to): the IRA account holder, the account holder’s spouse, lineal descendants (e.g. children, grandchildren), lineal ascendants (e.g. parents, grandparents), and spouses of those people, business entities owned 50% or more by these people and certain business partners, directors and employees in these businesses.
Frank is a disqualified person vis-à-vis Kevin’s SDIRA; however, Kevin’s IRA can still partner with Frank in an LLC provided the LLC is newly created and the membership interests are issued directly to Frank and Kevin’s SDIRA. After the membership interests are issued and the LLC is funded, the LLC becomes a disqualified person for Kevin’s SDIRA (for all future transactions).
Kevin’s mistake was in asking Frank to make an additional contribution to cover unanticipated expenses and in distributing the profits from deal #1 then asking for a new contribution for deal #2. When a transaction like the one described herein is entered into, it is a one shot deal meaning the LLC can only be funded one time. Any future contributions from either related party will run afoul of 4975. Thus, Kevin should have made sure the LLC had ample reserves to complete deal #1 or sought additional monies from an unrelated 3rd party. Further, Kevin should never distribute funds to either party if he contemplated using the funds for future deals.
The reason I bring this to your attention is the need to get your ships in order. If you think you may have engaged in any of the aforementioned transactions, (Note: I did not discuss any obvious issues e.g., living in a house owned by your SDIRA, loaning yourself money, etc.) it may be time to take a second look at your investing. Beginning this year, IRA custodians are required to report on certain assets held within IRAs. The IRS is specifically looking at real estate and business entities. I can only think of one reason why the IRS has changed the reporting requirements to zero in on these types of investments – they looking for potential audit targets.
It’s unfortunate, but I can safely state at least 50% of people I have spoken to who are using SDIRAs have committed one, if not more, of the mistakes outlined above. Many of these mistakes were caused by the lack of oversight by SDIRA custodians and SDIRA/LLC promoters. The good news is many of my concerns can be averted with proper guidance.