This week’s Kiplinger Tax Letter (which, for those of you that work in the legal/accounting/financial field, is an excellent way to stay current on tax-related topics that affect you and your clients) puts a spotlight on several self-directed IRA issues that I have written about in the past.
First, if an IRA invests into a partnership (e.g., LLC, master-limited-partnership, etc.), the IRA’s owner needs to be aware that the income earned by the partnership is not always exempt from current tax. Rather, unrelated business taxable income (UBTI) or unrelated debt-financing income (UDFI) can “flow through” to the IRA (by way of the partnership’s “Schedule K-1”, which should be issued each year). The end result is that the IRA must file a tax return (Form 990-T) and potentially pay current tax [note: the income and/or the tax payment definitely cannot be paid by the individual that owns the IRA; also, as Kiplinger points out when referencing a recent Tax Court decision, any losses resulting from the investment into the partnership cannot be used the IRA’s owner on his/her personal tax return (Form 1040)]. Kiplinger points out that some IRA custodians will prepare Form 990-T on behalf of their clients – however, I believe that this is a very dangerous road to go down, because the IRA custodians are supposedly “passive”, and therefore, cannot give legal and/or tax advice and they do not owe a fiduciary duty to their IRA accountholders. Also, I know from experience that some IRA custodians do not have the level of tax expertise required in order to prepare Form 990-T properly. Rather, an IRA’s owner should consult with a CPA that is experienced with Form 990-Ts (note: my firm refers this type tax preparation to outside CPA firms that we trust).
[Side Note: there is a misconception in the marketplace that a “Solo 401(k)” does not need to worry about UBTI, and therefore, in the example above, a Solo 401(k) that is invested into a partnership/LLC/MLP would not owe current tax. This is not true. Rather, a Solo 401(k) is only exempt from UDFI (debt-financed income), not UBTI – so, depending on what the partnership is ultimately investing into, the Solo 401(k) could also owe current tax.]
For an article I wrote for the Journal of Accountancy on the hidden dangers of UBTI/UDFI within the self-directed IRA world, see here: Self-directed IRAs: A tax compliance black hole.
Second, Kiplinger points out that if an IRA violates the prohibited transaction rules, the IRA’s owner cannot later claim that the IRA is exempt from bankruptcy. The assets of an IRA are generally exempt from bankruptcy, but that exemption is lost if the IRA technically no longer exists – which is the practical consequence of committing a prohibited transaction. Although there are many case law examples of this result, Kiplinger cites a recent district court case out of Arkansas. In that particular case, the self-directed IRA transacted with a business entity that was 50% owned by the IRA’s accountholder (individually). The prohibited transaction rules (see Internal Revenue Code Section 4975) state that a “disqualified person” includes a business entity that is 50% or more owned by a fiduciary of the IRA (i.e., the IRA’s accountholder). This is a relatively easy mistake for the IRS (or in this case, the bankruptcy trustee) to see.
Both of the self-directed IRA scenarios described in the Kiplinger Tax letter support the idea that unknowing IRA accountholders can get themselves into serious trouble if they do not understand the inter-workings of the tax laws surrounding self-directed IRA investment.