PRESENTATION SUMMARY: “Self-Directed IRAs and other Interesting Retirement Plan Developments”

Estate Planning, Recent News, Self Directed IRA, , , , , , , , , ,

[The following blog post is a written summary of my presentation at the 59th Annual Estate Planning Conference in Seattle, WA on October 31, 2014.  It was truly an honor to be asked to speak at such an important event to northwest attorneys, CPAs, and financial professionals].

The overall purpose of my presentation was to highlight issues that all attorneys, CPAs, and financial planners, should know when speaking with a client who has invested (or is planning to invest) using a so-called “self-directed IRA” – i.e., an individual retirement account that is primarily used to invest into “nontraditional” (not publicly traded) assets, such as real estate, private companies, loans, etc.  The presentation also provided on overview of other significant developments over the past few years that affect all types of IRAs (not just self-directed IRAs).  Finally, I discussed the differences between self-directed IRAs and “rollover as business startup” (ROBS) structures and why advisors need to be careful to not get the two types of investment vehicles confused.

The following is a summary of my presentation points:

1.    Introduction to Self-Directed IRAs:

a.     Self-directed IRAs are generally allowed to invest into any asset other than life insurance and “collectibles” (IRAs are also not eligible shareholders in S-Corporations).

b.     Although many large brokers (e.g., Schwab, Fidelity, etc.) offer “self-directed” retirement accounts, they accounts are generally limited to publicly traded assets.  When I refer to a “self-directed IRA”, I am referring to an IRA that is either buying non-public assets directly, or is first investing into an LLC, with the LLC then making the investments into non-public assets.

c.      Self-directed IRA landscape: Custodians vs. IRA/LLC Facilitators

2.    Formation of a Self-Directed IRA:

a.     Everything starts with the IRA custodian.

b.     Need to be careful regarding the type of SDIRA being formed (e.g., Roth, Traditional, SEP), the assets being moved into the new SDIRA, and the method that the funds are being moved (e.g., transfer vs. rollover).

c.      SDIRA vs. SDIRA-owned LLC.

d.     Additional complexities if SDIRA or SDIRA/LLC invests into a “Project LLC” (joint venture) and/or multiple SDIRAs invest into the same LLC.

3.    SDIRA legal and tax problems:

a.     Prohibited transactions.

i.     “Automatic” prohibited transactions vs. “Fiduciary” prohibited transactions.

ii.     Disqualified people – not isolated to only “family members”.

iii.     Violation of rule = complete retroactive invalidation of IRA = income tax, penalties, interest, loss of tax-deferred growth going forward, etc.

iv.     Fiduciary prohibited transactions can occur regardless of whether a disqualified person is involved – e.g., “divided loyalty” or “conflict of interest”.  Lots of potential ammunition for the IRS.

b.     Unrelated Business Taxable Income (UBTI) and Unrelated Debt-Financed Income (UDFI) [note: to read my more extensive article on this topic, click here)

i.     Not all income is exempt from current tax to an SDIRA.

ii.     Operating business and/or debt-financed investments (either by an SDIRA directly or through an SDIRA-owned LLC) = current tax to SDIRA.  SDIRA must file a tax return (Form 990-T) and pay current tax (note: the tax consequences to the IRA owner personally when the IRA’s assets are distributed during retirement years does not change, regardless of whether the IRA owed tax on its past investments due to UBTI/UDFI).

iii.     Active business vs. passive investment in a real estate context involves analyzing numerous “factors”.  This is why “flipping” real estate out of an SDIRA or SDIRA/LLC can be, but is not always, an operating business subject to UBTI.

4.    Recent SDIRA case law.

a.     Peek v. Commissioner.  Two SDIRAs invested into a C-Corporation.  C-Corp purchased an active business.  As part of the purchase price for the business, the IRA owners personally guaranteed a seller financed Note from the businesses former owner.  This guarantee was a prohibited transaction, resulting in a complete retroactive invalidation of both IRAs.  [Note: the business was eventually sold for a large gain by the SDIRA-owned C-Corp; the IRS was able to impose capital gain on that sale because the C-Corp was deemed to be owned by the IRA owners personally (rather than by the IRAs) because of the deemed retroactive distribution of the IRAs to a year prior to the business sale].

b.     Ellis v. Commissioner.  IRA purchased 98% of new LLC.  LLC began operating a used car business.  IRA owner was paid a salary to be the car business’s “General Manager”.  This was a prohibited transaction, resulting in a complete retroactive distribution of the IRA to the IRA owner.  [Note: It’s possible that the law firm that originally structured this transaction was attempting to setup a “ROBS” (more on this below), but didn’t understand the differences between an SDIRA/LLC and a ROBS].

c.      Dabney v. Commissioner.  In this case, the IRA was held at Charles Schwab (which is the type of custodian that normally does not hold real estate within its IRAs) and the IRA owner wanted to buy a piece of undeveloped land.  The IRA owner filled out a “distribution” form and had Schwab wire funds directly from his IRA to the title company that was handling the real estate purchase.  The IRA’s name was listed on the title of the property.  Several years later, the property was sold and the IRA owner attempted to deposit the funds back in the Schwab IRA.  Schwab informed the IRA owner that he had a taxable distribution when the funds originally left his IRA – and the tax court agreed.  The lesson here is that an IRA owner cannot unilaterally force an IRA custodian to hold real estate (or other non-public asset) within an IRA if the custodian’s general policy is to not hold those types of assets.

5.     Estate Planning Complications involving Self-Directed IRAs.  Beyond prohibited transactions and UBTI, there are additional unique legal issues that self-directed IRAs can raise.  For example, self-directed IRAs raise both “during life” and “post death” estate planning issues, but unfortunately many clients (and their advisors) ignore these complexities [for a more detailed analysis of these estate planning issues, see my full-length article here).

6.     Rollover as Business Startup (“ROBS”).  Many problems arise when a self-directed IRA or IRA-owned LLC conducts an “operating business” (e.g., if the IRA/LLC pays the IRA owner compensation, a prohibited transaction will occur; income will be subject to current UBTI tax).  However, what if retirement funds could be used to invest into a start-up business and the retirement account’s owner could be an employee of the business?  Well, that is exactly what a ROBS structure accomplishes.  In short, the ROBS involves the following: (1) a new C-Corporation is formed; (2) the C-Corp sponsors a 401(k) plan; (3) “old” retirement assets are rolled into the new 401(k); (4) the new 401(k) invests all of its cash into the C-Corp in exchange for “qualifying employer securities” (QES); (5) the 401(k) accountholder contributes enough cash to acquire 5% or more of the C-Corp’s stock; (6) the C-Corp uses the cash to purchase or start an operating business; (7) the C-Corp pays reasonable compensation to the 401(k)’s accountholder, who is generally the key employee in the business; and, (8) the 401(k) accountholder begins to defer part of his/her salary into the 401(k) plan.  Although the IRS has acknowledged that ROBS is legal, there are potential problems that can occur – for example, the C-Corp hires new employees but they are not offered participation in the 401(k); 401(k) recordkeeping is not done properly.  From my perspective, I am okay with the ROBS structure, but I warn clients that if the business fails, they will be left with not only no job, but also no retirement funds (assuming they used all of their retirement funds to initially invest into the ROBS).

7.     Inherited IRAs in Bankruptcy.  Thanks to the U.S. Supreme Court case in Clark v. Rameker, inherited IRAs are no longer protected under federal bankruptcy law.  In the case, “Heidi” inherited an IRA from her Mom.  Heidi’s pizza business later failed and she filed for bankruptcy, believing that her $300k inherited IRA was protected from creditors.  The Supreme Court ruled 9-0 that inherited IRAs are NOT protected, and thus, Heidi’s IRA would need to be paid to her creditors.  Some states (around 8 at last check) have specific bankruptcy exceptions for inherited IRAs, but most do not.

8.     IRA Trusts.  The potential use of a standalone “IRA Trust” (aka “IRA Legacy Trust”, “IRA Preservation Trust”, or “IRA Asset Protection Trust”) can help protect an IRA post death – and can also ensure that the trust’s beneficiaries (“Heidi” in the Rameker case) do not withdraw the IRA assets faster than they should.  The benefits of an IRA Trust are even greater when the IRA funding the trust at death is a Roth IRA.

9.     IRA Rollovers – new “once-per-year” rule.  The tax court in Bobrow v. Commissioner ruled that the “once-per-year IRA rollover rule” does not apply on an IRA-by-IRA basis, but rather on an aggregate basis.  In other words, an IRA owner can no longer withdraw funds from IRA#1, use those funds for 60 days, contribute the same amount to IRA #2, and then immediately repeat the process with IRA #3 and IRA #4.  Although I think this new rule makes more sense (and the IRS concurs), there are potential traps for an IRA owner that is simply trying to consolidate his/her IRAs and misunderstands the rule.  If more than one IRA rollover occurs in any 12 month period, every rollover after the first one is considered a taxable distribution to the IRA owner.  [Note: there are exceptions to this rule – for example, rollovers from “qualified plans” do not count; direct custodian-to-custodian transfers also do not count].

10.     401(k) “In Plan” Conversions.  For several years now, active participants in a 401(k) can “convert” as much as they want from their pre-tax 401(k) account to their Roth 401(k) account (assuming the particular 401(k) offers a Roth component and the 401(k)’s accountholder is willing to pay the tax on the conversion).  However, I don’t see a lot of 401(k) owners taking advantage of this rule.

11.    Form 5498 Reporting Changes.  As I detailed in my “Boom! Boom! Boom!” article, the IRS is about to start collecting additional information about self-directed IRA accounts.  These changes could lead to additional scrutiny to IRA accountholders.