[To view Part 1 (“Formation”), click here; Part 2 (“What Clients are Doing and Why”), click here.]
In 2011, I published a six-part article series entitled “Investing Retirement Funds into Non-Traditional Assets using a Self-Directed IRA”. Because readers found that information to be useful as a “starting point” for learning about self-directed IRAs (perhaps because it was less “technical” than many other articles I have written), I have now revamped those articles and will post them periodically . Part 3 is below…
For those readers who may have missed my first two articles, let me start with some background. Although most Americans invest their retirement funds into publicly-traded assets (e.g., stocks, bonds, mutual funds), the laws governing IRAs allow almost unlimited investment flexibility. I have worked with thousands of clients who have invested their “self-directed” retirement funds in “non-traditional” IRA assets, e.g., real estate, privately-held businesses, precious metals, loans, and almost every other investment you could ever imagine.
As a starting point, many of my clients use their self-directed IRA to purchase a newly-formed Limited Liability Company (“LLC”), which can greatly reduce the involvement of the IRA custodian (i.e. decreased transaction costs). The reason for this is that the LLC operates almost entirely out of a business checking account, with the “Manager” of the LLC (i.e., the account holder of the IRA) being the authorized signer on the account. However, as I will discuss below, these self-directed IRA (and IRA-owned LLC) structures have the potential to create major tax and legal problems if the IRA account holder is not extremely careful.
If you conduct a “self-directed IRA” Google search, you will find numerous websites that discuss “prohibited transactions”, but very few do a decent job of providing real life examples of the rules in action. In my opinion, the reason for this is that very few attorneys, accountants, or other professionals (let alone the people actually creating these websites) have real-world experience in this area – and/or, they would prefer to focus on the potential positive aspects of self-directed IRA investing, while downplaying the potential negative aspects. Dispensing these complicated tax laws without further explanation is like handing someone the 3,000+ page Internal Revenue Code and telling them to calculate their taxes.
The starting point when discussing prohibited transactions is Internal Revenue Code (“IRC”) Section 4975(c)(1). In an IRA context, this tax code provision 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 descendents (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.
I have listed all of the subsections of 4975(c)(1) below and provided several real-world examples to demonstrate the basic intent of each rule. Keep in mind that if a prohibited transaction occurs, the tax-exempt status of the IRA is lost and the IRA’s entire value is treated as taxable to the IRA account holder (plus possible interest and penalties). Note: all of these rules apply equally regardless of whether the IRA investment is being made directly out of the IRA or out of an IRA-owned LLC structure.
IRC Section 4975(c)(1). Prohibited Transaction.
(1) General rule. 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;
Example 1: The IRA purchases a piece of real estate from the IRA account holder or any other disqualified person. This sale is prohibited regardless of whether the IRA purchased the property in an otherwise “commercially reasonable” manner – i.e., a qualified appraisal justifying the purchase price is not going to help avoid the prohibited transaction.
Example 2: The IRA pays the IRA account holder’s son twenty dollars to mow the lawn on the IRA’s property. Because the son is a disqualified person, any financial exchange with him (regardless of the amount of the transaction) is prohibited. This is an example of how a very “minor” transaction can result in the complete invalidation of the IRA.
Example 3: The IRA purchases a piece of commercial real estate from a unrelated third party, but later rents a portion (or all) of the property to a business that is 50% owned by the IRA account holder. Because a business entity that is 50% or more owned by a disqualified person becomes a disqualified person itself, this transaction would be prohibited. Again, this is the case regardless of whether “fair market terms” were used when executing the lease agreement.
Example 4: The IRA (or IRA/LLC) owns a piece of rental real estate that requires repairs to a bathroom. The IRA (or IRA/LLC) hires Mark (a contractor) to make the repairs. All materials and labor expenses are paid directly out of the IRA (or IRA/LLC, as the case may be). Mark is a “friend” of the IRA account holder and owns 15% of a completely separate legal entity that is 25% owned by the account holder and 25% by the account holder’s wife. Because the IRA account holder and his wife own 50% or more of the entity, the entity becomes disqualified. Further, because the entity is disqualified, any 10% or greater owners in the same entity (e.g., Mark) also are disqualified. Thus, Mark is a disqualified person, and thus, the IRA (or IRA/LLC) paying him anything would be a prohibited transaction.
(B) lending of money or other extension of credit between a plan and a disqualified person;
Example 5: The IRA loans money to the IRA account holder or another disqualified person. This is automatically prohibited. A loan from the disqualified person to the IRA (or IRA/LLC) would also be prohibited. Thus, IRAs do not operate under the same general rules as 401(k) plans, which often do allow loans to account holders.
Example 6: The IRA account holder wants the IRA to purchase a piece of rental real estate but the IRA does not have enough cash to support an outright purchase. The IRA account holder seeks out a bank to make a loan to the IRA (or IRA/LLC) to make up the difference. The IRA account holder is asked by the bank to “personally guarantee” the debt, which he or she does. Because signing a personal guarantee is considered by the IRS to be an “extension of credit”, a prohibited transaction has occurred. This example is particularly problematic in IRA/LLC situations because the bank involved might not realize that an IRA owns the LLC, and even if they do, the banker is probably not aware of this rule, rather, he or she is just looking out for the best interests of the bank.
Example 7: The IRA account holder is listed as a “co-signer / joint-guarantor” on the IRA/LLC’s credit card and/or margin brokerage account application. Either situation results in the same problem as Example 6 above.
(C) furnishing of goods, services, or facilities between a plan and a disqualified person;
Example 8: Similar to Example 3, the IRA purchases a piece of commercial real estate from a unrelated third party. The IRA then allows the IRA account holder (or the account holder’s business) to use the property for free. This “furnishing of facilities” is prohibited. This transaction is also likely to be a violation under Sections (D) and (E) below.
(D) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;
Example 9: The IRA purchases a piece of rental real estate on Lake Dreamy. Although the IRA rents out the property for most of the year, the IRA account holder (or another disqualified person) uses the property for one week every July. Regardless, of whether the disqualified person pays the IRA fair market value rent or stays at the property for free, this is a prohibited transaction.
Example 10: Assume the same situation as Example 9 except that the property is rented to the IRA account holder’s brother or friend. Although a brother or friend are not normally going to be considered automatic disqualified person (assuming they do not have co-ownership with the IRA account holder in another business structure), there is a potential “conflict of interest” problem here. This is not an automatic prohibited transaction, but could be scrutinized by the IRS.
(E) act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account;
Assuming the disqualified person involved in the particular transaction is considered a “fiduciary” of the IRA, many of the above examples also implicate this section of the code. The tricky thing is that these “fiduciary prohibited transactions” are often much more subtle to detect, which causes IRA account holders to ignore them – big mistake!
(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.
Example 11: The IRA purchased a piece of real estate. The IRA account holder (or another disqualified person) is a licensed real estate agent and collects a commission on the purchase. This is a prohibited transaction regardless of whether the commission was reasonable under the circumstances. As a general rule, the IRA (or IRA/LLC) cannot “personally benefit” a disqualified person, even if the disqualified person is only indirectly involved in the transaction.
As you can see from the discussion above, there are many fact patterns that can cause prohibited transaction concerns. For this reason, the first thing that I advise my clients to think about when considering any IRA (or IRA/LLC) investment is whether a potential prohibited transaction exists. If so, further analysis is required.
For examples of real life situations where the IRS has ruled that prohibited transactions resulted in the complete invalidation of an IRA, see my articled entitled Boom! Boom! Boom! IRS fires three shots across the bow of self-directed IRA investors [Washington State Bar Association Taxation Law newsletter (March 2014)].
To be continued…