Introduction:
The popularity of investing retirement accounts into “non-traditional” assets (e.g. real estate, private lending, LLC and partnership interests, etc.) using a self-directed IRA or an IRA-owned LLC (sometimes sold as a “checkbook control IRA”) has increased exponentially over the past 15 years. This growth has brought increased mainstream media attention, scams, and a huge amount of legal and tax non-compliance.
The unfortunate reality is that most self-directed IRA account holders do not receive a sufficient amount of legal/tax education prior to investing. The reasons for this include:
- the account holder’s normal “gatekeepers” (e.g. attorneys, accountants, financial advisors) are either unfamiliar with the rules or are kept completely in the dark because the account holder is afraid that their advisor will not approve;
- the account holder receives incorrect or misleading information on the internet;
- information is provided by representatives/salesman of IRA custodians or IRA LLC “facilitators” who are financially motivated to sell the particular self-directed IRA product that their employer provides; and/or
- the IRA custodians and IRA LLC facilitators are not legally representing IRA account holders (nor are they trained to do so), but rather providing “casual information”.
All of the confusion and misinformation has lead me to create the following top 3 reasons why an IRA account holder should speak with a tax attorney before forming a self-directed IRA (or IRA LLC):
REASON #1 – Not all IRA custodians (and self-directed IRAs) are created equal. Two initial issues that should be carefully considered by a retirement account owner prior to setting up a self-directed IRA are: (1) what custodian should I use – there are actually a lot more of these custodians out there than you might think; and (2) will the IRA invest directly or through an IRA-owned LLC (IRA LLC) structure? Failure to consider these issues and rashly transferring funds to a particular custodian because “my friend uses them” can lead to administrative hassle, unnecessary fees, and potential legal/tax problems.
The fee structure of self-directed IRA custodians can vary dramatically, for example: some charge higher setup fees and lower revolving fees; some charge fees based on the IRA’s value; some charge fees based on the number and type of assets owned by the IRA; some charge fees when the IRA pays an expense, receives income, and/or custodian action is required in any way; and some even charge fees for “research” and account termination. In addition, the amount of “compliance” paperwork that is required when the IRA executes a transaction varies significantly between custodians – which, when an investment requires immediate action (e.g. real estate foreclosure auction), can be the difference between the IRA purchasing the asset or missing out on an opportunity. In short, no two custodians are exactly alike, so a thorough vetting based on the account holder’s likely IRA investment is essential.
Which custodian is the best fit for a particular account owner depends on the type of investments that will be made and the corresponding involvement of the custodian going forward. For example, purchasing rental real estate within a self-directed IRA is a very popular type of investment, but also leads to expenses that must be paid by the IRA (e.g. property taxes, insurance, maintenance and improvement costs, and possibly mortgage payments). The IRA custodian’s procedure for dealing with these expenses (and the transaction fees the custodian charges for this service) is a very important issue that should be considered by the IRA account holder before setting up an IRA.
Finally, if the IRA account holder chooses to gain the maximum amount of control by setting up an IRA-owned LLC, the account holder will generally want to pick a very low cost custodian. The reason for this is that the custodian will not be involved in the day-to-day investment decisions, which instead will be made at the “LLC level”. In short, why pay a custodian high fees to do almost nothing?
REASON #2 – IRA custodians and IRA LLC facilitators often miss legal and tax problems. It never ceases to amaze me when IRA account owners tell me that what they have done with their IRA (or IRA LLC) – or what they plan to do in the future – is legally permissible “because my custodian said it was okay”. There are numerous problems with this statement. First, IRA custodians and IRA LLC facilitation companies are not in the business of advising IRA owners on the subtleties of IRA legal and tax issues. These companies do not practice law, provide financial advice, or otherwise provide their clients with investment or tax advice. In fact, all IRA custodians and IRA LLC facilitators have language in their contracts that say things like “you are solely responsible for the success or failure of your account” and “we are not advising you on legal or tax issues”.
Second, although IRA custodians do their best to train their representatives to recognize obvious legal and tax problems, the ultimate motivation of IRA custodian and IRA LLC facilitator employees is to establish as many accounts as possible (i.e. more sales). The result is that these representatives often glaze over the legal parameters and/or ignore key facts that might cause legal and tax problems. After all, it is not the employee’s problem if the IRA account holder violates the IRA rules.
The third potential problem with relying on the advice provided by an IRA custodian or IRA LLC facilitation company is that not all IRA legal and tax issues are “black and white”. For example, the “prohibited transaction” rules (which, if violated, can result in an IRA being treated as fully distributed to the IRA owner in one lump sum = terrible tax consequences) state that a “disqualified person” includes an IRA account holder’s spouse – in other words, no financial interactions can occur between the IRA and the IRA account holder’s spouse. However, this does not mean that a loan from IRA to the IRA account holder’s girlfriend is legally proper. In fact, the IRS has the ability to scrutinize any IRA investment that creates a “conflict of interest” or “fiduciary divided loyalty”. This is a simple example of the intricacies involved in the federal law that IRA custodians and IRA LLC facilitators either are not aware of or choose to ignore.
REASON #3 – IRA tax returns – the tax compliance black hole. Many self-directed IRA (and IRA LLC) account owners are completely unaware that there are certain situations where the income earned by their self-directed IRA is not exempt from current tax (i.e. their IRA must file a tax return and pay a tax). Generically speaking, these situations occur when the IRA earns income that is “debt-financed” and/or income from an “operating business”. However, the devil is in the tax details when it comes to these situations. In addition, because the IRA custodians and IRA LLC facilitators take a completely hands-off approach, many of these situations are entirely unreported to the IRS, and thus lead to a potential ticking time bomb (think: IRS audit; note: if the IRA does not file a tax return, the statute of limitations will likely never run – meaning that the IRS could potentially look back an unlimited number of years).
For example, consider a situation in which a self-directed IRA (or IRA LLC) invests into a real estate partnership that has four other owners (which might or might not be other IRAs). The partnership then uses the initial investors’ funds along with a bank loan to purchase a piece of vacant land. The partnership then builds several houses on the property and sells all of them for a substantial profit. At the end of the tax year, the partnership will issue tax forms to the investors showing each investors’ share of the partnership’s gain. For the IRA investor, the forms will go to the self-directed IRA account holder (or IRA LLC’s Manager). This situation will definitely trigger a tax filing requirement for the IRA (due to development being considered an operating business and/or due to the debt- financing), but unfortunately the IRA custodian might never realize that this situation has occurred. Further, if the IRA account holder is unaware of the rules, a “tax compliance black hole” will emerge. (Note: for a more detailed analysis of the UBTI and UDFI situation, you can read my article that was published in the Journal of Accountancy here).
Summary:
The issues above demonstrate the importance of IRA account holders speaking with experienced legal and/or tax professionals before moving forward with a self-directed IRA (or IRA LLC) formation and investment. If there is one thing that my experience in representing over 3000 self-directed IRA investors has taught me, it is that up front education is critical in order to prevent both immediate and long term legal and tax compliance violations.