Client Question: I have a self-directed IRA, what are the ‘red flags’ that could cause an IRS audit?
My Answer: Anything the IRS can “see”.
In this article, I will discuss situations where the IRS has access to information that could trigger an audit of an Individual Retirement Account (“IRA”), which in turn can lead to the potential complete invalidation of the IRA. Unfortunately, most self-directed IRA investors are entirely unaware of these red flags.
One important thing to note is that the IRS doesn’t need to know that a self-directed IRA is involved. Historically, retirement accounts have been audited by the IRS or federal Department of Labor at very low rates. However, many of the “red flags” discussed in this article arise in situations where the IRS doesn’t necessarily know that a retirement account is involved, and in fact, that can be part of the problem.
In other words, red flags are more about inherent confusion being created at the IRS (or, more accurately, within the IRS’s computer system), not whether the IRS makes a conscious choice to audit your self-directed IRA.
Keep in mind that it’s also true that the IRS has historically not audited retirement accounts because most retirement accounts invest into very standardized investments (e.g., publicly traded stocks, bonds, mutual funds, etc.). However, with the growth of self-directed IRAs, which are intended to buy nothing but non-traditional assets (e.g., privately held companies, real estate, precious metals, etc.), the IRS has realized that more oversight is necessary. Thus, the red flags discussed in this article plus the federal government’s awareness that non-compliance exists in the self-directed IRA arena, makes audits more likely going forward.
Below are the five most common IRS red flags when investing using a self-directed IRA. The general theme here is that the problems described below result in the IRS seeing information (e.g., a tax form from a third-party) – and, because the IRS’s computer system is absorbing the information, there is a possibility of a “mismatch”, where the IRS believes income is taxable (whether correctly or not), but no corresponding tax is paid.
(1) Schedule K-1 Reporting. Many investments in private companies result in a “Schedule K-1” being sent to the IRS. The K-1 shows various tax items that are applicable to the investment. In situations where a self-directed IRA or IRA-owned LLC (“Checkbook IRA”) owns the company that is issuing the K-1, many problems can trigger an IRS inquiry – for example: incorrect tax ID number; income that appears to be taxable (e.g., “unrelated business taxable income”); and many others. Unfortunately, because most IRA investors assume that any tax form related to their IRA’s investment is irrelevant (because the IRA is “tax exempt”), these K-1 problems are never seen by the client’s professional advisors. Even if the K-1 is shown to the client’s CPA, problems are often still missed, because most CPAs deal with self-directed IRAs fairly rarely.
(2) Form 1099 Reporting. Similar to above, a Form 1099 can be issued by third parties that have paid income to an IRA – for example, interest income, dividends, etc. The 1099 is sent to the IRS, so, just like a K-1, the IRS will generally expect that tax will be paid on the income. For example, if the 1099 is issued incorrectly under the IRA owner’s social security number, a mismatch will occur, because the individual will not show this income on their personal tax return (because it’s actually occurring within an IRA).
(3) Custodian Reporting. An IRA custodian that is holding the self-directed IRA must report various information to the IRS each year (on IRS Form 5498) – for example, the year-end value of the IRA. Form 5498 is often sent to the IRS without any review by the IRA’s owner, but errors can exist that trigger IRS review.
(4) UBTI, but no tax return filed. As discussed extensively in other articles I have written, IRAs are not exempt from income tax in all situations. If income earned by an IRA is considered unrelated business taxable income (“UBTI”), the IRA can owe current tax. The easiest way for the IRS to “see” that UBTI is occurring is on a K-1. A correctly prepared K-1 will specifically show UBTI on “Statement 20V”. If the IRS sees UBTI and can’t identify whether the IRA filed a tax return and paid tax, a more in-depth audit can occur. As noted above, unfortunately many clients and their advisors entirely ignore the K-1, even if the 20V makes it clear that UBTI is applicable.
(5) IRA-owned LLC’s EIN used. A very common mistake is for a tax form (e.g., K-1, Form 1099, etc.) to be sent to the IRS that lists the tax ID number (“EIN”) of an IRA-owned LLC. Generally, in situations where an IRA owns 100% of an LLC, the LLC is considered a “disregarded entity” for tax purposes, which means the LLC’s EIN is supposed to be entirely ignored on tax forms. Regardless, tax forms often incorrectly list the LLC’s EIN – and because the LLC never files a tax return, the IRS can immediately get confused and ask questions. For example, imagine that a K-1 tells the IRS that the LLC is earning $100,000 of income. Because the LLC does not file a tax return, the IRS has no way of knowing what taxpayer is supposed to be paying tax on the $100k. Thus, the IRS might falsely assume that the client individually owes tax, when in reality the IRA owns the LLC and the IRA generally does not owe tax.
In summary, the IRS does not ask questions for random reasons – rather, they typically ask because their computer system identifies a “mismatch” between tax forms they have received from third parties and various tax returns that have been subsequently filed. Thus, it’s critical for self-directed IRA owners to be keenly aware of tax forms that are sent to the IRS and how to correct problems before they explode into a full-blown audit.
About the author, Warren L. Baker …
For the past 20 years, my practice has been focused on assisting clients in analyzing and structuring tax-efficient structures for complex investment and business transactions – often involving the use of “self-directed IRAs” or other retirement account vehicles to purchase “non-traditional” assets (e.g., private equity, real estate, promissory notes, etc.). My writing and commentary in this area has been featured in Forbes, the Wall Street Journal, ProPublica, Bloomberg, Journal of Accountancy, and many others.