My clients frequently ask, “what self-directed IRA investments have the most potential for IRS scrutiny?” While most clients think this question is related to the specific type of investment, to me, the question is more about the collateral consequences of a particular investment. IRS scrutiny is very rarely a random occurrence – instead, the IRS questions often start because of a computer mismatch problem. We all know that the IRS has limited audit resources (at least prior to their recent $80 billion of additional funding), which is why they leverage their computer system to provide them with promising leads.
A simple example if this “mismatch problem” is something that most people are familiar with: if you are working at your regular job and you receive a W-2 listing your income as $100,000 (and tying that income to your social security number), you sure as heck better show this $100k on your personal tax return! If you don’t, the IRS’s computer system will easily detect a mismatch between your personal tax return (which, of course, is filed using your social security number) and the W-2.
This same mismatch problem can arise very easily in the self-directed IRA investment world, but due to many factors, avoiding the problem is much more difficult and far less obvious. The most frequent problem occurs when a partnership or multi-member LLC (whether only a few owners or a large “private equity fund”) issues a Schedule K-1. A K-1 is the document that tells the partners (e.g., IRA) their share of income, loss, deductions, etc. of the partnership. As I will explain more below, in situations where an IRA is the investor in the partnership, the K-1 can cause many problems, including: (1) the K-1 is formatted incorrect, thereby causing automatic confusion within the IRS’s computer system; (2) the K-1 does not provide enough information for the IRA’s accountholder (and his/her accountant) to know whether the investment is triggering “unrelated business taxable income”; and, (3) the IRA’s accountholder (and/or the IRA custodian) entirely ignores the K-1, incorrectly believing that tax forms are irrelevant to an IRA, due to an IRA being “tax free” (big mistake!).
One practical problem with an IRA investing into a partnership or multi-member LLC is that the initial investment is often rushed – i.e., the IRA’s accountholder hurries to get the investment made, without considering the information that is being provided to the investment sponsor. This then sets up a situation where the investment sponsor passes incorrect or incomplete information to the sponsor’s accountants, who then produce the first K-1 one year (or more) after the IRA’s initial investment [for example, investment made in January 2023, but first K-1 doesn’t arrive until July 2024] – and, by that point, everyone has forgot to even consider whether the information originally provided by the IRA’s accountholder was correct.
With my above commentary as background, the following is a list of some (but not even close to all) of the problems that I see when K-1s are issued to IRAs or IRA-owned LLCs [note: for wording simplicity I will refer below to the partnership or multi-member LLC as the “Project entity”].
- Incorrect Partner Tax ID Number. Part II, box E of the K-1 is supposed to list the tax ID number of the partner/Member of the Project entity. In the case of an IRA investing directly into the Project entity, if the IRA accountholder’s social security number is listed on the K-1 (a very common problem!), the IRS will falsely believe that the IRA accountholder individually owes tax on the income listed in Part III of the K-1. If the IRA’s accountholder ignores the K-1 (which is somewhat logical because he/she knows that the investment is not owned by him/her individually, but rather by his/her IRA), the IRA’s accountholder will likely receive a letter from the IRS (i.e., “we believe that you underreported your income.”) and cause a whole lot of headaches going forward – particularly if the K-1 lists a significant amount of profit (as compared to loss) – whether rental income, interest income, capital gain, etc. With the above being said, the correct tax ID number to be listed is either the custodian’s EIN or a standalone IRA EIN (note: the dynamic of when a standalone IRA EIN should be used instead of the custodian’s EIN is a complex topic)
- 100% IRA-owned LLC’s EIN is listed. Related to item #1 above, if an IRA owns 100% of an LLC (a structure that is tragically referred to as a “checkbook IRA”), then the LLC’s name should be listed on the Project entity’s investment paperwork as the investor. However, for federal tax purposes, the IRA-owned LLC is completely ignored (i.e., it is a “disregarded entity”), so the IRA-owned LLC’s name and EIN should only be listed in Part II, box H2 of the K-1. However, often times, the LLC’s name and EIN will be listed as the “partner” on the K-1 (boxes E and F) and then the accountants issuing the K-1 (i.e., the accountants for the Project entity) will say that the partner’s (IRA-owned LLC’s) tax classification is “partnership” (see Part III, line I1 of the K-1). The problem with this is the IRS will falsely believe that the IRA-owned LLC should be filing a standalone tax return (Partnership / Form 1065), when it should not (again, because it’s a 100%-owned disregarded entity). In other words, despite the IRA-owned LLC’s name being the “investor”, the K-1 should “look through” to the IRA itself (except for box H2).
- Unrelated business taxable income (UBTI) or unrelated debt-financed income (UDFI) is applicable, but not enough information is provided. As I have written in many other posts and articles, counter to popular belief, a self-directed IRA can definitely owe current tax – if the income earned within the investment is either “UBTI” or “UDFI” [note: this tax is due from the IRA or IRA/LLC directly, not from the IRA’s owner individually, another common misunderstanding]. In the case of an IRA or IRA-owned LLC investing into a Project entity, whether UBTI or UDFI is applicable depends on the income that is “flowing through” on the K-1. For example, if income appears on Part III, line 1 of the K-1 (“ordinary business income”), then UBTI is almost guaranteed. Also, if income appears in other boxes in Part III (e.g., capital gain, rental income, interest, etc.), some of that income could be considered UDFI if the Project entity is using financing/debt (hint: look at Part II, part K of the K-1 to see whether the Project entity has “liabilities” – i.e., debt). However, even if it appears that UBTI or UDFI is applicable, unless the accountants that are preparing the K-1 attach a “Schedule 20V” to the K-1 (which will specifically say how much UBTI/UDFI is applicable), then the IRA’s accountholder (and his/her accountant) is in the dark. In other words, in order for the IRA’s accountholder (via his/her accountant) to prepare a standalone IRA tax return (Form 990-T, which is the IRS form that reports UBTI/UDFI) and pay tax, they need to have enough information from the Project entity’s accountants. [Note: if the accountants believe an LLC/partnership is the legal owner of the Project entity (see problem #2 above), they will almost never issue a Schedule 20V, because they have no idea that the underlying taxpayer is a tax-exempt IRA – i.e., UBTI is irrelevant to most taxpayers].
- K-1 mailed to IRA custodian is ignored. One practical problem that comes up regularly is that the Project entity’s accountants mail the tax forms (e.g., K-1, etc.) directly to the IRA’s custodian, but the custodian does not pass a copy along to the IRA’s accountholder (perhaps assuming that a copy went to him/her as well). This can be a major problem if one of the other problems identified above are present – because the SDIRA’s accountholder (and his/her tax advisors) will be completely unaware of the problem(s), and thus, have no ability to correct it.
- Prohibited transaction risk. One very real consequence of all of this is that the above problems put the IRA’s entire legal legitimacy at risk! If a “prohibited transaction” occurs within an IRA (or IRA-owned LLC), the entire IRA is treated as retroactively invalidated and all assets are distributed to the IRA’s accountholder – resulting in horrific tax consequences. Oftentimes, a prohibited transaction happens by mistake – or by a lack of awareness of the legal rules that govern self-directed IRAs. Regardless, as a practical matter, the only way the IRS will ever be able to see that a prohibited tranaction occurred is if they look closely at what the IRA has been investing into. The K-1 problems discussed above can cause the IRS to start asking questions – which then can spread into prohibited transaction questions. NOT GOOD!
In summary, when a Schedule K-1 is issued as a result of a self-directed IRA or 100% IRA-owned LLC investment, problems are extremely common. When clients provide me with a K-1 and there is not one of the problems discussed above, I’m honestly surprised(!) – which is a reflection of how widespread these problems are.
Finally, let me say that I have been working in this self-directed IRA arena for almost 20 years – and, historically, the IRS has not had the resources to scrutinize many of these K-1 problems (despite them being very easy to detect). However, with the IRS getting $80 billion of new funding, there is concern (certainly from my clients!) that additional resources will exist to dive into these self-directed IRA compliance problems more going forward.
Stay safe out there!