Performing Due Diligence Before You Invest & The Due Diligence Top 10 List

Before you invest your hard earned savings or your self directed IRA into a “non-traditional” business or real estate investment of another you need to ask some hard questions to the person or business receiving your money. Here are some tips to keep you out of legal trouble and to help you avoid bad investments or structures.

  1. If you don’t understand how the business or investment makes the returns being promised, then don’t invest.
  2. If you aren’t given adequate documents outlining what has been explained to you verbally or what has been put into a presentation then don’t invest.
  3. If you’re told that you can get a commission for bringing others to invest into the same company and if you don’t have a license to receive such commissions then don’t invest. If the investment sponsor is willing to violate the law to pay an un-licensed person to raise money from others then what’s stopping them from misappropriating your money you invested? It is only the law preventing them, which they’ve proved they will disregard.
  4. If you are loaning money for a real estate venture, then demand a deed of trust or mortgage on title to the property protecting your investment. Also, make sure that you get a copy of the title report or commitment showing what position your loan is being placed into when the deed of trust or mortgage is recorded. Many savvy investors (and what all banks do) create lending instructions to the title company closing the real estate transaction and tell the title company to only use the funds being loaned when the borrower signs the note/loan documents, when the title company verifies the priority of the deed of trust you are getting (1st position, 2nd, etc.), and whether all other defects to title have been cleared (and if not cleared, disclosure of what they are).
  5. If you’re investing into a PPM or private offering you should receive lots of documents outlining the investment, the use of funds, the background of those managing the company, and also documents regarding your rights as an investor (e.g. offering memorandum and LLC operating agreement or LP limited partnership agreement). Also, check to see if the PPM or private offering was properly filed with the SEC by going to SEC.gov and checking the company name in the SEC database. If no filing record exists for the PPM or private offering with the SEC then the person raising the funds has possibly disregarded the law. As stated earlier, if someone is willing to disregard the law to get your money what is stopping them from disregarding the law to not pay you back (it’s just the law)?
  6. Investigate the background of the person you are entrusting your money with. When you are investing with others you need to think like the bank and do what the bank does. What is this person’s credit worthiness? What is their employment or prior business experience? What is their business or investment plan? What are the terms of the investment? Is there a realistic rate of return that fairly recognizes the risk being taken?
  7. If you are pressured that this opportunity will pass if you don’t invest now, then let the opportunity pass. Most scams use this technique and most legitimate investments never have this funding crisis.
  8. Make sure a lawyer representing your interests reviews the documents. If a lawyer drafted the documents already it is still important to have a lawyer look at the documents as they relate to your interests and with an eye towards protecting you. Sometimes, unfortunately, the devil is in the details and many investments have clauses that can significantly impact your ability to get your money back out or that give the company raising the money the ability to pay whatever compensation to themselves they desire. These are obvious problems that will eat into the bottom line of the profits you may be expecting.
  9. Seek the opinion of another investor, business owner, or friend whose opinion you trust. Sometimes, when you explain the investment to someone else they can help you find issues to consider and questions you should be asking.
  10. Be comfortable saying no and only invest what you are willing to lose. Non-traditional investments have made many millionaires over the years but they have also caused lots of financial ruin. Just keep the risk in perspective and don’t “bet the farm” in one deal.

Don’t be scared about investing into non-traditional investments. Just remember though that you may need to get out of your comfort zone by asking lots of questions, by demanding additional documentation, or by simply saying no. Remember, you are the best person to protect yourself.  So do it.

LLC Versus Umbrella Policy

Image of an umbrella protecting some stacks of money with the text "LLC Versus Umbrella Policy."Many real estate investors and landlords often ask whether they should use an umbrella insurance policy or a LLC to protect them from liabilities that may arise on their rental property. An LLC protects the owner of the LLC from liabilities that arise on any property in the LLC and prevents a plaintiff from being able to go after the LLC owner personally. As a result, we often say that an LLC protects a business owner’s personal assets from the risks and liabilities of the LLC business. An umbrella policy is coverage above and beyond the typical property insurance and covers additional risks and adds additional coverage to a typical property insurance policy.

Issues and Factors

There are many issues and factors to consider in making this decision and there is no one-sized fits all recommendation. In many instances we recommend that you have both an LLC and an umbrella policy and in other instances we may recommend just an LLC or just an umbrella policy. The first factor to consider is the cost. The cost of an LLC in our office is $800 and on average you can expect about $200 in fees a year to keep that LLC active with the State (about $900 annually in California, each state is different). As a result, the major cost of an LLC is in the first year but you can plan on having about $200 in fees each year (each state is different) to keep your LLC active. If you have a partnership LLC then you also have the cost of a LLC partnership tax return but the LLC also provides a significant amount of partnership advantages and protections.

An umbrella policy on the other hand is typically paid for monthly. Let’s say you are able to get $1M in umbrella protection at a cost of $50 a month. That would run you about $600 a year. Insurance policies have benefits which include attorneys whom the insurance company will appoint and pay to defend you (and protect themselves from having to pay) but also contain certain exclusions to coverage that may leave you with no coverage for the liability you incur. Another important factor to consider is the type of property you own. If you own a multi-unit property or commercial property we would recommend having both an LLC and an umbrella policy because you have more liability exposure when you have more tenants. On the other hand, if you have a single family rental in an otherwise good neighborhood where you feel less likely to be sued then we may only recommend an LLC or an umbrella policy on its own. Bottom line, consider both an LLC and an umbrella policy in your analysis and get quotes and advice upon which to make an informed decision so that you are protecting your assets in the most efficient and effective way as possible.

 

IRA Ownership of an LLC: Self-Directed IRAs and IRA/LLCs

Image of the US Tax Court logo with the text "IRA Ownership of an LLC: Self-Directed IRAs and IRA/LLCs."There are numerous laws, cases, and regulations to consider in analyzing whether your IRA can own an LLC (commonly referred to as an “IRA/LLC” or a “checkbook control IRA”). Despite the complexity of the law, your IRA can own 100% of the ownership interest of an LLC and you as the IRA owner may serve as the Manager of this LLC. This proposition was first supported by the case of Swanson v. Commissioner, 106 T.C. 76 in 1996 where the U.S. Tax Court held that it is not a prohibited transaction under IRC Section 4975 for a retirement plan to invest and own 100% of newly created corporation nor was it prohibited for the IRA owner to serve as an officer of that company where no salary or compensation was paid to the IRA owner. In summary, the U.S. Tax Court has supported the structure whereby a new created company is wholly owned by a retirement plan and managed by the retirement plan owner and that is the same rationale used in many IRA/LLC’s.

So what does the IRS think about IRA/LLC’s? The IRS issued IRS Field Service Advisory #200128011 in April of 2001 which indicated that the IRS will not contend that there is a prohibited transaction when there is a newly formed and capitalized company that is 100% owned by a retirement plan. Keep in mind that both of these cases deal with newly formed companies and do not apply to LLC’s or corporations (or other companies) which a retirement plan owner may have already established. Also, it is possible to partner your retirement plan with others into one IRA/LLC but you must carefully consult with professional who are experienced in this area as there are numerous prohibited transaction issues that may arise when you partner your IRA with others.

Serving as the Manager of the IRA/LLC allows the IRA account owner to enter into contracts on behalf of the IRA/LLC and to sign checks on behalf of the IRA/LLC. There are restrictions on the amount of work you may do (for example, if the IRA/LLC owned a property you may not work on the property) but you may oversee the administrative matters like the signing of contracts and checks. The prohibited transaction rules still apply to IRA/LLC’s in the same way they apply to your self-directed IRA so you still must pay careful attention to these rules and most consult with professionals who are competent in the laws that apply to retirement plans. Moreover, an IRA/LLC is different from your typical LLC and the IRA/LLC documents should include numerous provisions which protect your IRA from a prohibited transaction. This doesn’t mean that an IRA/LLC should costs thousands of dollars. In fact, our law firm sets IRA/LLC’s up for $750 plus the state filing fee if the IRA/LLC is owned by one IRA or $1,500 if owned by multiple IRA’s or partners. In the end, an IRA/LLC can be a powerful tool to gain more control of your IRA’s investments but you must do so with adherence to the rules and laws that apply to your IRA. Written by Mathew Sorensen, Attorney at Law and Partner at Kyler Kohler Ostermiller & Sorensen, LLP, a law firm assisting self directed retirement plan owners across the U.S. for over ten years from offices in Arizona, Utah and California. To learn more about our law firm, please visit our website at ww.kkoslawyers.com or call us at 435-586-9366.