In Ellis v. Commissioner, a Federal Appeals Court recently held that an IRA owner engaged in a prohibited transaction when he paid himself compensation from his IRA/LLC. An IRA/LLC (aka, “checkbook control IRA”), is an LLC owned by an IRA and is used primarily by real estate investors who choose to have their self directed IRAs own an interest in an LLC (usually 100%) and then this IRA/LLC in turn owns the real estate asset. The LLC will typically have a bank checking account and will receive income from the property and will be used to pay property expenses. The most common IRA/LLC structure is one where the IRA owner serves as the Manager of the IRA/LLC. Most self directed IRA companies and legal professionals will require that the IRA/LLC documents restrict the IRA owner from receiving any compensation from the IRA/LLC for serving as the Manager of the LLC. This restriction is a result of the prohibited transaction rules for IRAs which effectively state that certain persons called “disqualified persons” (e.g. IRA owner, their spouse, parents, kids) cannot transact with or personally benefit from an IRA’s investments or assets. IRC § 4975 (c)(1)(D), (E). For reference to the underlying Tax Court case and additional case facts and issues, please refer to my 2013 blog article on the Tax Court case here.
As a result of the Ellis case, Self-directed IRA owners should note the following key points from the 8th Circuit Court of Appeals decisions when investing their IRA funds into LLCs or other closely held companies.
- No Compensation or Benefit. The company documents must restrict the company from paying any compensation to a disqualified person. In essence, the Tax Code restricts an IRA from transacting with so called disqualified persons and these disqualified persons include the IRA owner (as a fiduciary), their spouse, kids, and parents. For more details on who is a disqualified person, please refer to my disqualified person article and diagram here.
- Don’t Rely on the Reasonable Compensation Exemption for Payments from an IRA/LLC to a Disqualified Person. In the Ellis case, the IRA owner made an argument that the compensation paid from the LLC to the IRA owner was “reasonable compensation” exempt from the prohibited transaction rules. This argument was based on the “reasonable compensation” exemption found in IRC § 4975 (d)(10), which exempts “reasonable compensation” paid from an IRA to a disqualified person in the performance of plan duties. The Court held that the reasonable compensation exemption did not apply to Ellis as his compensation was for managing the LLC’s business activities and not in the performance of plan duties. Further, the Court noted the “in-direct” self dealing prohibited transaction restriction and also relied on DOL Opinion 2006-01A, which restricts an IRA from investing into a company if that company is supposed to then transact with or compensate a disqualified person. In the Ellis case, as would be in the case in all IRA/LLC arrangements, compensation paid to an IRA owner would follow this rationale and an in-direct prohibited transaction would a rise. Consequently, compensation should never be paid to a disqualified person in an IRA/LLC or other closely held IRA owned company structure.
- IRA/LLCs Are an Excellent Tool for Many Self Directed IRA Investors When Established and Operated Properly. The Ellis case is an excellent example of someone taking a good idea too far. The IRA/LLC is an excellent tool that provides many benefits to self directed IRA owners and the same structure has been used by pension and profits sharing plans for owning real estate or other alternative assets for years. That being said, the tax rules applicable to self-directed IRAs can be tricky to understand and investors self directing these accounts for the first time can find themselves in the middle of a prohibited transaction if they don’t seek competent advice before they invest their account. Before investing tens or hundreds of thousands of dollars into an IRA/LLC or checkbook control IRA, make sure that the documents are established properly by a competent lawyer and that the IRA owner properly understands how to operate the LLC following set-up. Self-directed IRA owners should not rely on advice from their IRA custodian or administrator as they make you sign waivers saying you aren’t relying on their advice. Also, don’t rely on someone selling you an investment as the may have mixed motives in completing the transaction. Instead, seek the guidance of a competent attorney in this area and avoid structures where an IRA owner or other disqualified person would be compensated personally as part of the IRA/LLC structure.
Our office has been establishing LLCs for IRAs and other retirement accounts for over ten years and our basic IRA/LLC set-up fee is $800 plus state filing fees. This fee includes an attorney consult, an operating memo and guidelines, and all of the IRA specific LLC documents your self-directed IRA custodian will require. For additional information on IRA/LLCs, please refer to my book The Self Directed IRA Handbook or my website at www.sdirahandbook.com.