Many investors are aware of the opportunities that are available with self directed IRAs. This article highlights the strategies being used by self directed IRA investors and addresses some important issues and some recent cases regarding the IRA/LLC strategy.
As most of our readers are aware, a self directed IRA can be used to execute “alternative” investments such as real estate, precious metals, private lending, or non-publicly traded stock, and the investment returns receive the same tax favored IRA investment treatment we are all familiar with when investing our retirement accounts into stocks or mutual funds (e.g. tax deferred growth with traditional IRAs and tax free growth with Roth IRAs). One of the commonly used strategies by self directed IRA investors is commonly referred to as an IRA/LLC (aka checkbook control LLC). The idea of the IRA/LLC is that the self directed IRA invests its funds into a newly created LLC and in return receives 100% (unless there are partners or more than one IRA) of the membership of the newly created IRA/LLC. The IRA/LLC typically establishes an LLC bank account to hold the IRAs cash investment and this account is managed by the IRA owner or an advisor/professional third party. The IRA/LLC then executes the transactions on behalf of the IRA and holds legal title or ownership to the IRA/LLC assets on behalf of its IRA owner. In many instances, the IRA owner serves as the Manager of the IRA/LLC and performs administrative and investment oversight functions on behalf of the LLC such as signing contracts on investments, managing the IRA/LLC checking account, and receiving income and paying expenses on behalf of the IRA/LLC and its investments. There are lots of rules, such as the prohibited transaction rules, that an IRA owner needs to be aware of before investing their retirement account with an IRA/LLC and we routinely advise clients on these laws and issues. For example, the IRA and the IRA/LLC cannot make a transaction with someone who is prohibited to the IRA such as the IRA owner itself or his spouse, children or parents. See IRC § 4975. This would prohibit the IRA from purchasing a rental property from the IRA owner’s father.
The original case where the IRA/LLC concept was permitted by the U.S. Tax Court is known as Swanson v. Commissioner, 106 T.C. 76 (1996). In this case an IRA owner established a corporation that was 100% owned by his IRA and which the IRA owner subsequently managed. The IRS challenged the investment into the corporation as a prohibited transaction and the Tax Court ruled that the investment was not prohibited. For many years, this was one of the few cases addressing the IRA/LLC investment structure whereby an IRA is the owner of 100% of a newly created company. However, in 2011 and 2012 there were two additional cases whereby the IRA/LLC structure has been analyzed by the Tax Court and the structure was again recognized as a valid investment option for an IRA that does not constitute a prohibited transaction.
The 2011 case was Hellwig v. Commisioner, 2011-58 (U.S. Tax Court 2011). This case involved the creation of four 100% owned corporations by Roth IRAs. The IRS challenged the 100% corporations which were managed by the respective Roth IRA owners. In the Court’s ruling the Court referenced the prior ruling in Swanson and stated that a retirement plan may purchase 100% of a newly formed company because the company is not a disqualified person upon formation. Also, the Court further held that actions of the Roth IRA owner who was managing the Roth IRA owned corporation was not prohibited.
The 2012 case was Repetto, et al v. Commissioner, T.C. , Memo 2012-168 (U.S. Tax Court 2012). This case involved a husband and wife who owned a construction company. The husband and wife both created corporations owned 98% by their Roth IRAs and 2% by a partner. The Roth IRA owned corporations then performed services for the construction company owned by the Repettos. The Court ruled against the taxpayer in this case because the Roth IRA owned corporations were performing services to the Repetto’s own company when there was no legitimate business purpose for such services and the resulting transfer and payment for services. While the taxpayer lost the case, the Court’s ruling was very helpful in analyzing the IRA/LLC structure as the Court stated in its ruling, “ The [IRS] agrees that generally an entity in which substantially all of the interest is owned or acquired by a Roth IRA may be recognized as a legitimate business entity for Federal tax purposes. However, …the resulting payments [from the Repetto construction company to the Roth IRA owned corporations] were nothing more than a mechanism for transferring value to the Roth IRAs [since there was no legitimate business purpose for the services and payments].”
In summary, the IRA/LLC strategy has been recognized as a legitimate investment structure for an IRA in three cases before the U.S. Tax Court. The strategy does not, however, allow the IRA investor to avoid the prohibited transaction rules or allow the IRA owner to unfairly shift income or assets from themselves personally to their IRA. While we’d never recommend a client use an IRA/LLC for these purposes it is important to understand that the IRA/LLC strategy is a valid and well recognized investment structure for your IRA and that your IRA is still subject to the prohibited transaction and income shifting rules.
For more information and a consultation regarding your particular situation, please call the KKOS law office at 435-586-9366.