Asset Protection for Your Self Directed IRA

Asset-Protection-for-Self-Directed-IRA-2Many self directed IRA investors misunderstand or are unaware of the protections afforded to their IRA (Roth or traditional) as it relates to creditors and judgments. This article seeks to address the key areas of the law that every self directed IRA investor should know.

First, your IRA is not always exempt from creditors up to $1Million. Many IRA owners believe that federal law protects their IRA from creditors up to $1M. While Section 522(n) of the federal bankruptcy code protects an IRA owner’s IRA from creditors up to $1M, this protection is only provided to IRAs when an account owner is in bankruptcy. If the IRA owner is not in bankruptcy then the creditor protections are determined by state law and the laws of each state vary. For example, if you reside are a resident of Arizona then your IRA is still protected from creditors up to $1M even without filing bankruptcy. The approach Arizona takes is the most common, however, many states protections for IRAs outside of bankruptcy are extremely weak. For example, if you are a resident of California then your IRA is only protected in an amount necessary to provide for the debtor and their dependents. That’s a pretty subjective test in California and one that makes IRAs vulnerable to creditors. If your California IRA is from a rollover of a company plan, you may have other protections. California residents should check out my prior article here.

Second, while your IRA can be exempt from your personal creditors, as explained above, it is not exempt from liabilities that occur in the IRAs investments. For example, if your IRA owns a rental property and something happens on that rental property then the IRA is responsible for that liability (and possibly the IRA owner). As a result, many self directed IRA owner’s who won real estate or other liability producing assets utilize IRA/LLC’s which protect the IRA and the IRA owner from the liability of the property.

Third, if the IRA engages in a prohibited transaction under IRC Section 4975 then the IRA is no longer an IRA and is no longer exempt from creditors. Despite the bankruptcy and state law protections outlined in my first point above, if a creditor successfully proves that a prohibited transaction occurred within an IRA then account no longer is considered a valid IRA and therefore the protections from creditors vanish. There seems to have been an increase in creditors who are pursuing IRAs, particularly self directed IRAs, and I have been representing more and more self directed IRA owners in bankruptcy and other creditor collection actions in defending against prohibited transaction inquiries.

Fourth, many proponents of solo 401(k)s have argued that investors are better off using a self-directed solo 401(k) plan instead of a self-directed IRA because solo 401(k)s receive ERISA creditor protection (federal law) that is better than most state law creditor protections afforded to IRAs. While it is true that ERISA plan protection is better then state law IRA creditor protection and courts have already held that while a Solo K plan is a qualified plan it is not subject to ERISA. Yates v. Hendon, 541 U.S. at 20-21. Since a Solo K plan is not subject to ERISA, its account holders cannot seek ERISA creditor protection and would instead be treated the same as IRA owners. In sum, there is no difference in creditor protection between a solo 401(k) account and a self-directed IRA. We love Solo 401(k) plans, we just aren’t setting them up instead of IRAs because of asset protection purposes.

In summary, the best way to protect your self directed IRA from creditors is to understand the rules that govern your self directed IRA and to seek counsel and guidance to ensure that your retirement is available for you and not just your creditors.

WHEN TO USE A LIMITED PARTNERSHIP?

Limited Partnerships (LP) have taken a back seat over the past ten years to the more popular Limited Liability Company (LLC).  That being said, LPs are still often used to hold assets, raise funds, or to achieve achieve specific tax benefits. Here are 5 things you should know about Limited Partnerships.

  1. General Partners and Limited Partners. Every Limited Partnership consists of at least one general partner and one limited partner. The general partner has decision-making authority and is also responsible for the liabilities of the limited partnership. The limited partners participate in the sharing of profits and losses but do not have a voting interest. Because the general partner is subject to liability of the LP, the general partner is usually a company that does not hold significant assets.  The limited partner on the hand is not responsible for the liabilities of the LP. For example, the general partner may be an operating s-corp or a shell company LLC while the limited partner may be an individual or a trust.
  2. Limited Partnerships and Asset Protection. Limited partnerships provide asset protection for the limited partners of the LP against the activities of the LP. For example, if there is a judgment against the LP, that creditor cannot go after the limited partners.  In addition, if an owner of an LP has a judgment against themselves personally, that creditor cannot go after the assets in the limited partnership. Instead, the creditor is given a charging order that only entitles them to the assets or income that the LP decides to distribute to the owner of the limited partnership. As a result, the assets of the limited partnership are protected from the personal activities/liabilities of the owner. Because of this, many individuals will use limited partnerships to hold their valuable assets. While some states offer this same liability protection to LLCs (protect the entity from the owners actions), most states do not.
  3. Hold Rentals in an LLC. Because LP’s are a great place to hold assets, it is important to know what assets should be held in an LP. The following assets are commonly held by LPs: brokerage/investment accounts; second homes; valuable personal property, and raw land. An LP, however, generally should not hold rental real estate, because the tax rules applicable to LP’s limit an owner’s ability to fully take advantage of certain tax losses. As a result, please consult with your CPA prior to placing rental real estate into an LP.
  4. Canadians Love LPs for Real Estate. While LLCs are great for U.S. Citizens, they cause corporate taxes in Canada for Canadian residents. As a result, Canadians who own rental real estate in the U.S. should use an LP to hold their properties as opposed to an LLC. The LP profits flow through to Canada and are only subject to personal level taxes and are not subject to Canadian corporate taxes. LLC income, on the other hand, flows to Canada and is subject to both corporate and personal taxes.
  5. Limited Partnerships Are Great Entities for Raising Money.  Limited partnerships are often used to raise funds because under the LP structure, the general partner (the one usually raising the funds) has authority to run the LP while the investors or limited partners do not have a voting right or interest. Because the LP structure places the control in the hands of the person raising the funds, the LP is presumed to be a security for securities law purposes and as a result a securities law attorney should be consulted as to the proper filings and disclosures necessary to raise funds and sell limited partnership interests to investors.

While an LLC is the most common default entity amongst business owners and investors, the LP can be a more beneficial entity or choice in certain situations and circumstances.  In a brief consult with you attorney, you will be able to determine what entity is right for you while taking into account the tax and asset protection issues that will apply to your specific situation.