New Case Answers Important Questions About IRA/LLCs

Image of the US Tax Court logo with the text "New Case Answers Important Questions About IRA/LLCs"Can my IRA own substantially all of the ownership of an LLC? Can my IRA/LLC pay a salary to me for serving as the manager of the IRA/LLC? Last week the U.S. Tax Court issued an opinion in the case of Ellis v. Commissioner, T.C. Memo 2013-245 and answered both of these questions.

In Ellis, the Tax Court resolved two questions posed by the IRS. First, did Mr. Ellis engage in a prohibited transaction when his IRA acquired 98% of the membership interest in CST, LLC? And second, did Mr. Ellis engage in a prohibited transaction when CST, LLC (owned 98% by his IRA) paid him compensation for serving as the manager?

Analyzing Ellis v. Commissioner

As to the first question, the Tax Court held that Mr. Ellis’ IRA did NOT engage in a prohibited transaction when it acquired 98% of the ownership of a newly established LLC. The other 2% was owned by an un-related person who was not part of the case and whose ownership did not have an impact on the decision. The IRS contended that a prohibited transaction occurred when the IRA bought ownership of CST, LLC. The Court disagreed, however, and held that the IRA’s purchase of the initial membership interest of the LLC was NOT a prohibited transaction. The Court stated that the IRA’s purchase of membership interest in a new LLC is analogous to prior holdings of the Court whereby the Court held that an IRA does not engage in a prohibited transaction when it acquires the initial shares of a new corporation. Similarly, the court held that a new LLC is not a disqualified person to an IRA under the prohibited transaction rules and as a result an IRA may invest and own the ownership of the LLC. IRC § 4975(e)(2)(G), Swanson V. Commissioner, 106 T.C. 76, 88 (1996). Consequently, the Court’s ruling means that it is NOT a prohibited transaction for an IRA to acquire substantially all or all of the ownership of a new LLC.

As to the second question, the Tax Court held that it was a prohibited transaction for the LLC owned substantially by Mr. Ellis’ IRA to pay compensation to Mr. Ellis personally. The court reasoned that, “In causing CST [the IRA/LLC] to pay him [IRA owner] compensation, Mr. Ellis engaged in the transfer of plan income or assets for his own benefit in violation of section 4975 (c)(1)(d).” This type of prohibited transaction is often times referred to as a self dealing prohibited transaction and occurs when the IRA owner personally benefits from his IRA’s investments. The Court looked to the operating agreement of the LLC which authorized payment to Mr. Ellis for serving as the general manager and also the actual records of the LLC which showed the payments to Mr. Ellis. When using an IRA/LLC, one of the many important clauses in the operating agreement is one which restricts compensation to the IRA owner or any other disqualified person (e.g. IRA owner’s spouse or kids). Also, the actual payment and transaction records of the IRA/LLC will be analyzed so it is important that both the LLC documents and the actual payment records do not allow for or result in payment from the IRA/LLC to disqualified person (e.g. IRA owner).

It is also important to note that the Tax Court rejected Mr. Ellis’ argument that the payments were exempt from the prohibited transaction rules under section 4975 (d)(10). Section (d)(10) provides an exemption to the prohibited transaction rules for payments from an IRA to a disqualified person [e.g. IRA owner] for services rendered to manage the IRA. The Tax Court rejected this argument stating that the payments from the IRA/LLC were not for management of the IRA but for management of the IRA/LLC and its business activities. In this case, the IRA owner was actively involved as the general manager of the IRA/LLC which LLC bought and sold cars. As a result, the Court held that the payments were not exempt and constituted a prohibited transaction.

I was happy to read this case and find the Court’s conclusions because it matches the same opinion and advice we have been giving clients regarding IRA/LLCs for nearly ten years: that a newly established LLC owned by an IRA does not constitute a prohibited transaction but the IRA/LLC cannot pay the IRA owner (or any other disqualified person) compensation for managing the IRA/LLC.

Asset Protection for Self-Directed IRAs

Photo of large bank vault opened with the text "Asset Protection for Self-Directed IRAs"When analyzing asset protection for self directed IRAs we must consider two types of potential threats. First, we must analyze how a creditor can collect against an IRA when the creditor has a judgment or claim against the IRA owner personally. Secondly, and most importantly for self directed IRA owners, we must analyze how a creditor can collect against an IRA or its owner when the IRAs investment incurs a claim or judgment.

There has been much written on the protections to retirement plans that prevents a creditor of the IRA owner from collecting against the IRA to satisfy their judgment.  Various federal and state laws provide this protection which prohibits a creditor of an IRA owner from collecting or seizing the assets of an IRA or other retirement plan.  For example, if an individual personally defaults on a loan in his or her personal name and then gets a judgment against them the creditor may collect against the individual’s personal bank accounts, non retirement plan investment accounts, wages, and other non-exempt assets but is prohibited from collecting against the IRA or other retirement plans of the individual. Even in the case of bankruptcy a retirement plan is considered an exempt asset from the reaches of the creditors being wiped out. U.S. Bankruptcy Code, 11 U.S.C. §522. Because of these asset protection benefits retirement plans are excellent places to hold assets outside the reach or creditors.

The second asset protection issue and the focus of this article is to consider how an is IRA protected from claims arising from the IRA’s investments and activities? This issue is one that is particularly important to self directed IRA accounts since some self directed IRA investments are made into assets that can create liability to the IRA and the protections preventing a creditor of the IRA owner against the IRA assets does not apply to liabilities arising from the IRAs investments. In other words, if the IRA has a liability the IRA is subject to the claims of creditors. For example, if a self directed IRA owns a rental property and the tenant in that property slips and falls the tenant can sue the self directed IRA who owned and leased the property to the tenant. Consequently, the IRAs assets are subject to the collection of the creditor including the property the IRA owned and leased to the tenant as well as the other assets of the IRA. But what about the IRA owner and their personal assets, are their personal assets also at risk?

Let’s analyze this issue further and look at whether a creditor/plaintiff against the IRA can also sue the IRA owner personally if the IRA’s assets are not sufficient to satisfy the judgment against the IRA. IRC § 408 states that an IRA is a trust created when an individual establishes an IRA by signing IRS form 5305 (this form is completed, with some variations, with every IRA) with a bank or qualified custodian. Courts have analyzed what an IRA is under law and have stated that they are a trust or special deposit of the individual for the benefit of the IRA owner. First Nat’l Bank v. Estate of Thomas Philip, 436 N.E. 2d 15 (1992). In other words, the IRA is not a separate entity or trust which would be exempt from creditor protection of its underlying owner. Since the IRA is a trust that is revocable and terminated at the discretion of the IRA owner, each investment in fact is truly controlled by the IRA owner as her or she could terminate the IRA at any time and take ownership in their personal name. As a result, the IRA is akin to a revocable living trust used for estate planning which trust is commonly understood by lawyers and courts to provide no asset protection and prevention of creditors from pursuing the trust creator and owner from liabilities and judgments that arise in the trust. Following this same rationale, a self directed IRA would likely be subjected to a similar downfall in the event of a large liability which is not satisfied by the assets of the IRA. As a consequence, the personal assets of the IRA owner may be at risk.

As a result of the asset protection liabilities for self directed IRAs, we recommend that self directed IRA owners consider an IRA/LLC for the asset protection reasons that many individuals use LLC’s in their personal investment and business activities. Simply put, an LLC prevents the creditor of the LLC from being able pursue the owner of the LLC (in this case the IRA). An IRA/LLC is an LLC owned typically 100% by the IRA and the LLC would operate and take ownership of the investments and the liabilities similar to an LLC used by an individual. For example, instead of the IRA taking ownership of a rental property directly and leasing it to a tenant the IRA/LLC would instead take title to the property and would lease the property to the tenant. When the IRA/LLC owns and leases the property any claims or liabilities that arise are contained in the LLC and as a result of the LLC laws a creditor is prevented from going after the LLC owner (in this case the IRA, or the IRA owner).

There are certain types of self directed IRA investments that benefit greatly from the asset protection offered by an IRA/LLC. Rental real estate owned by an IRA achieves significant asset protection benefits from an IRA/LLC since rental real estate can create liabilities to their owner. Other self directed IRA investments such as promissory note loans, precious metals, or land investments do not have the same asset protection issues and potential to create liability for the IRA and as a result an IRA/LLC isn’t as beneficial from an asset protection perspective for these types of investments.