Many self-directed investors have the option of choosing between a self-directed IRA or a self-directed solo 401k. Both accounts can be self-directed so that you can invest into any investment allowed by law such as real estate, LLCs, precious metals, or private company stock. However, depending on your situation, you may choose one account type over the other. What are the differences? When should you choose one over the other?
Must be an individual with earned income or funds in a retirement account to rollover.
Must be self-employed with no other employees besides the business owner and family/partners.
$5,500 max annual contribution. Additional $1,000 if over 50.
$53,000 max annual contribution (it takes $140K of wage/se income to max out). Contributions are employee and employer.
Traditional & Roth
You can have a Roth IRA and/or a Traditional IRA. The amount you contribute to each is added together in determining total contributions.
A solo 401(k) can have a traditional account and a roth account within the same plan. You can convert traditional sums over to Roth as well.
Cost and Set-Up
You will work with a self-directed IRA custodian who will receive the IRA contributions in a SDIRA account. Most of the custodians we work with have an annual fee of $300-$350 a year for a self-directed IRA.
You must use an IRS preapproved document when establishing a solo 401k. This adds additional cost over an IRA. Our fee for a self-directed and self-trusteed solo 401(k) is $1,200.
An IRA must have a third party custodian involved on the account (e.g. bank. Credit union, trust company) who is the trustee of the IRA.
A 401(k) can be self trustee’d, meaning the business owner can be the trustee of the 401(k). This provides for greater control but also greater responsibility.
A self-directed IRA is invested through the self directed IRA custodian. A self-directed IRA can be subject to a tax called UDFI/UBIT on income from debt leveraged real estate.
A Solo 401(k) is invested by the trustee of the 401(k) which could be the business owner. A solo 401(k) is exempt from UDFI/UBIT on income from debt leveraged real estate.
Keep in mind that the solo 401(k) is only available to self-employed persons while the self-directed IRA is available to everyone who has earned income or who has funds in an existing retirement account that can be rolled over to an IRA.
Based on the differences outlined above, a solo 401(k) is generally a better option for someone who is self-employed and still trying to maximize contributions as the solo 401(k) has much higher contribution amounts. On the other hand, a self-directed IRA is a better option for someone who has already saved for retirement and who has enough funds in their retirement accounts that can be rolled over and invested via a self-directed IRA as the self-directed IRA is easier to and cheaper to establish.
Another major consideration in deciding between a solo 401(k) and self-directed IRA is whether there will be debt on real estate investments. If there is debt and if the account owner is self-employed, they are much better off choosing a solo 401(k) over an IRA as solo 401(k)s are exempt from UDFI tax on leveraged real estate.
Choosing between a self-directed IRA and a solo 401(k) is a critical decision when you start self-directing your retirement. Make sure you consider all of the differences before you establish your new account.
When IRA-owned property is held for rent, the management of the rental property must be structured such that rental income is received by the IRA and expenses are paid by the IRA. The IRA owner and other disqualified persons (e.g. IRA owner, spouse, etc.) cannot personally be the “middle man” by paying expenses personally or by collecting the rent in their personal account and then forwarding the funds to the IRA. There are essentially three different methods whereby the IRA may be structured to properly collect rent and pay expenses.
Three Methods to Manage the Property
1. Manage directly through the IRA. Money goes to the IRA custodian and expenses are paid by the custodian at the direction of the IRA owner.
2. Property Manager. The IRA hires a property manager who manages the property and receives the income and pays property expenses. Cash flow is returned to the IRA.
3. IRA/LLC. Under the IRA/LLC, the IRA owner is the manager of the IRA/LLC and receives income and pays expenses from an IRA/LLC checking account. The IRA/LLC structure is very common in IRA owned real estate investments.
First, the IRA may be receiving the income directly and paying the expenses. This method involves a lease between the IRA and the tenant directly. Under this method, the tenant pays rental income to the IRA (e.g. ABC Trust Company FBO Sally Jones IRA) and sends the actual payment to the IRA custodian and the custodian then deposits that income into the respective IRA. If expenses are due, the IRA owner will need to direct the custodian to pay them by completing a written form (e.g. payment authorization letter) and instructing the IRA custodian as to the expenses to be paid from the IRA. There is usually a fee each time an instruction letter is issued to a self directed IRA custodian. This method can be tedious and can be fee intensive and as a result is not the most common way of managing a rental property held by an IRA.
Second, the IRA hires a property manager who receives the rental income to the property and pays the expenses to the property. The property manager cannot be a disqualified person to the IRA owner and the property manager will typically take a percent of the rental income collected as payment for their services. Under this method the IRA enters into an agreement with the property manager and the property manager then enters into leases with respective tenants. The IRA receives rental income minus property expenses and fees charged by the property manager.
Third, many IRA owners with rental property decide to use a structure known as an IRA/LLC. Under the IRA/LLC structure, the IRA invests into a newly created LLC and the IRA’s investment is then the ownership of the LLC. The IRA will invest an amount designated by the IRA owner into the LLC, and then funds are typically deposited into an LLC checking account at a bank selected by the IRA owner.
IRA/LLC Structure for Real Estate
The IRA owner then, as manager of the LLC, signs the contract for the LLC to purchase the real estate. The property should close in the LLC name with funds from the LLC bank account and the LLC then in turn rents the property, receives the income and pays the expenses all from the LLC checking account. The LLC is entirely owned by the IRA and all funds in the LLC checking account must eventually be returned to the IRA when the IRA owner desires to take a distribution.
Regardless of the method used to own and manage the IRA owned rental property, the property cannot be leased to a disqualified person. So, for example, the IRA cannot purchase a property and allow the IRA owner’s son to lease the property as that lease would be a transaction with a disqualified person which results in a prohibited transaction.
In addition to prohibited transactions that are involved in leasing the property to family members, the IRA owner should closely analyze any leasing arrangement to a company where the IRA owner or other disqualified persons are owners of the IRA or company. For example, any lease to a company that is owned 50% or more by the IRA owner or other disqualified persons would constitute a prohibited transaction. IRC § 4975(e)(2)G).
In summary, there are many different ways to manage a rental property owned by your IRA. Make sure you are implementing one of these methods and that you are managing the IRA’s income, expenses, and properties properly.
This article is an excerpt from Mat Sorensen’s book, The Self Directed IRA Handbook.
While every self directed IRA investor enters into investments with high hopes and expectations of large gains, sometimes an IRA has to declare a loss on its investments and sometimes those losses are total losses. However, how does an IRA document a loss on a private partnership investment or an uncollectible promissory note investment? Two Tax Court opinions released today show us what not to do. Berks v. Commissioner, T.C. Summary Opinion 2014-2, Gist v. Commissioner, T.C. Summary Opinion 2014-1.
Berks v. Commissioner and Gist v. Commissioner
In Berks and Gist, self directed IRA owners invested their IRAs into various real estate partnerships and had equity interests and promissory note interests. Approximately five years after the investments were made, the IRA owners sought to declare the values on all of the investments worthless as the partnerships were no longer in business and as the IRA owner was told by their friend who they invested with that the investments were worthless. The IRA custodian for Berks and Gist sought additional documentation before agreeing to write down the value of the investments. Writing down the value of an investment and closing an account is a red flag for the custodian and the IRS as both want to ensure that IRA owners are not unfairly writing down investments in an effort to avoid taking distributions from the IRA which are taxable. As a result, the IRA custodian sought documentation as to the valuation change and upon receiving no documentation; the IRA custodian distributed the account to the IRA owners with the original investment amounts made from the account.
The self directed IRA accounts were closed by the custodian and the IRA owners were responsible for the taxes due from the 1099-R as well as accuracy related penalties. Eventually the un-claimed 1099-R went into collections with the IRS and the IRS sought payment of the additional taxes owed. The taxpayers disputed the amounts owed and took the case to Tax Court. The case eventually proceeded to trial and the taxpayers both lost in separate cases because they went into the case with no documentation or evidence of collection attempts. Instead, there was only testimony from the IRA owner and from their advisor that assist them in the investments. In Berks, the Court stated, “…[the IRA owner] simply took Mr. Blazer [their friend they invested with] at his word, and they apparently never saw the need to request any documentation that would substantiate that the partnerships had failed or that the promissory notes in the IRA accounts had become worthless.” Accordingly, the Court ruled against the IRA owners and held that the investment values as reported by the custodian (the initial investment amounts) were the best representation of fair market value. As a result, the IRA owners were subject to taxes owed on the higher valuation amounts.
I handled a very similar case to this one in Tax Court myself. In my case, the case resulted in the IRS reducing the valuation of the distributed IRA down to the proper discounted fair market valuation the IRA owner was seeking. As a contrast to what the taxpayers did to document their losses in Berks and Gist (e.g., no documents or records), I have outlined the steps that should be taken to properly document a loss with your IRA custodian and/or with the IRS/Tax Court.
Documenting a Loss/Failed Investment
Hire a Third Party to Prepare an Opinion as to Value. Your custodian, the IRS, and the Tax Court all want to see an independent person’s opinion as to the value of an investment.
Provide Accounting Records Showing Losses and No Profits/Income. In my Tax Court case on the same issue (obviously different facts and investments), we were able to re-construct the accounting records and losses from the company that demonstrated the significant valuation change. These accounting records we assembled were accompanied by financial records and third party documents which supported our numbers. The IRS agreed with our decreased valuation before trial, and dismissed their case against our client.
Document Fraud. If fraud was involved by persons receiving the income. Was a lawsuit filed? Were complaints made to regulatory bodies (e.g. SEC or state divisions of securities)? Provide those documents to your custodian.
If the Investment Losses are from a Un-Collectible Promissory Note.
Engage a lawyer or collection agency to make collection efforts. Keeps documents of their collection efforts.
If the borrower filed bankruptcy, provide the bankruptcy documentation.
If the loan is totally un-collectible, Issue a 1099-C (Forgiveness of Debt Income to the Defaulted Borrower, you’ll need the borrower’s SSN/EIN for this).
The best way to document an investment loss is to provide a third party valuation to your custodian. A custodian cannot accept an e-mail or letter from the IRA owner saying the investments didn’t pan out. If a third party opinion as to value cannot be produced, you’ll need to provide some of the records and documents I outlined above to demonstrate the loss. Remember, as Tom Cruise said in A Few Good Men, “It doesn’t matter what happened. It only matters what I can prove.” To prove an investment loss in your IRA, you’ll need documents and records showing what went wrong.
The prohibited transaction rules applicable to self directed IRAs prohibit not what your IRA can invest into but WHO your IRA may engage in a transaction with. For example, the prohibited transaction rules restrict my IRA from buying a rental property from my father. This is not because rental properties are prohibited to my IRA but because my father is prohibited by law from transaction with my IRA. My self directed IRA could buy a rental property from a third party seller whom I have no family or other business relationship with since there is nothing wrong in buying the rental property the question is just who am I buying it from. Congress decided to restrict investments with certain persons who could potentially collude with the IRA owner to unfairly avoid taxes. As a result, transactions with certain family members and business partners of an IRA owner are prohibited. The consequence for engaging in a prohibited transaction can be drastic (e.g. no longer have an IRA, penalties and taxes on distribution) so IRA owners must avoid them in all situations.
The prohibited transaction rules therefore provide the greatest restriction on using self directed IRA funds and must be understood by self directed IRA investors. These rules are found in IRC 4975 and state that a prohibited transaction occurs when an IRA engages in a transaction (e.g. buy, sell) with a disqualified person. The question immediately arises, who is a disqualified person to my IRA?
Categories of Persons Disqualified to Your SDIRA
There are essentially four categories of disqualified persons to your IRA and they are as follows.
IRA Owner. The IRA owner is disqualified to his/her own IRA as the fiduciary making decisions for the account. IRC 4975(e)(2)(A), Harris v. Commissioner, 76 T.C.M. 748 (U.S. Tax Ct. 1994).
Certain Family Members. Disqualified family members include the IRA owner’s spouse, children, spouses of children, grandchildren and their spouses, and the IRA owner’s parents and grandparents. Family member who are NOT disqualified persons are siblings (e.g. brothers and sisters), aunts and uncles, cousins, nieces and nephews, and parent in-laws (e.g. spouses parents). IRC 4975 (e)(2)(F), IRC 4975 (e)(6).
Company Owned 50% or More by IRA Owner or Certain Family Members. Any Company that is owned 50% or more by the IRA Owner or Certain Family Members outlined above are disqualified to the IRA. For example, an LLC owned 30% by the IRA owner, 30% by the IRA owner’s spouse, and 40% by an un-related partner is a disqualified company to the IRA (owned 50% or more by disqualified persons) and any transaction between the IRA and the company would be a prohibited transaction. IRC 4975 (e)(2)(G).
Key Persons in Company Owned 50% or More by IRA Owner or Certain Family Members. Any person who is a 10% or more owner of a company owned 50% or more by disqualified persons (e.g. number 3 above) or any person who is an officer, director, or manager of a disqualified company (owned 50% or more by disqualified persons) is also disqualified. For example, if my wife and I own 60% of a company and if Julie is an officer of that company then Julies is a disqualified person to my IRA. Additionally, if Julie was a 15% or more owner of the company she would also be prohibited to my IRA.
When you are dealing with unrelated persons (not related as family or as business partners) the prohibited transaction rules do not need to be analyzed but once family members or business partners are involved in any part of the transaction, the IRA owner must ensure that the prohibited transaction rules are not being violated.
One of the most common tax minimization strategies used by operational small business owners is known as the salary/dividend or salary/net income split. This strategy can only be properly executed in an s-corporation where a business owner can pay themselves a portion of income in salary and a portion of income in dividend or net profit. The ultimate goal is to pay as little salary as possible (and therefore as much net income as possible) so as to minimize the amount of self employment taxes that are due.
This strategy cannot be utilized in a c-corporation nor can it be utilized in an LLC or sole proprietorship. It is only possible in an s-corporation as similar income running through a sole proprietorship or an LLC is entirely subject to self employment tax as income cannot be split between salary and net income in an LLC or sole proprietorship. Also, keep in mind that such a strategy is not utilized in passive business structures such as real estate businesses as rental income, interest income, and other passive income is exempt from self employment tax and therefore it is not necessary to implement the income splitting technique of the s-corporation.
In short, the strategy is implemented by “splitting” the income that is payable to the s-corporation owner into two categories: salary and net income (aka dividend). The reason this splitting of income is advantageous is that net income received by the s-corporation owner is not subject to the 15.3% self employment tax that is otherwise due and payable on salary. For every $10,000 of income an s-corporation owner can classify as net income as opposed to salary the business owner will save $1,530. Keep in mind that after about $100,000 of salary the savings of pushing additional income to net income is reduced as the self employment tax rate drops to 2.9%. It is still certainly worth implementing at higher income but the savings are then made at the 2.9% rate.
Watson v. Commissioner
When this strategy was first utilized many years ago, some taxpayers decided to just pay all of their income out as net income and elected to take no salary or wages and therefore pay no self employment tax. This was quickly challenged by the IRS and Revenue Ruling 59-221 was issued which stated that a business owner who renders services to their business must take “reasonable compensation” for the services rendered. Over the years, the Courts have ruled on many cases of what is reasonable compensation but in 2012 the Courts made a significant ruling where they adjusted a business owners allocation between salary and net income in a case known as Watson v. Commissioner, 668 F.3d 1008 (8th Cir, 2012).
In Watson, the owner/employee Watson was a CPA and took $24,000 of salary a year and about $190,000 of annual net income. The IRS challenged the allocation of $24,000 of salary as being unreasonably too low. Watson lost in the District Court and appealed to the 8th Circuit Court of Appeals who re-characterized Watson’s income to $93,000 of salary and about $120,000 of net income. The case is an important one for properly understanding the factors that should be considered in all businesses when determining how much income a business owner can claim as net income instead of salary. Here are some of those factors.
Factors Determining Net Income
Professional services businesses should take a larger portion of salary to net income than those in non-professional services: If the business is a professional services business (e.g. physician, dentist, lawyer, consultant, real estate broker, contractor, etc.) the IRS will more carefully scrutinize the services provided by business owners because the business provides a personal service.
Full-time working business owners should take a larger portion of salary to net income than part-time working business owners: If the business owner is involved full time in the business, more salary will be required. If the business owner’s involvement is part time or if they are involved in other businesses, a much lower salary can be justified.
Don’t take a salary that is below the salary paid to lower level employees in the business: In the Watson case the Court determined that a salary for Watson of $24,000 was not reasonable as new accountants salaries at his office were more than this.
Take a salary that is around the industry average for a person of similar experience in your industry: In the Watson case the Court scrutinized the experience and training of Watson and determined that a salary of $24,000 was not reasonable as accountants with similar experience and training in the industry were paid at least $70,000.
In summary, the salary/net income split is a legitimate tax planning technique for business owners but it is not one in which a business owner making over $200,000 a year can justify taking about 10% of income as salary (as was the case in Watson). The Court disallowed the 10% salary level but did allow him to take about 43% of his income as salary (and almost 60% as net income). This still resulted in some excellent tax savings.
As a general rule, we recommend that business owners take at least 1/3 of their income as salary and pay self employment tax on those amounts. Many other factors should be considered, such as those outlined above, and every business has a unique situation. The good news is that taking a large portion of income from a business as net income as opposed to salary is alive and valid and there are plenty of taxes to be saved each year by using this strategy. A business owner just can’t get too aggressive and take salary levels that are grossly below what people with similar experience in the industry are paid.
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"Mat's books is a great reference guide for self-directed IRA investing – Best I’ve seen in 30 years of being in the business."
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"The Self Directed IRA Handbook by attorney Mat Sorensen is the most comprehensive book ever written about one of the best investment and retirement savings tools ever created: the Self-Directed IRA."
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Mat’s book is the most practical and comprehensive self directed IRA guide in our industry. Reading this handbook should be the first step for any alternative asset investor, investment sponsor, or trusted advisor that seeks to become informed about how to maximize the value of IRAs.