by Mat Sorensen | Nov 5, 2013 | Prohibited Transactions
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.
by Mat Sorensen | Dec 18, 2012 | News
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.
by Mat Sorensen | Aug 21, 2012 | IRA/LLCs
There are numerous laws, cases, and regulations to consider in analyzing whether your IRA can own an LLC (commonly referred to as an “IRA/LLC” or a “checkbook control IRA”). Despite the complexity of the law, your IRA can own 100% of the ownership interest of an LLC and you as the IRA owner may serve as the Manager of this LLC. This proposition was first supported by the case of Swanson v. Commissioner, 106 T.C. 76 in 1996 where the U.S. Tax Court held that it is not a prohibited transaction under IRC Section 4975 for a retirement plan to invest and own 100% of newly created corporation nor was it prohibited for the IRA owner to serve as an officer of that company where no salary or compensation was paid to the IRA owner. In summary, the U.S. Tax Court has supported the structure whereby a new created company is wholly owned by a retirement plan and managed by the retirement plan owner and that is the same rationale used in many IRA/LLC’s.
So what does the IRS think about IRA/LLC’s? The IRS issued IRS Field Service Advisory #200128011 in April of 2001 which indicated that the IRS will not contend that there is a prohibited transaction when there is a newly formed and capitalized company that is 100% owned by a retirement plan. Keep in mind that both of these cases deal with newly formed companies and do not apply to LLC’s or corporations (or other companies) which a retirement plan owner may have already established. Also, it is possible to partner your retirement plan with others into one IRA/LLC but you must carefully consult with professional who are experienced in this area as there are numerous prohibited transaction issues that may arise when you partner your IRA with others.
Serving as the Manager of the IRA/LLC allows the IRA account owner to enter into contracts on behalf of the IRA/LLC and to sign checks on behalf of the IRA/LLC. There are restrictions on the amount of work you may do (for example, if the IRA/LLC owned a property you may not work on the property) but you may oversee the administrative matters like the signing of contracts and checks. The prohibited transaction rules still apply to IRA/LLC’s in the same way they apply to your self-directed IRA so you still must pay careful attention to these rules and most consult with professionals who are competent in the laws that apply to retirement plans. Moreover, an IRA/LLC is different from your typical LLC and the IRA/LLC documents should include numerous provisions which protect your IRA from a prohibited transaction. This doesn’t mean that an IRA/LLC should costs thousands of dollars. In fact, our law firm sets IRA/LLC’s up for $750 plus the state filing fee if the IRA/LLC is owned by one IRA or $1,500 if owned by multiple IRA’s or partners. In the end, an IRA/LLC can be a powerful tool to gain more control of your IRA’s investments but you must do so with adherence to the rules and laws that apply to your IRA. Written by Mathew Sorensen, Attorney at Law and Partner at Kyler Kohler Ostermiller & Sorensen, LLP, a law firm assisting self directed retirement plan owners across the U.S. for over ten years from offices in Arizona, Utah and California. To learn more about our law firm, please visit our website at ww.kkoslawyers.com or call us at 435-586-9366.
