A Checkbook IRA plan is generally also referred to as a Self Directed IRA LLC. In each case, a limited liability company (“LLC”) or trust is established that is owned by the IRA account and managed by the IRA account holder. The IRA Holder’s IRA funds are then transferred by the Custodian to the LLC’s bank account providing the IRA holder with “checkbook control” over his or her IRA funds.
With a “Checkbook Control” Self Directed IRA LLC you will never have to seek the consent of a custodian to make an investment or be subject to excessive custodian account fees based on account value and per transaction.
Who is a “Disqualified Person”?
The IRS has prohibited certain transactions between the IRA and a “disqualified person”. The rationale behind these rules was a congressional assumption that certain transactions between certain parties are inherently suspicious and should be disallowed.
The definition of a Disqualified Person (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the IRA holder, any ancestors or lineal descendants of the IRA holder, and entities in which the IRA holder holds a controlling equity or management interest. In essence, under Code Section 4975, a “Disqualified Person” means:
- A fiduciary (e.g., the IRA holder, participant, or person having authority over making IRA investments),
- A person providing services to the IRA (e.g., the trustee or custodian),
- An employer, any of whose employees are covered by the plan (this generally is not applicable to IRAs but dos include the owner of a business that establishes a qualified retirement plan),
- An employee organization any of whose members are covered by the Plan,
- A 50 percent owner of C or D above,
- A family member of A, B, C, or D above (family members include the fiduciary’s spouse, parents, grandparents, children, grandchildren, spouses of the fiduciary’s children and grandchildren (but not parents-in-law),
- An entity (corporation, partnership, trust or estate) owned or controlled more than 50 percent by A, B, C, D, or E. W hether an entity is a disqualified person is determined by considering the indirect stockholdings/interest which would be taken into account under Code Sec. 267(c), except that members of a fiduciary's family are the family members under Code Sec. 4975(e)(6) (lineal descendants) for purposes of determining disqualified persons.
- A 10 percent owner, officer, director, or highly compensated employee of C, D, E, or G,
- A 10 percent or more partner or joint venturer of a person described in C, D, E, or
Note: brothers, sisters, aunts, uncles, cousins, step-brothers, step-sisters, and friends are NOT treated as “Disqualified Persons”.
The Employee Retirement Income Security Act of 1974 (ERISA) ( Pub.L. 93-406, 88 Stat. 829, enacted September 2, 1974) is a federal statute that establishes minimum standards for pension plans in private industry and provides for extensive rules on the federal income tax effects of transactions associated with employee benefit plans. ERISA was enacted to protect the interests of employee benefit plan participants and their beneficiaries by requiring the disclosure to them of financial and other information concerning the plan.
Individual Retirement Arrangement (IRA)
Individual retirement accounts were introduced in 1974 with the enactment of the Employee Retirement Income Security Act (ERISA). Usually referred to as an Individual Retirement Account, it is a tax-deferred retirement account for an individual that permits individuals to set aside money each year, with earnings tax-deferred until withdrawals begin at age 59 1/2 or later (or earlier, with a 10% penalty). The exact amount depends on the year and your age. Funds can be invested into a broad range of assets, including stock, bonds, mutual funds, real estate, notes & mortgages, tax liens, private companies, business loans, foreign investments, equipment leases and more.
IRS Field Service Memorandum 200128011
IRS Field Service Advice (FSA) Memorandum 200128011 was the first IRS drafted opinion that confirmed the ruling of Swanson that held that the funding of a new entity by an IRA for self directing assets was not a prohibited transaction pursuant to Code Section 4975. An FSA is issued by the IRS to IRS field agents to guide them in conduct of tax audits.
USCorp is a domestic sub-chapter S Corporation. Father owns a majority of the shares of USCorp. Father's three minor children own the remaining shares of USCorp equally. USCorp is in the business of selling Product A and some of its sales are made for export.
Father and each child own separate IRAs. Each of the four IRAs acquired a 25% interest in FSC A, a foreign sales corporation (“FSC”). USCorp entered into service and commission agreements with FSC A. FSC A agreed to act as commission agent in connection with export sales made by USCorp, in exchange for commissions based upon the administrative pricing rules applicable to FSCs. USCorp also agreed to perform certain services on behalf of FSC A, such as soliciting and negotiating contracts, for which FSC A would reimburse USCorp its actual costs.
During Taxable Year 1, FSC A made a cash distribution to its IRA shareholders, out of earnings and profits derived from foreign trade income relating to USCorp exports. The IRAs owning FSC A each received an equal amount of funds.
IRS advised that, based on Swanson, neither issuance of stock in FSC to IRAs nor payment of dividends by FSC to IRAs constituted direct prohibited transaction. o IRS warned that, based on facts, transaction could be indirect.
In light of Swanson, the IRS concluded that a prohibited transaction did not occur under Code Section 4975(c)(1)(A) in the original issuance of the stock of FSC A to the IRAs. Similarly, the IRS held that payment of dividends by FSC A to the IRAs in this case is not a prohibited transaction under Code Section 4975(c)(1)(D). The IRS further concluded that in light of Swanson, the ownership of FSC A stock by the IRAs, together with the payment of dividends by FSC A to the IRAs, should not constitute a prohibited transaction under Code Section 4975(c)(1)(E).
Accordingly, the IRS believed that the case should not be pursued as one involving prohibited transactions.
The IRS noted however that since the owners of the IRAs are disqualified persons as fiduciaries with respect their IRAs and USCorp is a disqualified person with respect to the IRA owned by Individual A, if a transaction is made for the purpose of benefiting USCorp, the IRA owners would violate Code Section 4795(c)(1)(D). Also, if the facts were such that the IRA owners' interests in the transaction because of their ownership of USCorp affected their best judgments as fiduciaries of the IRAs, the transaction would violate Code Section 4975(c)(1)(E).
The significance of FSA 200128011 is that the IRS established that the payment of dividends by an IRA owned entity to an IRA that the creation and ownership of a new entity by an IRA for investment purposes would not be considered a prohibited transaction under Code Section 4975. Furthermore, the IRS established that the payments of dividends by an IRA owned entity to an IRA would not constitute a prohibited transaction.
Limited Liability Company
LLCs are a creation of state law. An LLC is somewhat of a hybrid entity in that it can be structured to resemble a corporation for owner liability purposes and a partnership for federal income tax purposes. An LLC offers the limited liability the benefit of a corporation and the single level of taxation of a partnership.
Manager Managed LLC
In a Self Directed IRA, the IRA holder is appointed as the manager of the Self Directed IRA LLC and has the authority to make all investment decisions on behalf of the LLC.
Non-Recourse IRA Mortgage
The only type of loan allowed for a Self Directed IRA. A nonrecourse loan is a secured loan (debt) that is secured by a pledge of collateral, typically real property, but for which the borrower is not personally liable.
A Self-Directed custodian, also called a passive custodian, allows IRA holders to engage in non-traditional investments (i.e. real estate), but generally does not offer investment advice. The custodian in the “Checkbook Control” Self Directed IRA structure is referred to as a “passive” custodian largely because the custodian is not required to approve any IRA related investment and simply serves the passive role of satisfying IRS regulations. By using a Self Directed IRA with “checkbook control” you can take advantage of all the benefits of self-directing your retirement assets without incurring excessive custodian fees and custodian created delays.
Plan Asset Rules
The Department of Labor’s Plan Asset Rules essentially define when the assets of an entity are considered ‘Plan" assets. Under the rules, IRAs are frequently viewed as pension plans subjecting them to the Plan Asset Rules. Under the Plan Asset Rules, if the aggregate plan (IRA/401(k)) ownership of an entity is 25% or more of all the assets of the entity, then the equity interests and assets of the “investment entity” are viewed as assets of the investing IRA/401(k) for purposes of the prohibited transactions rules, unless an exception applies. Also, if a plan (i.e. IRA or 401(k)) or group of related plans owns 100% of an “operating company”, the operating company exception will not apply and the company's assets will still be treated as plan assets.
In summary, the Plan Asset Rules can be triggered if
- 100% of an “operating company” is owned by one or more IRAs/401(k) and disqualified persons, in which case all the assets of the “operating company” are deemed Plan assets (assets of the IRA/401(k)), or
- If 25% or more of an “investment company” is owned by IRAs/401(k) and disqualified persons, in which case all the assets of the “investment company” are deemed Plan assets (assets of the IRA/401(k)). In determining whether the 25% threshold is met, all IRAs/401(k) owners are considered, even if they are owned by unrelated individuals.
Exceptions to the DOL Plan Asset Regulations
The Plan Asset look-through rules do not apply if the entity is an operating company or the partnership interests or membership interests are publicly offered or registered under the Investment Company Act of 1940 (e.g., REITs). They also do not apply if the entity is an “operating company,” which refers to a partnership or LLC that is primarily engaged in the real estate development , venture capital or companies making or providing goods and services, such as a gas station, unless the “operating company” is owned 100% by a Plan and/or disqualified persons. . In other words, if an IRA or 401(k) Plan owns less than 100% of an LLC that is engaged in an active trade or business, such as a restaurant or manufacturing plant, the Plan Asset Rules would not apply.
Internal Revenue Code Sections 4975 & 408 prohibit fiduciary and other Disqualified Persons from engaging in certain types of “prohibited transactions”. “Prohibited transactions” are any direct or indirect:
- sale or exchange, or leasing, of any property between a plan and a disqualified person;
- lending of money or other extension of credit between a plan and a disqualified person;
- furnishing of goods, services, or facilities between a plan and a disqualified person;
- transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;
- act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interests or for his own account; or
- receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.
- Fiduciary prohibited transactions appear to be the most common type of prohibited transaction in the self-directed IRA context. The IRA owner is a fiduciary to a self-directed IRA and cannot use the IRA funds to directly or indirectly benefit himself. The fiduciary prohibited transaction rules under Code Section 4975(c)(1)(D) and (E) are applicable, regardless of whether there is a disqualified person on the other side of the transaction.
The fiduciary prohibition transaction rules do not permit IRA owners to direct the IRA trustee to enter into any transaction in which the owner has an interest that may affect the “exercise of his judgment as a fiduciary” (the typical conflict of interest situation).
Qualified Retirement Plan
A plan that meets the requirements of Internal Revenue Code Section 401(a) and the Employee Retirement Income Security Act of 1974 (ERISA), thus making it eligible for favorable tax treatment. Contributions and earnings enjoy tax-deferred investment growth.
To permit tax-free transfers of retirement savings from one type of investment to another, as well as to increase the portability of qualified plan rights for employees moving from one job to another, Congress included a complicated web of rollover provisions in ERISA. These provisions cover transfers from one IRA to another, transfers from qualified pension, profit-sharing, stock bonus, and annuity plans to IRAs, and transfers from IRAs to qualified plans. An IRA may also, under limited circumstances, make a rollover distribution to a health savings account (HSA). In other words, if you receive a distribution from a qualified plan, you might decide to put some or all of the distribution amount into an IRA. The IRA that receives the qualified plan distribution is called a rollover IRA.
A distribution from an IRA to the individual for whose benefit the account or annuity is maintained is not taxable to the recipient if reinvested within 60 days in another IRA (other than an endowment contract) for the benefit of the same individual. The rule operates on an all-or-nothing basis. The entire amount received from the old IRA must be transferred to the transferee IRA. If anything is held back, the rollover rule does not apply, and everything received from the old IRA, including any amount transferred to another IRA, is treated as a taxable distribution. However, the distribution from the old IRA need not include the taxpayer's entire interest. An IRA can be split, for example, by rolling a portion of it into a new IRA.
If property other than money is received from the old IRA, that property, not substitute property of equal value or the cash proceeds of the property's sale, must be included in the transfer to the new IRA. According to the Tax Court, the rollover contribution must be of cash if the distribution is in cash.
The privilege of rolling over from IRA to IRA may be exercised only once in a 12-month period.
A type of IRA funded with nondeductible contributions or amounts converted (and taxed) from another type of IRA. Qualified distributions from a Roth IRA are free from income tax. Contributions or conversions to a Roth IRA may be made only in years in which the individual’s modified adjusted gross income within specified limits.
Self Directed IRA Operating Agreement
The LLC Operating Agreement is the core document that is referred to when issues concerning the LLC need to be resolved. The LLC Operating Agreement is the most important document for your Self-Directed IRA. It is extremely important that you create an Operating Agreement for your Self-Directed IRA LLC.
The standard LLC Operating Agreement will not meet the requirements for your Self Directed IRA LLC. In general, a Self-Directed IRA LLC Operating Agreement should include special tax provisions relating to "Investment Retirement Accounts" and "Prohibited Transactions" pursuant to Internal Revenue Code Sections 408 and 4975. In addition, since the LLC will be managed by a manager and not the member, the Operating Agreement would need to include special management provisions.
Simplified Employee Pension (SEP)
A simplified employee pension (SEP) is a special type of IRA that can be established by your employer or by you, if you are self-employed. Designed for small businesses, SEPs have many of the characteristics of qualified plans but are much simpler to establish and administer.
Any employer can establish a SEP.
Under a SEP, each participant has his or her own individual retirement account to which the employer contributes. The contributions are excluded from the participant's pay and are not taxable until they are distributed from the plan. If you are self-employed you may establish a SEP for yourself, even if you have no employees.
The advantage of a SEP over a regular IRA is that the contribution limits are higher. In general, the contribution can be as much of 25% of your annual compensation, up to a maximum contribution of $53,000.
The disadvantage of a SEP from an employer's standpoint is that an employer that establishes a SEP is required to make contributions on behalf of virtually all employees. Moreover, the employees must be 100% vested at all times. Those can be costly requirements for small employers whose workers often includes many short-term part time employees. In contrast, a 401(k) plan, as well as other qualified plans can extend the period before an employee is fully vested.
401(k) is a particular section of the Internal Revenue Code that refers to pension, profit sharing and stock bonus plans. These plans have two components, salary deferral and profit sharing contributions. In 2001, Congress passed rules allowing for easy set up and administration of the Solo or “mini-version” of the 401(k) plan.
A 401(k) plan combined with a profit-sharing plan, usually adopted by a sole proprietor or other business with no non-owner employees. Because 401(k) contributions do not count towards the limit on plan contributions which can be deducted (25% of compensation), a Solo 401(k) Plan enables some self-employed individuals to contribute and deduct more than under the 25% limit, which would apply under a regular profit-sharing plan or SEP-IRA.
Swanson v. Commissioner. 106 T.C. 76 (1996)
The relevant facts of Swanson are as follows:
1. Mr. Swanson was the sole shareholder of H & S Swansons’ Tool Company (Swansons’ Tool).
2. Mr. Swanson arranged for the organization of Swansons’ Worldwide, Inc. (Worldwide). Mr. Swanson was named as president and director of Worldwide. Mr. Swanson also arranged for the creation of an individual retirement account (IRA #1).
3. Mr. Swanson directed the custodian of his IRA to execute a subscription agreement for 2,500 shares of Worldwide original issued stock. The shares were subsequently issued to IRA #1, which became the sole shareholder of Worldwide.
4. Swansons’ Tool paid commissions to Worldwide with respect to the sale by Swansons’ Tool of export property. Mr. Swanson, who had been named president of Worldwide, directed, with the IRA custodian’s consent, that Worldwide pay dividends to IRA #1.
5. A similar arrangement was set up with regards to IRA #2 and a second corporation called Swansons’ Trading Company.
6. Mr. Swanson received no compensation for his services as president and director of Swansons’ Worldwide, Inc. and Swansons’ Trading Company.
The IRS attacked Mr. Swanson’s IRA transactions on two levels. First, the IRS argued that the payment of dividends from Worldwide to IRA #1 was a prohibited transaction within the meaning of Code Section 4975(c)(1)(E) as an act of self-dealing, where a disqualified person who is a fiduciary deals with the assets of the plan in his own interest. Mr. Swanson argued that he engaged in no activities on behalf of Worldwide which benefited him other than as a beneficiary of IRA #1.
The Tax Court ruled for Mr. Swanson, and found that the IRS was not substantially justified in its position. The court said that section 4975(c)(1)(E) addresses itself only to acts of disqualified persons who, as fiduciaries, deal directly or indirectly with the income or assets of a plan for their own benefit or account. In Mr. Swanson’s case the court found that there was no such direct or indirect dealing with the income or assets of the IRA. The IRS never suggested that Mr. Swanson, acting as a “fiduciary” or otherwise, ever dealt with the corpus of IRA #1 for his own benefit. The Tax Court, in holding for Swanson, stated the following:
We find that it was unreasonable for [the IRS] to maintain that a prohibited transaction occurred when Worldwide's stock was acquired by IRA #1. The stock acquired in that transaction was newly issued -- prior to that point in time, Worldwide had no shares or shareholders. A corporation without shares or shareholders does not fit within the definition of a disqualified person under section 4975(e)(2)(G). It was only after Worldwide issued its stock to IRA #1 that petitioner held a beneficial interest in Worldwide's stock, thereby causing Worldwide to become a disqualified person under section 4975(e)(2)(G). . . Therefore, [the IRS’] litigation position with respect to this issue was unreasonable as a matter of both law and fact.
Therefore, the Tax Court held that the only direct or indirect benefit that Mr. Swanson realized from the payments of dividends by Worldwide related solely to his status as a participant of IRA #1. In this regard, Mr. Swanson benefited only insofar as IRA #1 accumulated assets for future distribution.
The second issue the IRS raised was that the sale of stock by Worldwide to Mr. Swanson’s IRA was a prohibited transaction within the meaning of section 4975(c)(1)(A) of the Code, which prohibits the direct or indirect sale or exchange, or leasing, of any property between an IRA and a disqualified person. Mr. Swanson argued that at all relevant times IRA #1 was the sole shareholder of Worldwide, and that since the 2,500 shares of Worldwide issued to IRA #1 were original issue, no sale or exchange of the stock occurred.
Once again, the Tax Court agreed with Mr. Swanson. The critical factor was that the stock acquired in that transaction was newly issued – prior to that point in time, Worldwide had no shares or shareholders. The court found that a corporation without shares or shareholders does not fit within the definition of a disqualified person under section 4975(e)(2)(G). It was only after Worldwide issued its stock to IRA #1 that Swanson held a beneficial interest in Worldwide’s stock, thereby causing Worldwide to become a disqualified person. Accordingly, the issuance of stock to IRA #1 did not, within the plain meaning of section 4975(c)(1)(A), qualify as a “sale or exchange, or leasing, of any property between a plan and a disqualified person”.
In ruling in favor or Mr. Swanson, the Tax Court formally approved the idea of an IRA holder being the sole director and officer of an entity owned by his IRA. In other words, by having the IRA invested in an entity such as an LLC of which the IRA owner is the manager, the Swanson Case seemingly endorses the concept that the IRA owner can have “checkbook control” over his or her IRA funds.
One thing to note is that the LLC does not insulate the IRA from the prohibited transaction rules. Based on Swanson, once an IRA purchases an interest in an entity, that entity then becomes a disqualified person pursuant to Code Section 4975. Accordingly, any investments made by the IRA owned entity must be closely scrutinized based on the prohibited transaction rules outlines in Code Section 4975.
An Individual Retirement Arrangement (IRA) which is not a ROTH, SEP or SIMPLE IRA.
The movement of a retirement account assets from one custodian directly to another. An asset transfer is not a distribution and is not taxable or reportable to the IRS. There are no limits as to the number or frequency of IRA transfers.
There are 4 legal requirements for creating a trust:
- the grantor must have capacity to create a trust;
- the gantor intended to create a trust;
- the trust has funding;
- the trust has ascertainable beneficiaries.
Unrelated Business Taxable Income (UBTI)
Income taxable to an IRA (or other tax-exempt entity) because it is “unrelated” to the IRA’s tax-exempt purpose. Typical examples are income from a manufacturing, sale or service business operated by an IRA or a partnership or LLC in which an IRA is a member, as well as unrelated debt-financed-income. The tax on this income is called unrelated business income tax, or UBIT. There are some important exceptions from UBTI: those exclusions relate to the central importance of investment in real estate - dividends, interest, annuities, royalties, most rentals from real estate, and gains/losses from the sale of real estate.
Unrelated Debt Financed Income (UDFI)
Income taxable to an IRA (or other tax-exempt entity) which is attributable to borrowing, either by the IRA directly or a partnership or LLC of which it is a member. Typical examples are income from real estate purchased with borrowing and securities bought on margin. Unrelated debt-financed income is a type of unrelated business taxable income.