This glossary of terms provided by IRA Financial are created to help individuals who are interested in establishing a self-directed retirement plan and need to know the rules, separate plans and general terminology. The glossary of terms is also valuable for individuals who already have a self-directed retirement plan and may not know all of the terms that apply, such as a disqualified person/who a disqualified person is, ERISA laws and much more.
Glossary of Terms – Key Self-Directed Retirement Phrases
Self-Directed Retirement Plans
Self-Directed Retirement Plans allow IRA investors invest their retirement funds in alternative asset classes. As a result, you don’t have to put all your retirement money in traditional investments. As you may know, traditional investments include stocks, bonds, mutual funds and ETFs (exchange traded funds). Alternative assets include real estate, private business, tax liens and cryptocurrency.
Self-Directed Plans allow you, the IRA investor, to invest in assets you know and understand.
At IRA Financial, we offer different types of Self-Directed retirement plans:
- Self-Directed IRA (SDIRA)
- Solo 401(k) (a.k.a Individual 401(k))
- ROBS (Rollover for business startups) Solution
Our professional tax and ERISA specialists can provide a free consultation to help you determine which Self-Directed IRA retirement plan best fits your needs.
Self-Directed IRA (Individual Retirement Account)
A Self-Directed IRA is similar to many IRAs, but differs in what types of investments you can make. Essentially, there are three types of Self-Directed IRAs.
Financial Institution Self-Directed IRA:
A traditional financial institution, such as Fidelity or Bank of America, provides this type of account. However, while it’s called a “Self-Directed IRA” it’s very limiting in what investments you can make.
For example, although the IRS approves real estate as an investment, your financial institution is under no obligation to provide it as an option. Instead, they will likely provide products only they offer. These are traditional investments, such as stocks, bonds and mutual funds. This is because financial institutions don’t make money selling alternative assets.
Custodian Controlled Self-Directed IRA:
The second type of Self-Directed IRA includes a custodian who you must go through to make any type of investment. This type of account is also limiting, as the custodian may not approve all the investments you wish to pursue. Also, there are custodian fees to consider, such as transaction fees and valuation fees, which can be steep. Notably, you must consider long delays as the custodian approves your investment(s).
Checkbook Control Self-Directed IRA:
With this structure, you (IRA holder) have complete control over your funds and investment decisions. There are no custodian fees, or delays. You will have to establish an LLC (limited liability company) which is where your money will be held. However, you can make investments whenever you want. With checkbook control, you can diversify your retirement portfolio. Not only can you invest in traditional investments, but alternative investments. This structure is a true Self-Directed IRA.
A Solo 401(k) comes with many names. You may know it as:
- One participant 401(k)
- Individual 401(k)
- Self-Directed 401(k)
A Solo 401(k) is an IRS approved type of qualified plan. It’s much like a traditional 401(k), however it’s for one individual. Congress and the IRS came up with the Solo 401(k) plan to benefit self-employed individuals and small business owners with no employees. It’s popular among such individuals particularly because of the “employee deferral” feature. This is an investment that you put into your retirement account. You make investments before taxes and the money builds interest in your account. The “employee deferral” feature offers the highest contribution benefits for the self-employed. This is because it increases their maximum contribution.
The Solo 401(k) composes of two components. The first is salary deferral and the other is 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.
Because 401(k) contributions don’t 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. Thus, would apply under a regular profit-sharing plan or SEP IRA.
ROBS (Rollover for Business Startups) Solution
The ROBS solution is a self-directed plan that allows you to invest your retirement funds into a new business/franchise. These funds roll into your business, and you don’t pay penalties or taxes on withdrawals. If you are an entrepreneur, you can benefit from the rollover for business startup’s structure. You can invest into your business and withdraw funds from your account before 59 1/2 without being taxed or penalized. If you have a robust retirement account, you get to use this as capital for your business venture.
A ROBS account is the only way that you (a disqualified person) can use your retirement funds to buy or finance a business. The reason for this is, the Rollover for Business Startup takes advantage of an exception in the tax code: qualifying employer securities. As a result, you can use your retirement funds to buy stock in a C corporation.
Note: You may previously know of the ROBS solution as BACSS (Business Acquisition Solution) at IRA Financial Group.
When an IRA holder (you) have checkbook control, this means you have complete access and control over your retirement funds. You achieve checkbook control by establishing a Self-Directed LLC (limited liability company) or trust. Because the LLC is seen as a business entity, it can establish a checking account. You then fund the LLC with your retirement assets. As a result, you gain investment freedom to easily manage your retirement assets.
The LLC/trust owns the checking account, but you (the IRA holder) is manager of the account. When an investment opportunity presents itself, such as real estate, you can act on it quickly. This investment strategy is very popular for investors who need to access their IRA funds quickly. With Self-Directed IRA Checkbook Control, you have direct access to your IRA (individual retirement account) funds.
Another benefit of checkbook control is that it eliminates administrative, valuation and transaction fees typical of a custodian controlled account.
Limited Liability Company
A limited liability company (LLC) is a type of business structure. In fact, it’s the least complex business structure. It’s also considered a hybrid entity. In other words, you can structure your LLC to resemble a corporation for owner liability purposes and a partnership for federal income tax purposes. As a result, you receive 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.
A passive custodian, also called a Self-Directed custodian, allows IRA holders to engage in non-traditional investments. These types of investments include tax liens, real estate, private business and much more. However, they generally do not offer investment advice. The custodian in the “Checkbook Control” Self Directed IRA structure is a “passive” custodian. The custodian doesn’t have to approve any IRA related investment. A passive custodian 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 delays.
Who is a “Disqualified Person”?
The IRS (Internal Revenue Service) prohibits certain transactions between the IRA and “disqualified persons”. The rationale behind these rules was an assumption that certain transactions between certain parties are inherently suspicious. As a result, the IRS doesn’t allow them.
A Disqualified Person has many definitions. However, it includes the IRA holder and his/her ancestors or lineal descendants. Additionally, it includes entities in which the IRA holder holds a controlling equity or management interest.
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.
- 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).
A Disqualified Person Is:
- A fiduciary. In other words, the IRA holder, participant, or anyone who has authority over making IRA investments.
- A person providing services to the IRA, such as a trustee or custodian.
- An employer whose plan covers his/her employees. This generally is not applicable to IRAs. However it does include the owner of a business that establishes a qualified retirement plan.
- An employee organization whose plan covers it members.
- A 50 percent owner of examples 3 or 4 above.
- A family member of examples 1, 2, 3, or 4 above. Family members include:
- The fiduciary’s spouse
- Spouses of the fiduciary’s children and grandchildren
- An entity (corporation, partnership) that has ownership or control by examples 1, 2, 3, 4, or 5 above. An entity can be disqualified based on the indirect stockholdings/interest. This is 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 examples 3, 4, 5, or 6 above.
- A 10 percent or more partner or joint venturer of a person described in the examples 3, 4, 5, or 6 above.
The following are not considered “Disqualified Persons:”
Individual Retirement Arrangement (IRA)
The Employee Retirement Income Security Act (ERISA) came into effect in 1974. This is when IRAs came about, also known as the Individual Retirement Account. This is a tax-deferred retirement account for an individual that allows others to set aside money each year. Earnings are tax-deferred until withdrawals begin at age 59 1/2 or later. Sometimes earlier, but with a 10% penalty. The exact amount depends on the year and the individual’s age. Individuals can invest funds into a broad range of assets, including:
- Mutual funds
- Real estate
- Notes & mortgages
- Tax liens
- Private companies
- Business loans
- Foreign investments
- Equipment leases
- Much more
Qualified Retirement Plan
This is a plan that meets the requirements of Internal Revenue Code Section 401(a). It also meets the Employee Retirement Income Security Act of 1974 (ERISA). So this makes it eligible for favorable tax treatment. Contributions and earnings enjoy tax-deferred investment growth. The most popular types of qualified retirement plans are profit sharing plans, like 401(k) Plans. Benefit plans and money purchase pension plans are popular, too. Most of the plans you get through your job are qualified retirement plans.
To allow tax-free transfers of retirement savings from one type of investment to another, Congress began a web of rollover provisions in ERISA. It also increases the portability of qualified plan rights for employees moving from one job to another. These provisions cover transfers from one IRA (individual retirement account) to another. Transfer include:
- Qualified pension
- Stock bonus
- Annuity plans to IRAs
- Transfers from IRAs to qualified plans
An IRA may also, under limited circumstances, make a rollover distribution to a health savings account (HSA). So, 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 receiving the plan distribution is a “rollover IRA.”
A distribution from an IRA to the individual who benefits from the account or amount maintained is not taxable to the recipient. This is the case if the distribution is reinvested within 60 days in another IRA (other than an endowment contract). This is for the benefit of the same individual. The rule operates on an all-or-nothing basis. The entire amount from the old IRA must transfer to the transferee IRA.
If anything is held back, the rollover rule does not apply. Therefore, everything from the old IRA is now a taxable distribution. That includes any amount transferred to another IRA. However, the distribution from the old IRA doesn’t have to include the taxpayer’s entire interest. An IRA can be split, for example, by rolling a portion of it into a new IRA.
If the old IRA receives property other than money, that property must be part of the transfer to the new IRA. However, this doesn’t include substitute property of equal value or the cash proceeds of the property’s sale. According to the Tax Court, the rollover contribution must be of cash if the distribution is in cash.
Rolling over from one IRA to another is a privilege that you should only do once in a 12-month period.
The Employee Retirement Income Security Act of 1974 (ERISA) is a federal statute. It establishes minimum standards for pension plans in private industry. It provides extensive rules on the federal income tax effects of transactions that associate with employee benefit plans. ERISA protects the interests of employee benefit plan participants and their beneficiaries. It does so by providing disclosure to these participants of finances and other information concerning the plan.
A traditional IRA is an Individual Retirement Arrangement (IRA). Most know of it as an Individual Retirement Account. It is not a ROTH, SEP or SIMPLE IRA. The term “traditional” separates it from the Roth IRA, which shares many similarities. With a traditional IRA, you can create a nice nest egg for retirement. Investment growth is tax-deferred, meaning you don’t have to pay taxes until you hit retirement age and make withdrawals.
A Roth IRA is a type of individual retirement account. You fund your Roth IRA with post-tax income. As a result, all of your future withdrawals are tax-free. Because the money in your Roth IRA is yours, you can make withdrawals anytime. Of course, withdrawals are tax and penalty-free. You can make contributions or conversions to a Roth IRA only in years of your modified adjusted gross income within specified limits. It’s a good idea to choose Roth if you think you’ll be in a higher tax bracket during retirement than your current tax bracket.
Simplified Employee Pension (SEP)
A simplified employee pension (SEP) is a special type of IRA that your employer can establish. You can also establish it if you’re self-employed. Specific to 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 not part of the participant’s pay. Additionally, they are not taxable until 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. The contribution can be as much as 25% of your annual compensation, up to a maximum contribution of $56,000.
The disadvantage of a SEP from an employer’s standpoint is that the employer who establishes a SEP must 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. Particularly for those whose employees are short-term/part time. In contrast, a 401(k) plan, as well as other qualified plans extend the period before an employee is fully vested.
Non-Recourse IRA Mortgage
This is the only type of loan allowable for a Self Directed IRA. A non-recourse loan is a secured loan (debt). It is by a pledge of collateral. It typically involves real property, but for which the borrower is not personally liable.
This is the movement of 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.
A trust is a provision that involves a fiduciary. It allows a trustee to hold assets for the beneficiary. There are four legal requirements for creating a trust:
- A grantor must have capacity to create a trust
- The grantor intended to create a trust
- His/her trust has funding
- The trust has ascertainable beneficiaries
Unrelated Business Taxable Income (UBTI)
This is income that’s taxable to an IRA (or other tax-exempt entity). This is because it’s “unrelated” to the IRA’s tax-exempt purpose. Typical examples are income from a manufacturing, sale or service business. It operates by an IRA or a partnership or LLC in which an IRA is a member. Also, it operates as unrelated debt-financed-income. The tax on this income is “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:
- most rentals from real estate
- gains/losses from the sale of real estate
Unrelated Debt Financed Income (UDFI)
UDFI is income that’s taxable to an IRA (or other tax-exempt entity) which is attributable to borrowing. This is taxable by the individual retirement account directly. Or it’s taxable by a partnership or LLC of which it is a member. Typical examples are income from real estate that someone purchases with borrowing and securities bought on margin. Unrelated debt-financed income is a type of unrelated business taxable income.
Plan Asset Rules
The Department of Labor’s Plan Asset Rules essentially define when the assets of an entity are “Plan” assets. Under the rules, individual retirement accounts are frequently seen as pension plans. This subjects 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 seen as assets of the investing IRA/401(k). This is for purposes of the prohibited transactions rules, unless an exception applies. Also, if a plan or group of similar plans owns 100% of an “operating company”, then the operating company exception will not apply. Also, the company’s assets will still be treated as plan assets.
In summary, anyone can trigger the Plan Asset Rules if:
- IRAs/401(k) and disqualified persons own 100% of an “operating company.” In which case all the assets of the “operating company” are Plan assets (assets of the IRA/401(k)).
- IRAs/401(k) and disqualified persons own 25% or more of an “investment company.” In which case all the assets of the “investment company” are Plan assets (assets of the IRA/401(k)). In determining whether the 25% threshold is met, all IRAs/401(k) owners are considered. Even unrelated individuals own them.
Exceptions to the DOL Plan Asset Regulations
The Plan Asset look-through rules do not apply if the entity is an operating company. Also, it does not apply if the partnership interests or membership interests are publicly offered or registered under the Investment Company Act of 1940. Furthermore, they do not apply if the entity is an “operating company.” This refers to a partnership or LLC that primarily engages in the real estate development, venture capital or companies that make/provide/providing goods and services. So, this can include a gas station, unless a Plan and/or disqualified persons owns 100% of the “operating company.” If an IRA or 401(k) Plan owns less than 100% of an LLC that engages in an active trade or business, the Plan Asset Rules will not apply.
Self Directed IRA Operating Agreement
The LLC Operating Agreement is the core document that is referred to when LLC issues need resolving. 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 SDIRA 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 includes special tax provisions relating to “Investment Retirement Accounts” and “Prohibited Transactions” pursuant to Internal Revenue Code Sections 408 and 4975. In addition, a member will not manage the LLC. A manager will be in charge. Therefore, the Operating Agreement will need to include special management provisions.
IRS Field Service Memorandum 200128011
IRS Field Service Advice (FSA) Memorandum 200128011 is the first IRS opinion that confirms the ruling of Swanson. It states that the funding of a new entity by an IRA for self directing assets was not a prohibited transaction. This is according to Code Section 4975. As a result, the IRS issues an FSA to IRS field agents to guide them in conduct of tax audits.
USCorp is a domestic sub-chapter S Corporation. Assume Joe Avatar owns a majority of the shares of USCorp. Joe Avatar’s three minor children own the remaining shares of USCorp equally. USCorp is in the business of selling Product A and they make some of their sales for export.
Joe Avatar and each child own separate individual retirement accounts. Each of the four IRAs acquire a 25% interest in FSC A, a foreign sales corporation (“FSC”). USCorp enters into service and commission agreements with FSC A. FSC A agrees to act as commission agent in connection with export sales made by USCorp. This is in exchange for commissions upon the administrative pricing rules applicable to FSCs. USCorp also agrees to perform certain services on behalf of FSC A, such as soliciting and negotiating contracts, for which FSC A must reimburse USCorp its actual costs.
During Taxable Year 1, FSC A makes a cash distribution to its IRA shareholders out of earnings and profits from foreign trade income relating to USCorp exports. The IRAs owning FSC A each receive an equal amount of funds.
Swanson and Prohibited Transactions
IRS advises that, based on Swanson, neither issuance of stock in FSC to IRAs nor payment of dividends by FSC to IRAs constitute a direct prohibited transaction. IRS warns that, based on facts, transaction can be indirect.
In light of Swanson, the IRS concludes 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 states 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 concludes 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).