In this episode of Adam Talks, IRA Financial’s Adam Bergman Esq. discusses the Self-Directed IRA LLC with Checkbook Control, and what you should be aware of.
What NOT to do with Your Self-Directed IRA Checkbook Control
Hey, everyone, Adam Bergman here, tax attorney and founder of IRA Financial. On today’s Adam Talks, I’m going back and, at a request, this is a topic request from a really, really old and dear friend, who’s also a client. And I spoke to this person who wanted to remain nameless; they said, Adam, you’re always doing some newsworthy current event-type topic on Adam Talks, can you just kind of go back old school and just give everyone a refresher who has Self-Directed IRA LLC with checkbook control, what they should be aware of; what they should be concerned of. Just kind of go back, refresher, summer – everyone’s busy, probably going away, doing some good stuff. No one’s really traveling much for last few years because COVID; people are doing that now, probably reading a good book on the beach, and maybe they’ve forgotten some of the key tips if they have a Self-Directed IRA, specifically a Self-Directed IRA LLC. So, could you do a 10-15 minute quick recap of all the key relevant points to keep in mind if you have one? I said, you know what, let’s do it. Should have done it earlier. Yes, I continue to do Live every Wednesday, 12 EDT on YouTube. But, this is a good platform, since I’m almost at 350 episodes, that I should kind of go back and go back in the past and do what I used to do and kind of just give a quick refresher on some of the key Checkbook Control IRA LLC points. So, that’s what I’m going to do.
First thing, what’s the Checkbook Control IRA LLC if you’re out there, if you’re watching, listening, you don’t know what the hell I’m talking about. Well, there’s two different types of Self-Directed IRAs, okay? You’re not going to see the word Self-Directed IRA anywhere in the tax code. What it means is an IRA that lets you invest in alternative assets. Typically, technically I should say, Schwab, Fidelity and Vanguard should let you buy real estate or other alternative assets. It’s in the code. There’s only three things you can’t do in the tax code if you have an IRA. Can’t buy life insurance; can’t buy collectibles, like art; and you can’t do any transaction outline internal Revenue Code Section 4975, which basically means you just can’t self-deal; do anything that personally benefits you or your lineal descendants: parents, your children, spouse, daughter in law, son in law; any entities controlled by such persons. Right? Can’t buy house and live in it. Or can’t take your IRA and go to Hawaii with your family.
The investment must be exclusively benefiting the IRA. So, if your IRA buys Tesla or Gold or Bitcoin or real estate and it goes up, the money goes back to the IRA and not you, personally; that is permitted. The money just cannot go to you personally; it has to go to your IRA, and the benefit directly or indirectly must be borne by the IRA.
So, two types of Self-Directed IRAs, you can do what’s called a full service, traditional, custodian-controlled, which basically means the Custodian – IRA Financial Trust, for example, makes the investment, for example, in the real estate. Real estate is titled in the name of the custodian, for the benefit of the IRA owner, IRA Financial Trust Company, FBO Adam Bergman IRA. And all transactions go through the custodian. So, it’s the trust company that facilitates the investment and is responsible for all related investment transactional activity. Paying the taxes, paying the handyman; anything you need to deal with, with that IRA needs to go through the custodian.
Well, in the mid 90s, LLC’s got more popular. Important Tax Court case called Swanson v. Commissioner came out in 1996, and confirmed that an IRA could own an entity, like a corporation or LLC, and be managed by the IRA owner. So, Adam Bergman’s IRA can own an LLC and can be managed by Adam Bergman through a local bank account without triggering the prohibited transaction rules under 4975, and this caused a lot of excitement. This kind of coincided with LLCs becoming more popular; every state recognizes them. The advantage of an LLC is you get the limited liability protection of a corporation, but you don’t have any entity level tax, right? A corporation, for example, has a 21% entity level tax. An LLC has no federal income tax. There’s only one level of tax, and that’s at the shareholder level. But in this case, the IRA is the shareholder, and we know IRAs are exempt from tax, just like charities. So, it gives you; doing the checkbook control, you get limited liability protection, you get the privacy, right? The investment’s made in the name of the LLC, not in the name of IRA Financial Trust, for the benefit of Adam Bergman IRA. It would be named in XYZ, LLC or Blue Sky LLC or White Snow LLC, whatever you decided to name that LLC. And you can set up the LLC in any state, or where you’re doing your transactions with respect to the IRA.
So, over the last 20 years, I would say, the checkbook control, the LLC has gained in popularity. If you’re going to be doing investments in your IRA that will Involve lots of activity, like rental real estate, or if you just really are focused on limited liability protection, because you’re going to do real estate, or if you’re going to need a loan; most lenders will only lend to an LLC; they won’t lend to an IRA. Or maybe you just want more control, right? Because you want to deal with the LLC or local bank account. You don’t want to have to go through the custodian every time you need a check written to a handyman or to fix the pool; or maybe you just want a little more privacy, then the checkbook control is a really good solution.
So, if you have a checkbook control LLC for your IRA or you’re thinking of getting one, what are some of the things to keep in mind? Well, number one, 4975 what I mentioned right? You don’t want to do anything prohibited. All activity needs to be done through the LLC. So you, the manager, will write checks. Do not write any checks yourself. You are a lineal descendant. You are your own disqualified person. Don’t write checks to yourself; any entities you control, to any disqualified person, don’t do it. Okay?
I actually had a client about twelve years ago. He was a doctor, is a doctor, I should say, probably still, and by mistake he wrote a check from his IRA LLC for $500. He had probably about $275,000 in his IRA. He wrote a $500 check by mistake from his IRA LLC to an entity he owned. He got mixed up. He had a bunch of different entities because he owned multiple rental properties. The names were kind of similar and he got audited. Why? Probably because he was over 70 and a half at that point, and they did a spot check on his tax return, on his 1040, just kind of ask questions about his IRA and they go deeper. They said he had real estate. This was around 2010, so they were interested in valuation. Did he undervalue the assets? Anyways, it turns out they dug deeper and found that he wrote this check to himself and they basically disqualified his IRA. You just pay tax. He didn’t pay 10% or any other penalty because it was over 59 and a half, but he was subject to tax. This is for just $500. So be careful. You have the control, you have the responsibility. Do not write checks yourself or any other disqualified person.
What else? If you’re doing a loan, make sure it’s a non-recourse loan. You cannot personally guarantee an obligation to your IRA. So if you’re borrowing money, it has to be a non-recourse loan. You or a lineal descendant cannot personally guarantee it. That means no credit cards. You can use a debit card, but no credit cards associated with your IRA LLC. Okay? Just be cautious about that. The bank, where you open your LLC account, and we can do it for you if you’re a client of IRA Financial, can do it at Capital One, the bank account will keep good records. Okay? So, that will be your recordkeeping platform, where you’ll have the proof to show that the checks you wrote did not go to yourself or lineal decendants. So, you don’t need to make photocopies of checks. You don’t have to keep paper files. The online banking account and it’s recordkeeping system will give you all the necessary support you need to show if you are ever audited, that you didn’t do anything prohibited. So, that’s the good news about electronic banking – the Capital One system. You’ll have proof of where your checks went, where the wires went, and where the money came from. So, you can easily show you didn’t do anything prohibited. Okay?
What about if you’re doing real estate? You’re doing transactions. Where should you set up the LLC? So, if you haven’t set up an IRA LLC, listen up. Generally, you can set up the LLC in any state, right? All states recognize LLCs. You typically want to set up the LLC where you’re going to own the real estate. Why? Most states seem to be engaged in a business in that state if you own real estate, so you therefore want to form the LLC in that state, because if you don’t, say you form it in Delaware and then you live in Texas or the real estate is in Texas, you’re going to have to pay two filing fees. You can do it. If money is not an option, you can do it. I have plenty of clients that say, Adam, I just want more privacy. I’m going to set the LLC up in Delaware, Wyoming, and then I will just register that LLC to do business in the state I want to transact it. That’s fine. No problem. But just remember, you’re going to have to pay dual fees.
California. If you are a resident of California, beware, even if you are doing activity in a different state, but if you are a resident of California and you’re the manager of your IRA LLC; even if that LLC is set up in New York or New Hampshire or North Dakota, California could potentially deem you to be engaged in a business in California and require you to register that LLC in California, even if you have no nexus or connection to the state. Why? Because you’re the manager and you’re a California resident and you are making decisions for the LLC in the state of California. So, why is California an issue? Because it has a minimum franchise fee of $800. It’s the most expensive state for setting up an IRA LLC or any LLC for that matter. So just be cautious, okay? Some people will try to tell you, well, you can just set up the LLC in Delaware; no one’s going to know if you have real estate in California. I disagree. You can set up a trust in California. No, you’re still going to be subject, potentially, to California state tax on that trust. So, be super careful. California is definitely the most aggressive when it comes to defending their franchise fees.
New York is a little bit less aggressive than California, but their fees are much lower. There’s no franchise fee that goes that high. Okay? So, just to summarize where you’re going to set up the LLC, generally, I say set up where you buy the real estate. If you’re not doing real estate, if you’re doing gold or cryptos or just in hard money loans or investing in a private business, you can set up the LLC in any state. We have offices in multiple states. You can use our address for no charge. But, if you are a resident of California. Be cautious. You may want to have a nonresident, someone you trust, be the manager just so you don’t have to deal with the California franchise fee, right? Maybe your brother or sister lives in another state, and then you can set up the LLC in a different state. You will obviously have to give up authority over that LLC to that third party. But, because you’re not the manager, you won’t be subject to the California franchise fees. So, just be cautious.
Single member LLCs do not file tax returns. Most of the clients that work with us, that set up Self-Directed IRA LLCs, they’ll have one IRA own the LLC. A single member LLC is treated as a disregarded entity for tax purposes, so it’s treated as a tax nothing. But you still get the limited liability protection from a corporate standpoint; so that’s good. And best of all, there’s no federal income tax return. Why? Because a single member LLC, if it’s owned by an individual, will file a Schedule C, which is attached to the individual’s 1040, which will report to the IRS all the flow-through income from the LLC.
But in this case, the IRA is the owner. And we know IRAs don’t file tax returns, right? They’re treated as 501 trusts, just like charities, so there’s no filing, which is pretty interesting. However, if your IRA LLC is owned by two or more parties, it could be an IRA in an individual, and IRA in an entity, two or more IRAs, you have to file a partnership return, a form 1065. It’s an information return; no taxes due at the federal level, but a 1065 form, along with a corresponding K-1, which is given to each member, telling the member, providing them a snapshot of the activity of the LLC for that year, ie. their net income, net losses, so on and so forth. Copy’s also sent to the IRS. So, if you are managing your LLC, and let’s say you have a traditional and Roth IRA, even though they’re both IRAs, you still have to file a 1065, along with a corresponding state tax return for that state. K-1s will go to the IRA and the IRS – we will assist you if you need information. Most of our clients will use the tax ID number of IRA Financial Trust and our address to complete the K-1, and then you’ll obviously just need to allocate the income or losses from the partnership to each specific partner, ie. IRA. So, not a tax return; no taxes due at the federal level, but the 1065 must be filed.
Okay, so when you set up the IRA LLC, we will handle setting up, obviously, the LLC. We will also get a tax ID number for your LLC, so you can open a bank account, which we can do for you, or you can choose any bank of your choice. We’ll also provide you a customized LLC operating agreement. The LLC operating agreement, is not filed with the state, but essentially shows ownership: IRA is owned by the LLC; IRA owns the LLC, it’s managed by you, it sets forth the rules of the LLC, who’s the manager, discusses all the prohibited transaction rules, how cash is distributed, how profits and losses are allocated, what happens on liquidation. So that’s something we do, so don’t worry, and we also update it. If you’re part of our annual consultant service, which is something that we offer that I think is really underrated, where each client, for $199, is enrolled in our annual consulting service, where you’ll get updated docs, and you’ll also have access to talk to our tax professionals, CPAs, accountant, things like that if you have related questions, which is helpful, right? It’ll help you navigate the rules. Where else you’re going to be able to find a tax professional for $200, who actually knows these rules as they pertain to Self-Directed IRAs? So, say about 90% or so of our clients do it; I think, a really good service. So, if you are a client of IRA Financial, or if you’re thinking of doing a Self-Directed IRA with checkbook control, don’t sweat it. You’re not going to be on your own. It’s not like you just go on our app, set it up, and kind of leave you on your own. No. We are here to help; we have amazing team members that we spend a lot of time training. I’ve written eight books on the subject, so I’m spending hours a day training people, going through questions, and helping my team make sure that they’re providing accurate and reasonable information to clients based off their facts and circumstances.
So, basically, it’s not a complex structure at all. As I mentioned, there’s three things you can’t do. You can’t do life insurance, collectibles and self-dealing. There’s a case called Neiman v Comissioner. It’s a 2016 Tax Court case. And, if you want to take a look at it and laugh, it’s a good case because this guy, Neiman, did everything wrong. Everything wrong right? He set up an IRA LLC. He transacted with himself. He kind of treated the LLC as his own. So, it’s a good case to look at what not to do, because this guy did it all wrong. Clearly, he wasn’t one of my clients. Literally, he treated the LLC as his own personal piggy bank. You can’t do that. Okay? So, if you take away anything from this podcast, remember, the IRA owns the LLC – you manage it. You do not own it!
So, If you invest $100,000 in your IRA LLC and you buy the next great Google, and that $100,000 goes to $20 million, that money doesn’t go to you. It goes to your IRA. Yes, ultimately, you can take a distribution and put that money in your pocket, but it could be subject to tax. If it’s a Roth IRA and so long as the Roth has been open five years and you’re over 59 and a half, you can just pull the money out tax free. But, if you’re not, you would have to pay the corresponding tax and potential penalty. So, that’s the most important thing to remember. The IRA owns the LLC. You manage it and make decisions on behalf of the IRA, but all the profits and losses go to the IRA, before they can go to you. That means if there’s expenses related to the LLC, whether it’s paying a contract or paying taxes, whatever, you need to use the LLC funds. Do not use the LLC to pay off personal expenses, like your mortgage or go on vacation. Do not do that. You need to keep the IRA LLC and you totally separated. It’s like Superman and Kryptonite – do not mix it. It’s very important. If you don’t believe me, read this Neiman case, and you’ll see what can go horribly wrong, and he ended up just saying, okay, I did everything wrong. It’s prohibited. Just be done with it. And that’s what happened. But, it didn’t have to be that way. If he got the right advice, he would have been able to use the IRA LLC properly; do his investments, make sure they’re in the IRA, and maintained the tax-exempt status of that investment. But, he didn’t.
So that’s it. There’s not a lot of things that can go wrong with the checkbook control, okay? It’s really simple. It’s not something that you need to stress about. And if you do stress, then don’t worry, we’re here to help you. Our team has the expertise to help you navigate these rules, but you need to understand 4975.
And the last thing I want to talk about is UBIT. Okay? Or UBTI, unrelated business taxable income. That’s really the biggest pitfall, and I saved it for last, that people fall into. Now, UBTI is only triggered in three instances. Use a margin loan to buy stock. Use a non-recourse loan to buy real estate. Or your IRA LLC invests in an active trade or business, like a restaurant or bar, that’s operated through an LLC. So, if you invest in a business that’s operated through a corporation, like Tesla or Apple, 99.9% of all publicly traded companies are corps. But, even if you invest in your buddy’s business and it’s a C corp, there’s no UBIT, okay? So, you don’t have to worry about UBIT. It’s only if you invest in a business that’s operated through an LLC or partnership. Then, if there’s $1,000 or more of net income that’s allocated to your IRA, you potentially have UBIT, unrelated business income tax. The IRA pays the tax, not you personally. It’s filed on a Form 990-T, as in Thomas, okay, and we can assist you with that. You generally get an EIN for your IRA, and you just pay the tax from the IRA.
UBIT is an ugly four-letter word; used that many times. Don’t want to get triggered with UBIT. But, sometimes you have a choice. If you’re investing in a real estate fund; most real estate funds are going to have leverage, and we know if there’s more than net $1,000 of gain, you’re going to get hit with UBIT. Now, some real estate deals don’t have gains in the first few years because of all the related expenses, depreciation. But, in later years it could, and if that loan is still outstanding, that capital gains deal that you thought would go tax-free to the IRA could be subject to this 37% tax, the highest tax rate in 2022. UBIT tax rate follows the trust tax rates, which can go as high as 22%, excuse me, 37%, and that threshold is hit at a very low level around $15 to $18,000. So, it’s a really ugly tax.
And again, it only gets triggered in three instances: use a non-recourse margin loan to buy stock, non-recourse loan to buy real estate, you invest your IRA in an active trade or business, like a restaurant, a hotel, consulting company. C Corps block it. So, sometimes, if you invest in a real estate fund or a private equity, venture capital fund, they will have an offshore C Corp blocker, like a Cayman Island Corp; which your IRA will invest in and then the Cayman Island Corp. will invest into the US fund, and that will block the UBIT, right? Because it’s a corp, and since it’s a foreign corp, you’re not going to get hit with the 21% corporate tax. So, there are some wiggle ways out of it and some maneuvering that could be done.
Another way to get around it is you can structure your investment into a business as a loan and not an equity investment. The upside is the interest from the loan is tax-exempt; it’s not subject to UBIT. But, obviously, a loan doesn’t have the upside of equity. When you own something, you have equity. And for example, if you were the first investor in Facebook and you put $500 grand in, that’s probably worth hundreds of millions of dollars; where if you lent Mark Zuckerberg $100,000 at 20% interest, that’s all you’re getting, $120,000 or so back; that’s it. Obviously, equity has more upside, but it could trigger UBIT. In some passive categories of income, like rental income, real estate rental income, capital gains, interest, dividends, royalties, are not subject to UBIT.
It’s only these three instances: use a margin loan to buy stocks, non-recourse loan to buy real estate, you invest in an active business through a pass-through entity using an IRA.
Now, one last exemption; not in the IRA world, it’s in the 401(k) world. So, if you’re a real estate person and you really want to use leverage, who doesn’t, who doesn’t like using other people’s money? I think every great real estate developer does that, or investor. If you have a 401(k), if you use a 401(k) instead of an IRA, or if you’re self-employed and get in a Solo 401(k), you could take advantage of an exemption under 514(c)(9). Use a non-recourse loan to buy real estate and pay no, UBIT taxes. Zip. Zero. Whereas, if you did it in IRA, you’d be subject to that potentially, 37%, tax. So it’s another really great segue.
It won’t help you block the UBIT if you invest in an active trade or business, like a restaurant, through an LLC. But, for using nonrecourse loan to buy real estate, the 401(k) versus the IRA is far more tax advantageous because of the exemption under 514(c)(9) blocking UBIT for corps, for 401(k)s, but unfortunately, the IRA doesn’t have that same exemption as 401(k)s do, under 514(c)(9).
So, that’s kind of the stuff to keep in mind. Just a final recap. Remember prohibited transactions; remember UBIT; remember no credit cards, right? Remember, set up the LLC, probably where the real estate’s located, or kind of where you reside, if you’re not doing real estate. If you’re in California, you need to think twice because of the franchise fee. Be super careful when you are the manager of the LLC writing checks; make sure those checks are going to third parties, not yourself or any disqualified person. Do not use this as a piggy bank. If you don’t trust me, you can look at the Neiman case, it’s a 2016-11 Tax Court case, and you can kind of read about all the mistakes that individual did.
One other thing, if you form the LLC, each year, you’re going to need to keep it in good standing. The fee can be anywhere from $0 to the $800 in California; most states it’s generally from $50-150. Pay that out of your LLC, try to pay it out of your LLC, don’t pay it personally. And it’s just an annual fee. It’s not a tax return, it’s an annual fee.
Single member IRA LLC does not file a tax return. If you have a multiple member LLC, it’s a partnership, two or more parties, IRA, individual, two IRAs, five IRAs own the LLC, you’re going to have to file 1065 and also state-related partnership return. Okay? So just remember that, and obviously think about using our consultant service if you are a client. It’s only open to clients. We will help you stay in the loop. You’ll get weekly newsletters, you’ll get updates, you’ll get new documents, and you’ll be kept abreast of any changes, whether it’s new legislation, new case law, anything that impacts your Self-Directed IRA LLC.
So, hope you guys enjoyed this. If you don’t have an IRA LLC, well, hopefully at least it’s educational. If you have one, hopefully, it’s just kind of a good refresher. I’m sure if you’re a client of IRA Financial, you know about all these rules and you’re pretty much an expert. But, it’s always good to get a refresher, right? Can’t hurt. So, hopefully, the last 15 or so minutes were worthwhile, and now going forward, you kind of know what to at least issue spot. That’s the key. Just issue spot. You don’t need to solve your own problems. But, if you’re doing an investment, I always tell clients, call us, right? If you’re unsure. If it’s a slam dunk investment, like you’re investing in a third-party business or fund, you should be thinking of UBIT. And if you want to dive deeper, call us, email us, we will assist you. We will get you to the right place. If we have to reach out to attorneys, on staff or off, to get you at least an answer that makes sense based off your facts. So, use us, okay? And just remember, you don’t own the LLC, the IRA does. Do not treat this as a piggy bank. Use it for what it’s worth, as an investment vehicle, to give you limited liability protection, privacy, and give you just a little bit more control over the process. You can get investments done quicker and easier.
That’s it. So, I appreciate you guys spending some time with me today. Thanks for listening. If you’re watching on YouTube, thank you very much. Hope your summer is going great. And we’re getting close to 350; this is, I think 348 or so, so pretty cool. We’ll do something special for 350, episode number 350, but really couldn’t do it without all you; really appreciate the Self-Directed IRA Nation. You guys are awesome. And, take care, talk to everyone again next week.