Over the last several years, there has been a growing trend to use LLCs to start businesses and for investment ventures. There are over 22 million LLCs in the United States. In comparison, there are approximately 2 million traditional C Corporations, and approximately 24 million sole proprietorships. IRS statistics show a year-over-year increase in domestic LLCs since 2004. This article will explain what an LLC is and why it is so popular for businesses and retirement accounts. It will then explore the emergence of the Self-Directed IRA LLC for investors and the types of IRA investments that can benefit from the use of an LLC.
- The use of an LLC for Self-Directed IRA has become increasingly popular
- Although an LLC is not needed, it offers one with protection, privacy and control
- Investments that require frequent transactions benefit from the Checkbook IRA LLC structure
What is an LLC?
A Limited Liability Company (LLC) is a business structure allowed by state statute. The LLC is so popular because it combines the corporate advantages of a corporation with the pass-through tax advantages of a partnership. Owners of an LLC are called members. Most states do not restrict ownership, so members may include individuals, corporations, other LLCs, and even retirement accounts; there is no maximum number of members. Most states also permit “single-member” LLCs, those having only one owner. Obviously, an LLC provides its owners with limited liability protection.
A domestic LLC with at least two members is classified as a partnership for federal income tax purposes. Whereas, an LLC with only one member is treated as an entity disregarded as separate from its owner. An LLC has one layer of tax at the member lever. On the other hand, a C corporation has two layers of taxation, an entity level tax and a shareholder level tax. For example, if a C corporation generated $1,000 of net income, it would be subject to a 21% corporate level tax, and if the retained earnings are sent to the shareholder as a dividend, the shareholder would be subject to tax on the dividend. The shareholder tax would be based on whether the dividend is from a private or public company (qualified).
Why Use an LLC?
As discussed above, the primary reasons to use an LLC over a corporation when making an investment are limited liability protection, and pass-through taxation. Whereas, the main advantage of using an LLC versus a sole proprietorship is the limited liability protection.
Protecting one’s assets outside of the LLC is extremely important to many business owners and investors. This is why using an LLC as a shield against a creditor attack of the LLCs owner’s assets outside of the LLC is so important.
What is a Self-Directed IRA?
As mentioned, over the last 25 years or so, a significant number of Self-Directed IRA investors have elected to use an LLC wholly owned by the IRA and managed by the IRA owner. So what exactly is a Self-Directed IRA?
Since IRAs were created by ERISA in 1974, the IRS rules have permitted a retirement investor to use retirement funds to make almost any type of investment, aside generally from any investment involving a disqualified person. The tax code never distinguished between an IRA that could invest in equities and an IRA that could invest in alternative assets. In fact, the IRA that was created by ERISA permits the IRA to invest in almost any type of investment from stocks to real estate.
The term Self-Directed IRA is not a legal term. You will not find it in the tax code. In general, so long as the IRA is not invested in life insurance, collectibles, or any investment personally benefiting the IRA owner or another disqualified person, the investment can be made.
Two Self-Directed IRA Options
In general, pursuant to Internal Revenue Code Section 408, an IRA can be established and administered by a bank, financial institution, or authorized state-regulated trust company. An IRA trustee, also called a custodian, is the institution that administers the IRA plan. By law, every IRA must have a custodian or trustee.
The IRA custodian has the right to decide what types of IRS approved investments it will allow its IRA clients to invest in, such as real estate. Most banks and traditional financial institutions that offer IRAs only permit their IRA clients to invest in traditional assets, such as equities, mutual funds, and ETFs. On the other hand, a Self-Directed IRA custodian, such as IRA Financial Trust, allows IRA owners to invest in alternative asset investments, such as real estate. In addition, a Self-Directed IRA custodian does not offer investment advice or sell investments and is, thus, not treated as a fiduciary.
There are several reasons why an IRA owner would consider establishing an LLC as an investment vehicle. However, an LLC is not required to make an IRA investment. The following are the two common ways to use an IRA to make alternative asset investments.
Self-Directed IRA
In order to establish a Self-Directed IRA, the plan should be opened with a “special” Self-Directed IRA custodian, such as IRA Financial Trust Company. Even though ERISA never differentiated between an IRA that invests exclusively in traditional investments, and one that invests in alternative assets, traditional banks and financial institutions generally do not allow their IRA holders to invest in alternative assets for the simple reason that they don’t make any money from those investments.
The IRA custodian is essentially responsible for maintaining and administering the IRA. To this end, the IRA custodian is tasked with the responsibility of complying with all IRS reporting requirements with respect to the IRA, such as the filing of IRS Forms 5498 and 1099-R.
With a Self-Directed IRA, the custodian will serve as the custodian of the IRA and offers alternative asset investment options. Unlike a typical financial institution, most IRA custodians generate fees simply by opening and maintaining IRA accounts and do not offer any financial investment products. The IRA funds are generally held with the custodian and at the IRA owner’s sole direction, the custodian will then invest those funds. The investment is titled in the name of the IRA custodian for the benefit of the IRA owner.
For example, John Smith establishes an IRA with IRA Financial Trust to buy a home. John rolls over $100,000 from his former employer 401(k) plan tax free. John uploads the necessary real estate closing document on the IRA Financial app. IRA Financial processes the closing documents and signs the documents as follows: IRA FINANCIAL TRUST COMPANY CFBO JOHN SMITH IRA. IRA Financial then wires the funds to the seller and the IRA takes title to the property.
Self-Directed IRA LLC
The 1996 Tax Court case, Swanson v. Commissioner, 106 T.C. 76 (1996), facilitated the growth of the Self-Directed IRA industry by allowing IRAs to invest in entities owned by a retirement account and controlled by the IRA owner to make investments. With the growing popularity of LLCs, the Swanson case provided a track for how one could use a special purpose entity, wholly owned by an IRA, and managed by the IRA owner to make investments. The Self-Directed IRA LLC, also known as a Checkbook IRA, has become an enormously popular solution for real estate investors looking to use IRA funds to invest in alternative assets while also benefiting from the power of limited liability protection.
The LLC will have its own bank account that will be controlled by the IRA owner. Once the LLC is funded, the IRA owner, as manager of the LLC, will have the authority to make IRS-approved investments. In other words, you will have “checkbook control” over the IRA assets and will be able to make investments directly from your LLC bank account, which can be opened at any local bank. If there is an alternative investment you want to make – simply write a check or wire the funds straight from your IRA LLC bank account.
For example, Jane Smith establishes an IRA with IRA Financial Trust to buy a home in Texas. Jane rolls over $100,000 from his former employer 401(k) plan tax-free to IRA Financial Trust. Jane works with IRA Financial to establish an LLC in the state of Texas. She names the LLC JS Investments LLC. IRA Financial acquires a Tax EIN for the LLC and even provides an LLC operating agreement showing the IRA as owner and manager of the LLC.
IRA Financial then opens an LLC bank account for JS Investments LLC with Capital One bank, its banking partner. Funds are sent from the IRA to the LLC via the bank account at Capital One. Jane, as manager of the LLC, then wires the funds to the seller of the real estate. Title to the real estate will be titled in the name of the LLC.
Do I really Need an LLC for My Self-Directed IRA?
A Self-Directed IRA investor is not required to use an LLC to make an alternative asset investment. In fact, the majority of investors typically are made directly by the IRA into the underlying investment. There is no right or wrong answer as to whether one should use an LLC, however, the following is a helpful guide that describes the investments categories when an LLC is typically used.
Self-Directed IRA with No LLC
If you are looking to invest your IRA into an investment that is not expected to involve a high number of transactions, the LLC is typically not employed, such as:
- Private placement
- Investment fund
- Real estate fund
- Private business investments
- Debt fund
- Raw land
- Cryptocurrency
Self-Directed IRA LLC
The most popular reason why a Self-Directed IRA owner would use an LLC to invest is the limited liability protection. In addition, the use of an IRA LLC provides the IRA owner with a certain level of privacy since the investment is made in the name of the LLC and not their individual name. The most important reason an LLC is used is the greater control one has over the investment process. Investments can be made quickly and expenses are handled more efficiently.
The following are the most popular investments where a Self-Directed IRA investor will use an LLC to make an investment:
- Rental real estate
- Real estate flips
- Investment fund investments involving fund personnel
- Private business investments involving business management
- International real estate
- Investments requiring an entity, such as a real estate investment using a loan
- Cold wallet cryptocurrency investments
- Defi digital asset investments
Conclusion
The Swanson case set forth the path for Self-Directed IRA owners to use a special purpose entity, such as an LLC, to make investments. The fact that the LLC offers limited liability protection and pass-through tax treatment makes it a perfect vehicle for investors. In general, investments that involve a high frequency of transactions, have liability risk, or involve an IRA owner seeking more control or privacy, are well suited for the Checkbook IRA LLC solution.
