The use of a limited liability company (LLC) has become a popular option for many retirement account investors seeking to make Self-Directed IRA investments. This article will explain the tax treatment of an LLC and detail why using it to make investments has become so popular for many retirement account investors. Also, it will explain if the IRA LLC gets taxed twice or not.
- The use of an LLC for Self-Directed IRA investors is popular for the control it offers
- An LLC does not have an entity-level tax – it is passed to its members
- An LLC that is owned by an IRA is not taxable until the funds are distributed from the plan
What is an LLC?
Limited liability companies 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 benefit of a corporation and the single level of taxation of a partnership. The owners, not the entity, are then responsible for the payment of tax, if any.
LLCs are owned by investors, also known as members. The company is typically managed by a designated member or group of members. Like shareholders of a corporation, the members’ liability is limited to the amount of their investment. For tax purposes, LLCs with more than one owner are treated as partnerships, and LLCs with one owner are disregarded. In both cases, the LLC income is taxed to the owner directly without any entity level tax.
An LLC offers all its members limited liability without restrictions on their participation in the venture. Furthermore, ownership interests in the LLC can be freely transferable if it’s members so choose. For these reasons, it is significantly more common for a new business to select the LLC entity form when starting a new business and not a C corporation.
The following are the main reasons why the use of an LLC has become the most popular entity type for new businesses and investors:
- Easy and inexpensive to form
- Recognized by all states
- Limited liability for all members
- One level of tax for federal income tax and state income tax purposes (in most cases)
- Pass-through of business losses to the member(s)
- Can utilize a corporate management structure
- Can have one member or multiple members
- Flexibility in distributing cash to the members
- Flexibility in allocating profits/losses to the members
- Flexibility in conducting business affairs
- Can exist indefinitely
LLC Tax Treatment
An LLC’s income passes through to its members, who report the income on their personal income tax returns. For tax purposes, a single member LLC is treated as a sole proprietorship, and a multi-member LLC is treated as a partnership.
The LLC itself does not ordinarily pay federal income taxes on its own behalf as a separate entity (some states impose taxes on LLCs as a separate entity). However, an LLC is required to file an annual informational tax return with the IRS.
It is possible for an LLC to elect to be taxed in the same manner as a C corporation (double taxation), but this is generally not advisable, as this election will last for a minimum of five (5) years and as there may be tax consequences for switching back to pass-through taxation.
In the case of a Self-Directed IRA LLC, the member of the LLC is the IRA, which is exempt from taxation pursuant to IRC Sections 501(a) and 408. If the LLC member is a traditional IRA, the IRA owner would be subject to tax on IRA distributions. Whereas, if the member of the LLC is a Roth IRA, qualified distributions would be tax-free.
Single Member vs. Multiple-Member LLC
The member of a single member limited liability company will benefit from the limited liability associated with an LLC, as well as the benefit of a single level of tax and the flow-through of business losses. However, some states, such as Florida, do impose limitations on this protection.
For tax purposes, a single member LLC is treated as a sole proprietorship and will not require a separate federal income tax filing. The income tax can be reported on schedule C of the member’s personal income tax return (Form 1040). For federal income tax purposes, it is disregarded. Therefore, if it is treated as a disregarded entity for federal income tax purposes, the income of the LLC is taxed to the owner directly, without any entity level tax. In addition, LLC losses would flow through to the member and the member could deduct his, her, or its ratable share of the losses generated. However, in the case of a Self-Directed IRA LLC, since the sole member of the LLC is an IRA, no tax would generally be imposed on the flow through of the LLC income or gains.
A multi-member LLC can be either a partnership or a corporation, including an S corporation. To be treated as a corporation, an LLC must file a Form 8832, Entity Classification Election, and elect to be taxed as a corporation. An LLC owned by an IRA should not elect S Corporation status since an IRA is not permitted to own S Corporation stock. A multi-member LLC that does not so elect will be classified by the IRS as a partnership. A single member LLC can be either a corporation or a single member “disregarded entity.”
The Self-Directed IRA LLC
The Self-Directed IRA LLC with “checkbook control” has quickly become the most popular vehicle for investors looking to make alternative assets investments, such as rental real estate, that require a high frequency of transactions. Under the Checkbook IRA format, an LLC is created, which is funded and owned by the IRA and managed by the IRA holder. This allows one to eliminate certain costs and delays often associated with using a full-service IRA custodian. The Checkbook IRA structure allows the investor to act quickly when the right investment opportunity presents itself cost effectively and without delay.
Advantages of the Self-Directed IRA LLC
- Limited liability protection
- No entity level tax
- No double taxation
- Greater control as manager of the LLC
- Investment diversification
- Ability to make investments quick
An LLC is treated as a pass-through entity for federal income tax purposes. As a result, an LLC does not have an entity level tax and only the member of the LLC would be subject to tax on the allocated pass-through income. However, in the case of an LLC that is owned by your Self-Directed IRA, it is generally not subject to any tax at the entity or member level.