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Tax Treatment of Self-Directed IRA LLCs

Tax Treatment of Self-Directed IRA LLCs
3 Minute Read

The use of a limited liability company (LLC), that is wholly owned by an IRA, has become increasingly popular over the last 25 years.  The primary reason Self-Directed IRA investors have sought to use an LLC as a special purpose vehicle to make IRA investments is because of its flow-though tax treatment and availability of limited liability protection. The following will detail the tax treatment of Self-Directed IRA LLCs and how to minimize your tax hit.

Key Points
  • An LLC offers you liability protection and more freedom
  • When you invest using a Self-Directed IRA LLC, you don’t need to ask for custodial consent
  • The LLC itself is not required to pay taxes; the owner(s) of the entity is.

What is an LLC?

LLCs are established pursuant to 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.  While other business entities also provide protection from creditors, an LLC possesses the important characteristics of being a “pass-through” entity for federal (and in most cases state) income tax purposes. 

A pass-through entity is an entity in which all taxable gains and losses are passed through to the owners of the entity.  The owners, not the entity, are then liable for the payment of the tax.

The company’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.

LLC Tax Treatment

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).  For example, if an LLC earns $100 of net profits, the LLC would not be subject to an entity level tax on that income, and only the LLC member would be subject to the tax.

However, in the case of a Self-Directed IRA LLC, the IRA is the member of the LLC and an IRA is exempt from federal income taxation since it is treated as a tax-exempt trust.  Whereas, if a C Corporation earned $100 of net income, the $100 would be subject to a corporate level tax and then the net amount (retained earnings) could be sent to the shareholder as a taxable dividend.  This is known as the C corporation two-level tax.

Self-Directed IRA LLC Tax Return Filings

A single member LLC is known as a disregarded entity and is not required to file a federal income tax return.  Whereas, an LLC that is owned by two or more members, including IRAs, is treated as a partnership for federal income tax purposes and is required to file an annual informational tax return with the Internal Revenue Service (IRS Form 1065) as well as a state partnership return.

It is possible for an LLC, especially a Self-Directed IRA 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 there may be tax consequences for switching back to pass-through taxation.

How the Self-Directed IRA LLC Works

The checkbook control Self-Directed IRA has become a popular way for real estate and other IRA investors to gain more control and protection when making an investment with retirement funds.  Like the term Self-Directed IRA, the terms Checkbook Control IRA or Checkbook IRA is not a legal term or even a term you will find in the tax code.

A Checkbook IRA is basically a type of Self-Directed IRA that uses an LLC or other entity to invest while having the entity managed or controlled by the IRA owner.  Ever since the court in Swanson V. Commissioner 106 T.C. 76 (1996) held that the funding of a new entity by an IRA managed by the IRA owner was not a prohibited transaction pursuant to Code Section 4975, IRA investors have turned to the Checkbook IRA as a way to gain greater control and better protect their IRA assets.

How the Checkbook IRA Works

Checkbook IRA Steps
(click to enlarge)

Conclusion

The flow-through tax advantages and limited liability protection offered by an LLC offers Self-Directed IRA investors multiple advantages.  In addition, since the IRA investment is made in the name of the LLC and not the IRA, the IRA owner can also benefit from greater privacy and investment control.

To be clear, an LLC is not required for a Self-Directed IRA. However, for many investors, especially those who perform a number of transactions, it’s the only way to go! Like most things, it boils down to each individual, and his or her investment goals.

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[10:44 PM] Valerie Marszalek-Boik