One of the most common questions for any potential Self-Directed IRA LLC investor who is a resident of the state of California, or is seeking to invest in the state, is how can they avoid the minimum California annual corporate franchise fee of $800. This article will examine how the California franchise fee impacts the Self-Directed IRA LLC solution and some of the solutions for minimizing its impact on investors.
- Virtually every state requires an annual fee for an LLC
- California’s annual franchise fee is a whopping $800
- There are options for Self-Directed IRA investors looking to eliminate the fee
What is a Self-Directed IRA LLC?
There are two types of Self-Directed IRAs: (i) full-service IRA and (ii) Checkbook Control IRA LLC.
With a full-service Self-Directed IRA, a special IRA custodian will serve as the custodian of the IRA that will allow the IRA to invest in alternative assets, such as real estate. The IRA funds are generally held with the IRA custodian and at the IRA owner’s sole direction, the custodian will make the investment. Since an IRA is tax-exempt, in general, all income and gains will flow back to the IRA without tax.
Whereas, with a Self-Directed IRA LLC with “checkbook control,” a limited liability company (LLC) is created, funded, and owned by the IRA and managed by the IRA owner. The LLC can be owned by one or more IRAs. It offers the IRA owner limited liability protection and allows one to act quickly when the right investment opportunity presents itself cost effectively and without delay. Since an LLC is taxed as a pass-through entity, all LLC income will flow back to the IRA without tax.
LLC State Formation Rules
All 50 states have LLC statutes and recognize the LLC entity. Every state imposes a fee to set up an LLC, however, the annual LLC state fees vary by state. Some states, such as Missouri, do not have an annual state filing fee; the majority of states impose an annual LLC fee of between $50-$150. Although, Massachusetts has an annual LLC fee of $500. However, California has the highest annual LLC filing fees because of its franchise fee.
California LLC Annual Fee/Franchise Fees
A California LLC must file a Biennial Report on Form LLC-E012R. The Biennial Report may be filed five (5) months prior to the filing month. The report is due by the end of the filing month. California LLC’s and foreign California LLC’s registered to do business in California are required to file an Initial Report (California Statement of information) within 90 days of the date the LLC was formed. Typically, you will receive the Initial Report mailed back to you with your completed file stamped “filing.”
Every LLC that is doing business or organized in California must pay an annual tax of $800. In addition to the minimum franchise fee, LLCs are subject to a gross receipts-based annual fee, regardless of their federal entity classification. The fee is based on a graduated scale and ranges from $900 for LLCs with receipts from California between $250,000 and $500,000 to $11,790 for LLCs with California receipts more than $5 million.
This yearly tax will be due even if the LLC is passive and not actually conducting business. The LLC manager will have until the 15th day of the 4th month from the date the LLC was filed with the Secretary of State to pay the first-year annual tax. The subsequent annual tax payments will continue to be due on the 15th day of the 4th month of the taxable year.
California Annual Franchise Fees & The IRA LLC
As the most populous state, California is obviously a very popular state from an investment perspective. Hence, many investors will look to investment opportunities in California, such a real estate or otherwise. With the emergence of the IRA LLC as a popular investment structure for investors, finding a way to limit the application of the California LLC annual franchise fee of $800 becomes paramount. Since the fee is far and away the largest annual LLC fee in the country, and the fact that the state of California is super aggressive in protecting its state tax base, finding solutions to minimize the annual California LLC franchise fees has become a popular topic.
California State Franchise Tax in a Nutshell
In general, for an LLC to be subject to taxation in the state, the LLC must have a nexus or connection to the state. For most LLC’s that is as simple as having an office or employee in the state. However, in the case of a passive investment LLC, most states will only deem the LLC to have a nexus to the state if the LLC owns or leases real estate. Most states will not deem an LLC to have a connection to the state if its only link is a passive investment into a business in the state or via a loan to a resident of the state. Then there is the case of California.
The state of California is by far the most aggressive state when it comes to claiming an LLC has nexus to the state. For example, California takes the position as long as an LLC has a California resident as manager of the LLC, even if the LLC is formed in a different state and is not doing business in California, the state of California takes the position that the LLC has nexus to the state and is subject to the California LLC franchise fee. For example, in the case of a Self-Directed IRA LLC where the IRA is the sole owner of the LLC, if the manager of the LLC is a California resident (the IRA owner), even if the LLC is formed in a different state and is not doing any investments in California, simply because the manager is a California resident, the LLC would be subject to the California annual franchise fee.
Reducing the Franchise Tax
The following are the most common solutions for eliminating or reducing the impact of the annual California minimum franchise fee
Full-Service Self-Directed IRA
Using a full-service Self-Directed IRA, as described above, would allow one to make investments in California without being subject to the annual franchise fee. Of course, the full-service option would not provide the IRA owner with limited liability protection.
One of the other downsides is that the IRA investment will be in the name of the IRA. For example, title to an IRA investment into an investment fund or real estate would be as follows: IRA Financial Trust Custodian of the John Doe IRA. Whereas if the IRA owner used an LLC to make the investment, title of the investment would be in the name of the LLC and not the IRA. Some investors wish for the anonymity the LLC provides.
Lastly, since you do not have checkbook control, you must go through your custodian for all IRA-related transactions.
Related: California Self-Directed IRA
The Solo 401(k) Plan
The Solo 401(k) plan has become known as the most popular retirement plan for the self-employed or small business owner with no full-time employees. The plan can be adopted by a sole proprietor or any type of business entity. The trustee of the plan is typically the business owner.
A Solo 401(k) plan can be established with “self-directed” features, such as a Self-Directed IRA, giving you the opportunity to invest in alternative assets, such as real estate. In addition, it has high annual contribution limits, the $50,000 tax-free loan option, powerful Roth options, and strong asset and creditor protection.
For a resident of California, establishing a Solo 401(k) plan would allow the individual to invest in alternative assets in the state of California without being subject to the annual California franchise fee. Of course, you must meet the eligibility requirements to consider this option.
Revocable Grantor Trust
There is a belief by some that establishing a trust instead of an LLC will solve all state California problems for IRA LLC investors. Unfortunately, that is not the case. A California trust should technically not be subject to the annual California franchise fee, however, the State of California will impose a state tax on grantor revocable trusts that operate in the state. A trust is subject to tax in California “if the fiduciary or beneficiary – the trustee of the trust – (other than a beneficiary whose interest in such trust is contingent) is a resident, regardless of the residence of the settlor.” See Cal. Rev. & Tax 1774(a).
Hence, even if the IRA would be the grantor settlor of the trust, the trustee, as the trust fiduciary, would likely have to file a California state tax return and could even be subject to California state tax. The bottom line is that trust tax rules are very complex and vary by state. Hence, a trust in Florida will operate under different rules than a trust from Iowa or California.
California is one of the most beautiful states but also one of the most expensive to live in. The saying goes you get what you pay for. However, in the case of a Self-Directed IRA LLC, which is tax-exempt, being subject to an annual $800 franchise fee becomes a financial headache. For some investors who wish to have an LLC, the $800 California minimum franchise fee is a cost of doing business and something they will put up with.
However, for other IRA investors, the full-service option is a viable solution to eliminating the franchise fee. If you are self-employed, not only is the Solo 401(k) a great retirement plan, but it will also help eliminate the annual fee. The trust solution could be an option for reducing the impact of the $800 fee, but remember that state trust rules are complex and could trigger additional state tax and filing requirements.