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Tax Treatment of Self-Directed IRA LLC Distributions

Tax Treatment of Self-Directed IRA LLC Distributions

When it comes to using a Self-directed IRA LLC, also known, as a Checkbook Control IRA, all LLC distributions would flow to the member of the LLC, an IRA, which is tax-exempt pursuant to Internal Revenue Code (IRC) Section 408. Generally, the LLC and its members do not recognize gain or loss on a distribution of cash or property.  Gain or loss would only be recognized when deferral is impractical or when it would result in a change of character.

In other words, in the case of an LLC, where the member is a taxable individual or entity, the member would be subject to tax on the pro rata share of LLC net income.  However, since an IRA is generally not subject to tax since it is a retirement account, LLC net profit allocated to an IRA would not be subject to any LLC entity level tax or member level tax.

Key Points
  • The Self Directed IRA LLC offers many benefits over a regular IRA
  • The IRA LLC is generally not taxed while the asset remains in the plan
  • Recognition of gains and losses and nonrecognition of gains act differently inside an IRA LLC

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 where the IRA owner is seeking a high degree of control.

Under the Checkbook IRA set-up, a limited liability company is established, which is funded and owned by the IRA and managed by the IRA owner. The Checkbook IRA LLC structure allows the investor to act quickly when the right investment opportunity presents itself cost effectively and without delay. It also offers a greater degree of privacy than the standard IRA since the investment is made in the name of the LLC versus in the name of the IRA itself.

In addition, using an LLC owned by the IRA provides limited liability protection to the IRA owner on all IRA assets owned outside of the LLC. It is extremely important to have an LLC operating agreement so that the manner in which cash will be distributed to the members is well documented.

In sum, these are the major advantages when using an LLC:

  1. Limited liability protection for IRA assets outside of the LLC
  2. Privacy – investments are made in the name of the LLC versus the IRA
  3. Greater control for the IRA owner as manager of the LLC

Related: Alternative Assets & Self-Directed IRA Custodians

Tax Basis for LLC Nonrecognition of Gain

IRC Section 731 provides for nonrecognition of gain or loss to all parties when LLC property or money is distributed. In the case of a cash distribution, the distributee simply reduces his/her outside basis by the amount of money received, preserving any inherent gain or loss in his or her LLC interest.  A member’s initial outside basis equals the amount of cash the member contributes to the LLC, the basis the member had in any property contributed, and the member’s share of the LLC’s debt.

In the case of a property distribution, the distributee’s outside basis is allocated among both the property or properties received and his/her continuing interest in the LLC (if any).  Any pre-distribution inherent gain or loss in the distributee’s LLC interest is preserved either in the property received or in his/her continuing interest in the LLC.  Gain or loss is recognized only when deferral is impractical or would change the character of income or loss.

Learn More: Self-Directed IRA Custodian Controlled vs. Checkbook Control

Recognition of Gain

Distributions generally trigger a gain if a member receives a distribution of money in excess of his/her outside basis or when an LLC with “hot assets” makes a non-pro rata distribution.  In general, “hot assets” are defined as unrealized receivables or inventory of the LLC.  However, when an LLC distributes property to a member, the inherent gain or loss in the member’s interest can be preserved by adjusting the basis of the distributed property.

Recognition of Loss

A member recognizes a loss only in a liquidating distribution, and then only under certain circumstances.  A loss is never recognized in a current (non-liquidating) distribution.  In a situation where a liquidating distribution consists only of cash, unrealized receivables and inventory, the distributee will recognize a capital loss if his/her outside basis exceeds the sum of money distributed plus the basis he/she takes in the distributed property.  This is because, in this situation, the distributee receives no capital asset in which to defer the loss.

However, in the case of a Self-Directed IRA LLC, net losses do not have any tax value since an IRA does not pay tax and is generally tax exempt.  The only instance where a loss involving a Self-Directed IRA LLC can have a tax benefit is in the case of the Unrelated Business Taxable Income tax, also known as UBTI or UBIT.

UBTI & Self-Directed IRA LLC Losses

For many retirement account investors, there is no reason that they would have ever heard of the UBTI tax. The main reason for this is that the majority of IRA or 401(k) plan investors invest in traditional types of investments, such as stocks.

In general, the UBTI tax is triggered in three types of investment categories involving retirement accounts:

  1. Using margin to buy stocks or securities
  2. Using a nonrecourse loan to acquire real estate (there is an exemption for 401(k) plans under certain conditions). The loan cannot be guaranteed by the IRA owner pursuant to the IRS prohibited transaction rules.
  3. Investing in an active trade or business operated through an LLC or pass-through entity, such as a partnership.

For 2022, the highest UBTI tax rate is 37%.  When an IRA uses an LLC to make an investment that triggers the UBTI, losses allocated to the IRA can be used to offset future net income subject to the UBTI tax.  It is good practice for the IRA to file IRS Form 990-T in years when the IRA is allocated losses from an activity that would be subject to the UBTI to lock in the loss carry-forward potential.

Conclusion

The tax advantage of using an LLC to make investments is that there is no entity level federal income tax, like a corporation, and only a member-level tax.  However, since an IRA is exempt from tax, in most cases, LLC net income allocated to an IRA would not be subject to federal income tax.  The only exception would be in the case of the application of the UBTI tax.

As we also mentioned, using an LLC for your Self-Directed IRA has many other advantages, including more control, better privacy, and limited liability protection. It might be wise to talk to a tax professional about the IRA LLC structure before self-directing your retirement funds.

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