Over the years there has been interest by Self-Directed IRA investors to gain checkbook control without the cost of using an LLC. Most states charge moderate LLC filing fees and annual fees, and some states, like California, impose a high annual franchise fees on all CA LLCs ($800). For this reason, some CA residents have looked for an alternative to using an LLC to gain checkbook control. For some states, like FL, that do not have any state income tax, using a trust can be alternative to using an LLC for a Self-Directed IRA, however, the investor would not be able to avail themselves of any limited liability protection, which is important for many real estate investors. Plus, almost all states, even those that do not have a state income tax, require trusts to file a state tax return, on top of the IRS Form 1041.
- For most Self-Directed IRA, an LLC is better than a trust
- LLCs offer protection for your investments
- Trusts have annual filing requirements
Over ten years ago, IRA Financial was one of the first Self-Directed IRA providers to offer clients the ability to use a trust instead of an LLC for checkbook control IRA investments. However, there are a number of important reasons why an LLC makes far more sense in the Self-Directed IRA context than a trust.
Before I get into the advantages and disadvantages of using a trust versus an LLC with a Self-Directed IRA, it is important to understand some basis trust terms.
What is a Trust?
A trust is a legal vehicle that allows a third party, a trustee, to hold and direct assets in a trust fund on behalf of a beneficiary. You need three parties to legally have a trust:
The trust is not filed with the state, but is simply an agreement between three parties
Can an IRA be a Grantor of a Trust?
It appears that an IRA can be a grantor of a trust. The grantor is the party contributing the asset to the trust. The trustee is the party that manages the trust’s assets and the beneficiary is the party that receives the income or assets of the trust.
In the case of a Self-Directed IRA, the IRA trust company, the custodian for the benefit of the IRA, will be the grantor and beneficiary of the trust and the IRA owner would be the trustee. The trust agreement would details the terms of the trust and its rules.
Type of Grantor Trusts
Trusts can generally be revocable or non-revocable. In the case of a Self-Directed IRA, the trust would be revocable.
Federal Tax Treatment
A grantor trust is taxed similarly to a single member LLC and there would be no federal income tax liability, except that it still has a federal income tax filing requirement – Form 1041. The income or assets of the trusts are reported by the grantor, in this case the IRA, which is a tax-exempt party. However, unlike a single member LLC, where no federal income tax return is required to be filed, for a grantor trust, IRS Form 1041 must be filed on an annual basis. The IRS Form 1041 does not have to completed in full, but it must be partly completed and submitted to the IRS annually.
State Tax Treatments
Depending on the state where the trust is formed, trustee resides, or trust assets are located, the state may impose state taxation on the trust, plus require a trust return. The complexities involved in the state tax treatment of trusts is one of the main reasons why using a trust for self-directed IRA purposes is unpopular. For example, California will impose state tax and require the trust to file a state return if the trustee resides in California or if the trust as California source income. The same goes for the state of New York. Some states, like Florida that do not have a state tax regime, will not impose any state tax or filing on a Florida trust, but the trust will still have a federal tax filing requirement under IRS Form 1041.
The difficulty with the state taxation of trusts is that every state is different and every state has different trust rules and taxation principles. Whereas, the state rules surrounding LLC are far more uniform and consistent. It is for this reason that LLCs are seemingly a better option than trusts for most self-directed IRA investors.
Advantages of using a Trust vs an LLC
The main advantage of using a trust versus an LLC for a Self-Directed IRA investor is the ability to gain checkbook control without having to incur costs for state LLC establishment. A trust is not a legal entity formed under state law and can be created by simply having an agreement between three parties: a grantor, trustee, and beneficiary. In addition, the trust can have its own EIN and can use a bank account managed by the trustee to make self-directed IRA investments. However, the majority of states have moderate LLC filing and annual fees, and most are under $150. Furthermore, the state with the highest LLC annual fees, California, will also impose similar fees and filing obligations on California state trusts.
Disadvantages of using a Trust vs an LLC
The two primary disadvantages of using a trust versus an LLC for a Self-Directed IRA investor are (i) loss of limited liability protection, and (ii) annual tax filing obligations.
The advantages of using an LLC to make investments is that the LLC protects all assets outside of the LLC from creditor attack. Hence, a creditor of an IRA LLC can only attack the IRA assets in the LLC and not any of the IRA owner’s other IRA assets. Whereas, a trust does not offer any limited liability protection, although it does offer better privacy since it is quite difficult to identify the grantor or beneficiaries of a trust since the trust agreement is not filed with any state authority.
Because each state generally has its own trust rules and tax regime, using a trust puts a lot of administrative responsibility on the trustee of the trust, the IRA owner, to make sure the trust is satisfying all state trust reporting and filing requirements.
In general, an IRA can be the grantor of a trust and a trust can technically be used as a vehicle for a Self-Directed IRA investor to gain checkbook control. However, the federal and state trust tax rules and requirements and the lack of limited liability protection make the LLC the smarter choice for most Self-Directed IRA investors.
For more information, please contact one of our IRA experts @ 800.472.0646.