The ability to invest retirement funds in a newly established special purpose entity owned 100% by an IRA and managed by the IRA holder has been deemed legal by the Tax Court and IRS for over 18 years. However, only until recently, did the Tax Court confirm that the use of a newly established limited liability company (“LLC”) wholly owned by an IRA and managed by the IRA holder would not trigger a prohibited transaction. On October 2013, the Tax Court in T.L. Ellis, TC Memo. 2013-245, Dec. 59,674(M) (“TC Memo 2013-245”) held that establishing a special purpose limited liability company (“LLC”) to make an investment did not trigger a prohibited transaction, as a newly established LLC cannot be deemed a disqualified person pursuant to Internal Revenue Code Section 4975.
Tax Court Confirms Validity of Self-Directed IRA LLC Solution
The legality of the Checkbook IRA structure has not come under question since the IRS conceded that investing IRA funds in a wholly owned entity is not a prohibited transaction in the U.S. Tax Court case Swanson V. Commissioner 106 T.C. 76 (1996). The IRS later confirmed the ruling in Swanson by releasing IRS Field Service Advice Memorandum 200128011 (“FSA 200128011”).
A self-directed IRA is a type of IRA structure that allows the IRA holder (you) to have more control over your retirement funds. Unknown to some, not all self-directed IRAs are the same. It is well known that the IRS allows you to use your IRA to make traditional investments, such as stocks and mutual funds. It is not as well known that the IRS also allows you to use IRA funds to invest in real estate, precious metals, tax liens, private business and much more tax-free and penalty free! In fact, the IRS only prescribes a few restrictions on the type of investments that can be made using IRA funds.
A number of IRA custodians would like you to believe that the only way to use IRA funds to make non-traditional investments with your IRA is through a custodian controlled IRA account. However, beginning in the early 1990s, individuals began using special purpose entities wholly owned by their IRA to make investments. Investors wanted the ability to have more control over their IRA investments.
The idea of using an entity owned by an IRA to make investments was first reviewed by the Tax Court in Swanson V. Commissioner 106 T.C. 76 (1996). In the Swanson case, Mr. Swanson established a special entity wholly owned by the IRA and managed by Mr. Swanson to make an investment. The IRS attacked the transaction and argues the establishment of the special purpose entity owned by the IRA triggered an IRS prohibited transaction. The IRS quickly conceded the prohibited transaction issue in the Swanson case on July 12, ’93 when it filed a notice of no objection to an earlier motion by the Swansons for partial summary judgment on that issue. Nevertheless the Tax Court rules against the IRS and help for Mr. Swanson. The Tax Court disagreed with the IRS’ position, finding that it was unreasonable for the IRS to claim that a prohibited transaction occurred when a newly established entity wholly owned by an IRA and managed by the IRA holder was used as an investment vehicle.
In general, after 1993 when the IRS conceded the IRA prohibited transaction issue in Swanson, a number of attorneys began exploring the impact of the Swanson decision. At the same time, the Limited Liability Company (“LLC”) entity began emerging as the entity of choice for investment transactions and was becoming recognized by all fifty states as an entity that provided limited liability protection and passthrough tax treatment.
During this time, a number of attorneys began experimenting with the use of LLC’s as an investment vehicle. Attorneys began establishing special purpose LLCs wholly owned by an IRA as a vehicle for making real estate and other investments. Since an LLC is a passthrough entity it does not pay federal income tax – its owner does. But since the IRA is the sole owner of the LLC and an IRA is tax-exempt pursuant to Internal Revenue Code Section 408, no tax is generally due on the IRA LLC investment. This coupled with the ability to make investments quickly and with limited custodian intervention was gaining popularity quickly with the American public.
The increasing popularity of the Checkbook Control IRA caught the IRS’ attention. In light of their defeat in Swanson and their new position that a checkbook IRA is not prohibited, the IRS felt it was important that it provide clear rules and audit guidance to the IRS audit agents on the Checkbook IRA structure.
IRS Confirms Validity of Self-Directed IRA LLC
IRS Field Service Advice (FSA) Memorandum 200128011 was the first IRS drafted opinion that confirmed the ruling of Swanson that held that the funding of a new entity by an IRA for self-directing assets was not a prohibited transaction pursuant to Code Section 4975. An FSA is issued by the IRS to IRS field agents to guide them in conduct of tax audits. The facts presented in the FSA clearly mirrored those in the Swanson case.
Tax Court Re-Affirms Validity of Self-Directed IRA LLC Solution
On October 29, 2013, the Tax Court offered direct confirmation that the use of a newly established special purpose LLC wholly owned by an IRA and managed by the IRA holder would not trigger an IRS prohibited transaction.
In TC Memo. 2013-245, Mr. Terry Ellis retired with about $300,000 in his section 401(k) retirement plan, which he subsequently rolled over into a newly created self-directed IRA.
The taxpayer then created an LLC called CST Investments, LLC (“CST LLC”), taxed as a corporation and had his IRA transfer the $300,000 into CST LLC. CST LLC was formed to engage in the business of used car sales. The taxpayer managed the used car business through CST LLC and received a modest salary.
The IRS argued that the formation of CST was a prohibited transaction under section 4975, which prohibits self-dealing. The Tax Court disagreed and citing the Swanson case ruled that even though the taxpayer acted as a fiduciary to the IRA (and was therefore a disqualified person under section 4975), the LLC itself was not a disqualified person at the time of the transfer. After the transfer, the LLC was a disqualified person because it was owned by Mr. Ellis’s IRA, a disqualified person.
“Petitioners did not engage in a prohibited transaction when they caused Mr. Ellis’s IRA to invest in CST”]
Tax Court in TC memo, 2013-245
Additionally, the IRS also claimed that the taxpayer had engaged in a prohibited transaction by receiving a salary from the LLC. The court agreed with the IRS on this point. Although the LLC (and not the IRA) was officially paying the taxpayer’s salary, the Tax Court concluded that since the IRA was the sole owner of the LLC, and that the LLC was the IRA’s only investment, the taxpayer (a disqualified person) was essentially being paid by his IRA.
The impact of the Tax Court’s ruling in TC Memo. 2013-245 is significant because it directly confirms the legality of the self-directed IRA LLC solution by validating that a retirement account can fund a newly established LLC without triggering a prohibited transaction.
As confirmed in Swanson and later by the IRS in Field Service Advice Memorandum
200128011 and TC Memo 2013-245, using retirement funds to invest in a newly established LLC wholly owned by an IRA and managed by the IRA holder is not a prohibited transaction.
In light of Swanson and TC memo 2013-245, it is evident that the Tax Court believes firmly that using IRA funds to invest in a newly established LLC will not trigger a prohibited transaction and is 100% legal.