The Tax Court in T.L. Ellis, TC Memo. 2013-245, Dec. 59,674(M) recently 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. The impact of the impact of this ruling is enormous because it directly supports the position that a retirement account can fund a newly established LLC without triggering a prohibited transaction. This is very important because some people still try to deny the legality of the self-directed IRA LLC solution even after a 1996 Tax Court riling and 2001 IRS opinion letter confirmed its validity. The Tax Court held that using a special purpose LLC to make an investment would not trigger prohibited transaction and what would determine whether a transaction is prohibited is the ultimate use of the IRA LLC funds, not the establishment of the LLC.
In Ellis, the Tax Court rules that an investment of a husband’s IRA into a newly established LLC was not a prohibited transaction, but the payment of compensation to the husband by the LLC constituted a prohibited transaction. Mr. Ellis caused the creation of the LLC where the founding members were his IRA, with a 98-percent membership interest, and a third party, with a 2-percent interest. Subsequently, Mr. Ellis created his IRA with funds distributed from his 401(k) plan with his former employer, after which the IRA made the initial capital contribution to the LLC. This LLC was formed so that Mr. Ellis could sell used cars. He transferred $319,000 from his 401(k) account to fund the LLC business.
When it comes to making IRA investments the IRS does not state which transactions are allowed, but only states what types of transactions are prohibited. The IRA prohibited transaction rules are outlined in Internal Revenue Code Sections 408 & 4975 and generally involve the prohibition against using IRA funds to buy life insurance, collectibles, or enter into any transaction with a “disqualified person”. As per the Internal Revenue Code, a “disqualified person” is generally defined as the IRA holder and any of his or her lineal descendants or any entity controlled by such person(s). Based on Ellis, the use of the special purpose self-directed IRA LLC to make the investment was not what caused Mr. Ellis to engage in a prohibited transaction, the problem was that Mr. Ellis paid himself a salary from the LLC which violated Internal revenue Code Section 4975. 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 Ellis case is important for two main reasons. Firstly, it is the first case that directly reinforces the legality of using a newly established LLC to make IRA investments without triggering a IRS prohibited transaction. Secondly, it demonstrates the importance of working with tax professionals who have specific expertise working with the very complex IRS rules concerning using retirement funds to make investments.