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Using a Trust with a Self-Directed IRA – Is it a Good Idea?

The use of a trust established by an IRA in an effort to replace the LLC as the investment vehicle has been in existence for several years. With the increase popularity of the self-directed IRA LLC “checkbook control” structure, tax practitioners have been playing with the concept of using different types of entities as the IRA investment vehicle.  Along with an LLC, which offers limited liability protection and flow through tax treatment, tax practitioners have used a “C” corporation and partnership as the IRA owned vehicle used to make investments.   However, tax practitioners have looked for ways to make IRA investments without having to pay state entity fees, as is the case with an LLC or Corporation.   So along came the idea of using a trust that will be created by the IRA care of the IRA custodian.  A trust is not an entity but rather an arrangement that must involve three parties, a grantor, a trustee, and a beneficiary.  In the case of an IRA arrangement, the IRA care of the custodian would be the grantor of the trust and also the beneficiary of the trust.  The IRA owner would generally be the trustee of the trust providing that individual with investment authority over the trust’s assets.  Like an LLC, all income and gains would be allocated to the beneficiary of the trust, which would be the IRA.

What type of trust would be used?

Grantor trusts and non-grantor trusts are the two main types of funded trusts, trusts that hold assets. The type of trust you’re administering determines whether you must file Form 1041 for the trust, or declare all items of income and deduction on the grantor’s Form 1040.  In grantor trusts, the grantor retains certain powers over the trust administration. These powers include the power to revoke (amend or terminate) the trust. The grantor also keeps control over the property inside the trust.

For a grantor trust, the grantor is usually also a trustee and beneficiary of the trust’s income and principal. The principal refers to the property funding the trust. Items of income and deduction are generally declared on the grantor’s income tax return. The trust doesn’t have a tax identification number (TIN) or file its own return.

Grantor Trust Tax Reporting

In general, a grantor trust is ignored for income tax purposes and all of the income, deductions, etc., are treated as belonging directly to the grantor. This also applies to any portion of a trust that is treated as a grantor trust.

The John Doe IRA Trust is a grantor type trust. During the year, the trust sold 100 shares of ABC stock for $1,010 in which it had a basis of $10 and 200 shares of XYZ stock for $10 in which it had a $1,020 basis.

The trust does not report these transactions on Form 1041. Instead, a schedule is attached to the Form 1041 showing each stock transaction separately.  The trust does not net the capital gains and losses, nor does it issue John Doe IRA a Schedule K-1 (Form 1041) showing a $10 long-term capital loss.

The Self-Directed IRA Trust – the Downside

Tax Return Requirement: The main disadvantage of using a trust as the investment vehicle for making IRA investments is that the trust needs to complete an IRS Form 1041, whereas, in the case of a Self-Directed IRA LLC, no federal or state income tax return is typically required.  In the case of a grantor trust, one must complete only the entity information of IRS Form 1041. One is not required to show any dollar amounts on the form itself; show dollar amounts only on an attachment to the form.

With tax return filing requirements comes expensive CPA fees.  Unlike, a personal income tax return which can be completed using inexpensive software, a grantor trust return is far more complicated and typically is filed by trained tax professionals.  As a result, the fees could be quite expensive and in most cases will end up costing more than the LLC state filing fees.  In addition, certain states, such as California, have additional state trust tax returns that need to be filed with respect to the grantor trust.

No Limited Liability protection.  By using a Self-Directed IRA LLC with “Checkbook Control”, your IRA will benefit from the limited liability protection afforded by using an LLC. By using an LLC, all your IRA assets held outside the LLC will be shielded from attack. This is especially important in the case of IRA real estate investments where many state statutes impose an extended statute of limitation for claims arising from defects in the design or construction of improvements to real estate.  Whereas, in the case of a trust, no limited liability protection will be available which could potentially open up the IRA investments to creditor attack.

For additional information on the self-directed IRA and LLC and trust, please contact a tax professional at 800-472-0646

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