by Mat Sorensen | Jul 8, 2014 | News
Limited Liability Companies (LLCs) owned by a 401(k) or other qualified retirement plans (e.g. profit sharing plans, defined benefit plans) can be exempt from the California Franchise Tax, when the LLC is used exclusively for the purpose of acquiring and holding real estate. In other words, if you have a 401(k) owned LLC that is used to buy and hold real estate investments then that LLC is likely exempt from the California Franchise Tax.
The exemption from the California Franchise Tax is found in R&TC Section 23701x, and requires, among other things that the LLC.
1. Be Owned by a Qualified Pension Plan. This exemption only applies to qualified pensions, profits sharing plans, and stock bonus plans. This would include self-directed 401(k) and profit sharing plans, which are commonly used by many self directed retirement plan investors. It is important to note, however, that a self directed IRA (even if a SEP IRA) would not qualify as a qualified pension plan under the exemption.
2. The LLC Must Used to Buy and/or Hold Real Estate. The LLC owned by the 401(k) (or other employed based plan) must be used to buy and/or hold real estate.
3. Requires CAFTB Determination Approval. In order to rely on the exemption, the LLC must file receive an exemption approval letter from the California Franchise Tax Board (CAFTB). This is obtained by filing CAFTB Form 3500.
It is important to note that the exemption will not apply to IRA/LLCs, as IRAs do not specifically meet the exemption’s definition of a qualified retirement plan. I have had clients seek the exemption fro the tax with SEP IRAs, arguing that these retirement accounts were similar to a 401(k) or profit sharing plan, but their exemption request was denied.
Additionally, if the 401(k)/LLC is used to own assets other than real estate then the LLC will not meet the exemption requirements. Despite the narrow application of the exemption, it does cover many investors in California who use self directed 401(k)s and Profit Sharing Plans to invest and own real estate, and who do so using an LLC. Because the CAFTB tax rules can be tricky, please consult with your attorney or tax advisor prior to relying on the exemption. Also, please note that you must actively file for the exemption with the CAFTB as the exemption is only applicable when received by application.
By: Mat Sorensen, Attorney and Author of The Self Directed IRA Handbook
By: Kevin Kennedy, Attorney, KKOS Lawyers
by Mat Sorensen | Jun 24, 2014 | News
The United States Supreme Court recently issued a 9-0 opinion holding that inherited IRAs are not exempt and protected from creditors in bankruptcy. As a general rule, IRAs receive special protections from creditors and cannot be reached by the creditors of the account owner. In Clark v. Rameker Trustee, Clark inherited her mother’s large IRA upon her mother’s death. Nine years later, Clark filed bankruptcy and sought to protect the inherited IRA from the reach of her own creditors. Under the bankruptcy code, “retirement funds” are protected from the reach of creditors and may generally be kept by the owner following bankruptcy. Justice Sotomayor, who wrote the opinion of the Court, wrote that inherited IRAs (not to include spousal inherited accounts) do not constitute “retirement funds” for three reasons. First, the owner cannot continue to contribute to the account. Inherited IRAs remain in the deceased owner’s name and cannot receive additional contributions from an heir. Second, the new owner is forced to take required minimum distributions from the account under a different set of rules than typical retirement accounts. And third, the account owner may withdraw the balance at any time without a 10% early withdrawal penalty. Because of these reasons the Court held that inherited IRAs are not “retirement funds” within the meaning of IRC 408 and as a result they are not protected from creditors. Consequently, the Clark’s entire inherited IRA is subject to the claims of creditors in bankruptcy.
In addition to the Court’s ruling in Clark, it is important to note three other facts regarding inherited retirement accounts and creditors.
- IRAs Inherited From a Spouse. When a surviving spouse inherits a retirement plan from a deceased spouse, the surviving spouse may simply roll over the deceased spouses account into an IRA owned by the surviving spouse and the retirement funds become a new account or add to an existing account of the surviving spouse. This is different from a non-spousal inherited account that was involved in the Clark case. Spousal inherited IRA funds go into the surviving spouses own IRA and are subject to the typical retirement plan rules. Because of this, inherited spousal retirement plans funds are different than that of non-spousal inherited funds and are not subject to the Court’s holding in Clark.
- Certain States Specifically Protect Inherited IRAs. When in bankruptcy a debtor can seek the protection of certain assets from creditors under federal exemptions and/or they can seek the protection of certain assets (such as IRAs) under the laws of their State. Under the laws of a few states, inherited IRAs are specifically protected from creditors and as a result the Court’s opinion in Clark would likely not apply. Those states include, Arizona, Texas, and Florida.
- Consider an IRA Trust For Large IRAs. If you have an estate comprised of significant IRA holdings, you may be able to establish a special IRA Trust, which can be used to shelter your IRA funds from your heir’s creditors. A trust should only be listed as a beneficiary of an IRA upon careful planning and consideration as the Trust needs to contain certain provisions in order to qualify as a valid trust under retirement plan rules.
Since inherited IRAs have special rules and procedures, it is recommended that person’s with large IRAs seek the guidance and assistance of an attorney in planning their estate and retirement fund’s future. Also, if you have an inherited IRA and are considering bankruptcy, stop, consult, and plan with the proper counsel lest you lose the account to creditors.
By: Mat Sorensen, Attorney and Author of The Self Directed IRA Handbook
by Mat Sorensen | Jun 3, 2014 | News
Roth IRAs can be established and funded for high-income earners by using what is known as the “back door” Roth IRA contribution method. Many high-income earners believe that they can’t contribute to a Roth IRA because they make too much money and/or because they participate in a company 401k plan. Fortunately, this thinking is wrong. While direct contributions to a Roth IRA are limited to taxpayers with income in excess of $129,000 ($191,000 for married taxpayers), those whose income exceeds these amounts may make annual contributions to a non-deductible traditional IRA and then convert those amounts over to a Roth IRA.
Examples
Here’s a few examples of earners who can establish and fund a Roth IRA.
- I’m a high-income earner and work for a company who offers a company 401(k) plan. I contribute the maximum amount to that plan each year. Can I establish and fund a Roth IRA? Yes, even though you are high-income and even though you participate in a company 401(k) plan, you can establish and fund a Roth IRA.
- I’m self-employed and earn over $200,000 a year; can I have a Roth IRA? Isn’t my income too high? Yes, you can contribute to a Roth IRA despite having income that exceeds the Roth IRA income contribution limits of $191,000 for married taxpayers and $129,000 for single taxpayers.
The Process
The strategy used by high-income earners to make Roth IRA contributions involves the making of non-deductible contributions to a traditional IRA and then converting those funds in the non-deductible traditional IRA to a Roth IRA. This is often times referred to as a “back door” Roth IRA. In the end, you don’t get a tax deduction the amounts contributed but the funds are held in a Roth IRA and grow and come at tax-free upon retirement (just like a Roth IRA). Here’s how it works.
Step 1: Fund a new non-deductible traditional IRA
This IRA is “non-deductible” because high-income earners who participate in a company retirement plan (or who have a spouse who does) can’t also make “deductible” contributions to an IRA. The account can, however, be funded by non-deductible amounts up to the IRA annual contribution amounts of $5,500. The non-deductible contributions mean you don’t get a tax deduction on the amounts contributed to the traditional IRA. Don’t worry about having non-deductible contributions though as you’re converting to a Roth IRA so you don’t want a deduction for the funds contributed. If you did get a deduction for the contribution, you’d have to pay taxes on the amounts later converted to Roth. You’ll need to file IRS form 8606 for the tax year in which you make non-deductible IRA contributions. The form can be found here.
If you’re a high-income earner and you don’t have a company based retirement plan (or a spouse with one), then you simply establish a standard deductible traditional IRA, as there is no high-income contribution limitation on traditional IRAs when you don’t participate in a company plan.
Step 2: Convert the non-deductible traditional IRA funds to a Roth IRA
In 2010, the limitations on Roth IRA conversions, which previously restricted Roth IRA conversions for high-income earners, was removed. As a result, since 2010 all taxpayers are able to covert traditional IRA funds to Roth IRAs. It was in 2010 that this back door Roth IRA contribution strategy was first utilized as it relied on the ability to convert funds from traditional to Roth. It has been used by thousands of Americans since.
If you have other existing traditional IRAs, then the tax treatment of your conversion to Roth becomes a little more complicated as you must take into account those existing IRA funds when undertaking a conversion (including SEPs and SIMPLE IRAs). If the only IRA you have is the non-deductible IRA, then the conversion is easy because you convert the entire non-deductible IRA amount over to Roth with no tax on the conversion. Remember, you didn’t get a deduction into the non-deductible traditional IRA so there is not tax to apply on conversions. On the other hand, if you have an existing IRA with say $95,000 in it and you have $5,000 in non-deductible traditional IRA contributions in another account that you wish to convert to Roth, then the IRS requires you to covert over your IRA funds in equal parts deductible (the $95K bucket) and non-deductible amounts (the new $5K) based on the money you have in all traditional IRAs. So, if you wanted to convert $10,000, then you’d have to convert $9,500 (95%) of your deductible bucket, which portion of conversion is subject to tax, and $500 of you non-deductible bucket, which isn’t subject to tax upon once converted. Consequently, the “back door” Roth IRA isn’t well suited when you have existing traditional IRAs that contain deductible contributions and earnings from those sums.
There are two work-arounds to this Roth IRA conversion problem and both revolve around moving the existing traditional IRA funds into a 401(k) or other employer based plan as employer plan funds are not considered when determining what portions of the traditional IRAs are subject to tax on conversion (the deductible AND the non-deductible). If you participate in an existing company 401(k) plan, then you may roll over your traditional IRA funds into that 401(k) plan. Most 401(k) plans allows for this rollover from IRA to 401(k) so long as you are still employed by that company. If you are self-employed, you may establish a solo or owner only 401(k) plan and you can roll over your traditional IRA dollars into this 401(k). In the end though, if you can’t roll out existing traditional IRA funds into a 401(k), then the “back door” Roth IRA is going to cause some tax repercussions, as you also have to convert a portion of the existing traditional IRA funds, which will cause taxes upon conversion. Taxes on conversion aren’t “the end of the world” though as all of the money that comes out of that traditional IRA would be subject to tax at some point in time. The only issue is it causes a big tax bill now so careful planning must be taken.
The bottom line is that Roth IRAs can be established and funded by high-income earners. Don’t consider yourself “left out” on one of the greatest tax strategies offered to Americans: the Roth IRA.
by Mat Sorensen | May 20, 2014 | News
Roth IRAs can be established and owned by anyone who has earned income and that includes children. As many savvy investors have come to understand, Roth IRAs offer the best tax-free treatment for investment income and returns in the tax code. But these accounts aren’t just for adults. Minors who have earned income can also establish Roth IRAs.
I have many clients who establish Roth IRAs for their children who have earned income. Some use them to co-invest those funds with their own Roth IRAs into certain real estate deals or start-up companies. Some open up brokerage accounts and teach their kids how to buy and sell stocks. Whatever your investment strategy, don’t leave your kids out. Consider a Roth IRA as a valuable tool that can be used to teach your kids or grand-kids how to invest and how to save for their own college education. But before you open up a Roth IRA for your child, here’s what you need to know.
- Earned Income – The only qualification to establishing a Roth IRA is that the account-owner has earned income. If your child works in your business, on your rental properties or real estate investments, or even if they have a part-time or summer job, give them some income so they can establish a Roth IRA. Their earned income can be contributed to the annual Roth IRA contribution limit of $6,000. My own 13 and 15 year-olds actually have their own small business and we will be establishing Roth IRAs this year for both of them. If a child has made a Roth IRA contribution, it is generally recommended that they either have a W-2 for the income for that year or that they file a 1040-EZ for their 1099 income or self-employment income even if they are under the standard deduction. While earned income to a child is taxable, if the child is under the standard deduction amount of $6,200 the child will pay no income tax (though there may be employment taxes).
- Custodial IRA – If you open a Roth IRA for your child it is often times referred to as a custodial IRA because the account owner is not old enough to establish the IRA for themselves and therefore their parent or legal guardian must open and oversee the account for the child. When the child reaches age 18, the child will take over as the responsible party for the account.
- Tax & Penalty Free With-Drawls – In all instances, the amounts contributed to a Roth IRA can be withdrawn penalty free and tax free. Earnings withdrawn may be subject to a penalty and tax. Earnings may be distributed penalty free for the qualified higher education expenses of the child though the earnings withdrawn can be subject to tax. Check out the IRS explanation here. http://www.irs.gov/publications/p970/ch09.html. In other words, the Roth IRA can be accessed without penalty or tax when you simply pull out the amounts comprising contributions to the Roth IRA. Keep in mind, the withdrawn earnings used for qualifying higher education expenses (e.g. the investment returns or growth in the account above the contributions) will not be subject to the 10% early withdrawal penalty but they may be subject to taxes on the child’s tax return. As a result, I wouldn’t recommend withdrawing the earnings. While using a child’s Roth IRA for education expenses is common, it is not just education expenses to consider as contributions to a Roth IRA can be withdrawal without penalty and tax for anything. That could be a new car purchase, a non-traditional education expense, church service expenses, a new business, job training, or any other worthy cause or purchase worth saving for.
If you want to teach your child how to invest or if you want to help them save for college, the first account option to consider is a Roth IRA. Why choose an account that is taxable when you can choose one that grows tax-free?
by Mat Sorensen | May 6, 2014 | News
In a recent case known as Bobrow v. Commissioner, the U.S. Tax Court held that an IRA owner may only conduct one 60-day IRA rollover within a one year period for all of their IRAs. This holding from the Tax Court, was in opposition to the customs of many IRA custodians, financial advisors, and to IRS Publication 590. For more on Bobrow, and the rationale from the Tax Court please check out my prior blog article here.
Following Bobrow, the IRS issued Announcement 2014-15 and stated that the IRS was going to amend its guidance to taxpayers in Publication 590 and was going to adopt the Tax Court’s position of one 60-day Rollover per IRA per year
As a result of Bobrow and IRS Announcement 2014-15, taxpayers should consider the following issues when rolling over an IRA.
- Trustee to Trustee Transfers – If you want to change IRA custodians, the best way is via a trustee to trustee transfer whereby your old custodian transfers your IRA funds to your new custodian. Funds are sent directly from your old IRA to your new IRA and you as the IRA owner never touch the funds. IRA owners can still do as many trustee-to-trustee transfers as they want.
- New Rule to be Enforced in 2015 – The One 60-Day Rollover Per One Year Period rule won’t be enforced by the IRS until 2015. So don’t stress if you’ve already conducted multiple 60-Day rollovers over multiple accounts within a one year period. That is, unless your last name isn’t Bobrow.
- One 60-Day Rollover per 1-Year Period, Not Per Tax Year- The new rule has been explained as One 60-Day Rollover Per Year, however, the actual code (IRC 408(d)(3)(B) states per “1-year period” from the date of the last 60 Day Rollover. As a result, don’t think of one per tax year but rather think one can be done 1-year following the last 60 Day Rollover conducted by the IRA owner.
- One 60-Day Rollover Per Roth IRA and One Per Traditional IRA Per 1-Year Period – Based on my analysis of the Code, individuals would be allowed one 60-Day Rollover per Traditional IRA and one per Roth IRA. The analysis is certainly complex but I’ve tried to summarize it below. Traditional IRAs are governed by IRC 408. IRC 408(d)(3)(B) is the section which limits 60 day rollovers to one per 1 year period and this was the section the Tax Court relied on in Bobrow. Roth IRAs are governed by IRC 408A, and IRC 408A(e) is the section that enables 60-Day rollover contributions for Roth IRAs. Under, IRC 408A(e) the code allows Roth IRA qualified rollover contributions that meet the requirements of IRC 408(d)(3) [the traditional IRA code section] but specifically states that, “For purposes of IRC 408(d)(3)(B), there shall be disregarded any qualified rollover contribution from an individual retirement plan (other than a Roth IRA) to a Roth IRA.” In other words, the section enabling Roth IRA rollovers states that you only count the number of Roth IRA rollovers when considering the one-year rollover rule for a Roth IRA Rollover. As a result, even if the taxpayer had conducted a rollover of a traditional IRA in the prior twelve-month period, this rollover would not be counted in applying the one 60-Day rollover per year rule for the Roth IRA. This application of a separate One-Rollover-Per-Year for Roth and Traditional IRAs is also the position the IRS appears to be taking. In the IRS summary of the IRA One-Rollover-Per Year Rule, the IRS explained the One-60 Day Rollover per IRA rule for traditional IRAs and then stated that, “A similar limitation would apply to Roth IRAs.” Rather than lumping the Roth IRAs into Traditional IRAs for purposes of the rule, the IRS seems to be treating them separately. It would be nice though if they could be more clear on this issue before 2015 “rolls” around.
So, in sum, always opt for trustee-to-trustee transfers of IRA funds (where possible) and avoid taking a 60-Day Rollover from an IRA unless you are certain you have not conducted one in the prior 1-year period.
by Mat Sorensen | Apr 22, 2014 | News
In 2012, the SEC and NASAA issued Investor Notice 5866, Self-Directed IRAs and the Risk of Fraud. In the notice, the SEC and NASAA outlined how self directed IRAs can be susceptible to numerous types of fraud and how self directed IRA investors can be bilked. The notice outlined some significant cases where investors with self directed IRAs were involved and where the investors incurred significant losses as a result of fraud and misrepresentations in the companies where the self directed IRAs invested.
The due diligence issues for self directed IRAs are not any different from the due diligence issues for individual investors. The concern, however, is that for many self directed IRA investors, their retirement account is their largest source of funds. Consequently, those accounts can be targeted by crooks. The bottom-line point of the SEC Notice is that self directed IRA owners should carefully conduct due diligence before investing their self directed IRA funds.
I have my own thoughts as to appropriate due diligence, which are in accordance with the SEC Notice, and I have outlined those thoughts in the following due diligence “top ten list”.
DUE DILIGENCE TOP TEN LIST
Before you invest your self directed IRA into a “non-traditional” private business or into a real estate investment, you need to ask some hard questions to the person or business receiving your money. Here are some tips to minimize investment risks with your self directed IRA.
- If you don’t understand how the business or investment makes the returns being promised, then don’t invest.
- If you aren’t given adequate documents outlining what has been explained to you verbally or what has been put into a presentation, then don’t invest.
- If you’re told that you can get a commission for bringing others to invest into the same company and if you don’t have a license to receive such commissions, then don’t invest. If the investment sponsors are willing to violate the law to pay an non-licensed person to raise money from others, then what’s stopping them from misappropriating your IRA investment? It is only the law preventing them, which they’ve proved they will disregard.
- If your self directed IRA is loaning money for a real estate venture, then demand a recorded deed of trust or mortgage on title to the property, protecting your investment. Also, make sure that you get a copy of the title report or commitment showing what position your loan is being placed into when the deed of trust or mortgage is recorded. Many savvy investors (and what all banks do) create lending instructions to the title company or attorney closing the real estate transaction that instruct the closing agent to only use the funds being loaned when the borrower signs the note/loan documents, when the closing agent verifies the priority of the deed of trust or mortgage you are getting (1st position, 2nd, etc.), and when all other defects to title have been cleared.
- If you’re investing into a PPM, a private offering, or a crowdfunding offering, you should receive numerous documents outlining the investment, the use of funds, the background of those managing the company, and also documents regarding your rights as an investor (e.g., offering memorandum and LLC operating agreement or LP limited partnership agreement). Also, check to see if the PPM or private offering was properly filed with the SEC by going to SEC.gov and checking the company name in the SEC database. If no filing record exists for the PPM or private offering with the SEC, then the person raising the funds has possibly disregarded the law. As stated earlier, if someone is willing to disregard the law to get your money, what is stopping them from disregarding the law to not pay you back (it’s just the law)?
- Investigate the background of the person(s) with whom you are entrusting your money. When you are investing with others, you need to think like the bank and do what the bank does. What is this person’s credit worthiness? What is their employment or prior business experience? What is their business or investment plan? What are the terms of the investment? Is there a realistic rate of return that fairly recognizes the risk being taken?
- If you’re pressured that this opportunity will pass if your self directed IRA doesn’t invest now, then let the opportunity pass. Most scams use this technique, and most legitimate investments never have this funding crisis.
- Make sure a lawyer representing your interests reviews the documents. If a lawyer drafted the documents, it is still important to have a lawyer look at the documents as they relate to your interests and with an eye towards protecting your self directed IRA. Sometimes, unfortunately, the devil is in the details, and many investments have clauses that can significantly impact your ability to get your money back or that give the company raising the money the ability to pay whatever compensation to themselves that they desire. These are obvious problems that will eat into the bottom line of the profits you may be expecting.
- Seek the opinion of another investor, business owner, or friend whose opinion you trust. Sometimes, when you explain the investment to someone else, he or she can help you find issues to consider and questions you should be asking.
- Be comfortable saying no and only invest what you are willing to lose. Non-traditional investments have made many millionaires over the years, but they have also caused lots of financial ruin. Just keep the risk in perspective and don’t “bet the farm” in one deal.
I don’t want investors to be scared about self directed IRA investments, but I also don’t want investors going into them without having conducted adequate due diligence. It seems that some investors determine whether their IRA can invest based on the prohibited transaction rules but they neglect to determine whether their IRA should invest. Keep in mind that you can make great investment decisions that result in large gains in your self directed IRA, and you can also make terrible decisions that can result in huge losses for your self directed IRA. It’s all up to you.
Just remember that you, the self directed IRA owner, may need to get out of your comfort zone by asking a lot of questions, by demanding additional documentation, or by simply saying no. Remember: you are the best person to protect your self directed IRA.
This article is a modified except from The Self Directed IRA Handbook.
By: Mat Sorensen, Attorney and Author of The Self Directed IRA Handbook.
