by Mat Sorensen | Aug 23, 2016 | Uncategorized
In the recent case of Thiessen v. Commissioner, 146 T.C. No. 7 (2016), the Tax Court considered how long the IRS has to allege a prohibited transaction against an IRA. In general, the IRS must allege a prohibited transaction against your IRA within three years after the return is filed. IRC 6501(a). However, that time-period may be extended another three years for a total of six years pursuant to IRC 6501(e)(1) when the taxpayer fails to report an amount that is in excess of 25% of the gross income stated in the return. For prohibited transaction rule violations, a failure to report occurs when you don’t disclose the prohibited transaction to the IRS or when you fail to claim the distribution that occurs from a prohibited transaction on your personal tax return. A prohibited transaction could be disclosed to the IRS though attachments to the return or other correspondence but the Tax Court first looks to see what was reported to the IRS on the IRA owner’s personal 1040 tax return for the years in question. In other words, if you don’t volunteer clear information of a prohibited transaction to the IRS then the limitation period can be extended up to a total of six years so long as the prohibited transaction would result in an gross income in excess of 25% of the taxpayer’s personal return. Note: IRS Form 5329 is used to declare a prohibited transaction on your personal return.
There are a few very important takeaways from the Tax Court’s ruling in Thiessen and from the IRS Internal Revenue Manual on Prohibited Transactions.
STATUTE OF LIMITATION TIPS
| PRACTICAL THREE YEAR PERIOD
|
According to the IRS Agent Manual, Internal Revenue Manual, 4.72.11.6, IRS agents are instructed and trained to only review for prohibited transactions within a three-year window. In order to pursue a prohibited transaction past three years, an agent must receive approval from IRS Area Counsel. So, for practical purposes, the IRS is examining prohibited transactions within a three-year window. |
| FAILURE TO DISCLOSE SIX YEAR PERIOD
|
As had occurred in Thiessen, if any IRA owner fails to disclose a prohibited transaction to the IRS, the IRS may pursue a prohibited transaction for up to six years. This six-year clock runs six years after you filed your return in question. So, if you filed a 2010 personal return on April 15, 2011, and if the return did not include disclosure of a prohibited transaction, the IRS could pursue a prohibited transaction up until April 15, 2017. Keep in mind, this failure to report though must be a prohibited transaction that exceeds 25% of the gross income of the taxpayer for the year in question. |
A final word to note is that the IRS may pursue prohibited transactions past six years and into an indefinite time-period when the prohibited transaction was fraudulent or a willful attempt to evade tax. IRC 6501(c)(1),(2),(3). I’m not aware of cases in this situation, nevertheless, don’t expect to be in safe waters if you fraudulently entered into a prohibited transaction as the statute of limitations never runs in those situations.
by Mat Sorensen | Aug 9, 2016 | Uncategorized
I’ve consulted many clients over the years who used their IRA funds to buy an annuity investment. The most common questions I get are as follows.
- What is an annuity? Now mind you, these are persons who already own an annuity.
- Can I cancel it and get my money back to invest in something else, and is there a penalty?
Most of our clients who own an annuity with an IRA are seeking to use those retirement plan dollars in a new investment opportunity with the goal of increasing returns. However, “getting rid” of an annuity owned by your IRA isn’t as easy as selling a mutual fund or stock investment.
WHAT IS AN ANNUITY?
An annuity is a contract with an insurance company whereby the person invests a lump-sum (or a series of payments) with an insurance company and the insurance company agrees to pay certain sums to the owner over their life. There are many variations of annuities but the simple explanation is that you give up money now to an insurance company and they promise to pay you money later. The longer you wait to get paid the more they will pay you later on.
CAN I CANCEL MY ANNUITY?
You can cancel an annuity but you may be subject to a surrender penalty. Most annuities have a surrender penalty whereby the owner of the annuity is penalized for requesting a return of the investment within a certain period of years of the initial investment. This time period is known as the surrender period and on average will last from 5 to 10 years. The surrender penalty on a 10 year surrender time period is usually 10% and decreases by 1% each year thereafter until it goes to zero after 10 years.
So, if you invested a lump-sum of $100,000 into an annuity and one-year later (in years 2) you wanted to get the entire $100,000 back out, you would be subject to a 9% surrender penalty of $9,000. That would mean you could get back $91,000 but would forfeit the remainder. Some penalty schedules are more punitive and they all vary. The surrender schedule is in the annuity contract documents and can also be requested at any time from the company holding the annuity.
KEEP IT IN AN IRA TO AVOID TAXES
Once you cancel an annuity owned by your IRA, the funds need to stay within an IRA (e.g. self-directed IRA) in order to avoid taxes and penalties from the IRS. You can request the annuity company to transfer the IRA annuity cash balance over to a new IRA custodian of your choosing. Once you’ve taken these steps, you’re retirement plan funds will be in an IRA and available to invest in stock, bonds, mutual funds, real estate, private companies, precious metals, and all other investments available to IRAs.
by Mat Sorensen | Aug 4, 2016 | Uncategorized
Unrelated Business Income Tax (“UBIT”) is often misunderstood by self-directed IRA investors and their professional advisors. In essence, UBIT is a tax that is due to an IRA when it receives “business income” as opposed to “investment income”. When we think of IRAs and retirement accounts, we think of them as receiving income without having to pay tax when the income is made. For example, when your IRA sells stock for a profit and that profit goes back to your IRA you don’t pay any tax on the gain. Similarly, when you sell real estate owned by your IRA for a profit and that profit goes back to your IRA, you don’t pay any tax on the gain. The reason for this is because the gain from the sale of an investment asset is deemed investment income and as a result it is exempt for UBIT tax.
Tip 1: “When Does UBIT Apply?”
UBIT applies when your IRA receives “unrelated business income”. However, if your IRA receives investment income, then that income is exempt from UBIT tax. Investment income that is exempt from UBIT includes the following.
Investment Income Exempt from UBIT:
- Real Estate Rental Income, IRC 512(b)(3) – The rent of real estate is investment income and is exempt from UBIT
- Interest Income, IRC 512(b)(1) – Interest and points made from the lending of money is investment income and is exempt from UBIT.
- Capital Gain Income, IRC 512(b)(5) – The sale, exchange, or disposition of assets is investment income and is exempt from UBIT.
- Dividend Income, IRC 512(b)(1) – Dividend income from a c-corp where the company paid corporate tax is investment income and exempt from UBIT.
- Royalty Income, IRC 512(b)(2) – Royalty income derived from intangible property rights such as intellectual property and from oil/gas and mineral leasing activities is investment income and is exempt from UBIT.
There are two common areas where self-directed IRA investors run into UBIT issues and are outside of the exemptions outlined above. The first occurs when an IRA invests and buys LLC ownership in an operating business (e.g. sells goods or services) that is structured as a pass-thru entity for taxes (e.g. partnership) and that that does not pay corporate taxes. The income from the LLC flows to its owners and would be ordinary income. If the company has net taxable income it will flow down to the IRA as ordinary income on the k-1 and this will cause tax to the IRA as this will be business income and it does not fit into one of the investment income exemptions.
The second problematic area is when IRAs engage in real estate investment that do not result in investment income. For example, real estate development or a number of significant short-term real estate flips by an IRA will cause the assets of the IRA to be considered as inventory as opposed to investment assets and this will cause UBIT tax to the IRA.
Tip 2: UBIT Applies When You Have Debt Leveraging an IRA Investment
UBIT also applies to an IRA when it leverages its purchasing power with debt. If an IRA uses debt to buy an investment, then the income attributable to the debt is subject to UBIT. This income is referred to as unrelated debt financed income (UDFI) and it causes UBIT. The most common situation occurs when an IRA buys real estate with a non-recourse loan. For example, lets say an IRA buys a rental property for $100,000 and that $40,000 came from the IRA and $60,000 came form a non-recourse loan. The property is thus 60% leveraged and as a result, 60% of the income is not a result of the IRAs investment but the result of the debt invested. Because of this debt, that is not retirement plan money, the IRS requires tax to be paid on 60% of the income. So, if there is $10K of rental income on the property then $6K would be UDFI and would be subject to UBIT taxes.
For a more detailed outline on UDFI, please refer to my free one-hour webinar here.
Tip 3: UBIT Tax is Reported and Paid by the IRA via a Form 990-T Tax Return
Unrelated business income tax (UBIT) for an IRA is reported and paid via IRS Form 990-T. IRS Form 990-T is due for IRAs on April 15th of each year. IRA owner’s can file and obtain an automatic 6-month extension with the IRS by filing an extension request before the regular deadline.
If UBTI Tax is due, it is paid from the IRA and the IRA owner would send the prepared Form 990-T to their IRA custodian for their signature and for direction of payment to the IRS for any tax due as part of the 990-T Return.
For a more detailed outline of UBIT, please refer to Chapter 15 of The Self Directed IRA Handbook.
by Mat Sorensen | May 10, 2016 | Uncategorized
Many investors and financial professionals are familiar with the primary benefits of a Roth IRA: that the plans investments grow tax-free and come out tax-free. But if tax-free investing isn’t enough to get you excited, rest assured, there are more benefits to the Roth IRA. I’ll note just three more in this article.
Remember, Roth IRAs are for nearly everyone with earned income. They’re not restricted to high income earners. Check out my prior article here if you’re unfamiliar with the back-door Roth IRA. Okay, now lets over the other perks of Roth IRAs.
No Required Minimum Distributions
First, Roth IRAs are not subject to RMD. Traditional retirement plan owners are subject to rules known as Required Minimum Distribution rules which require the account owner to start taking distributions and paying tax on the distributions (since traditional plan) when the account owner reaches the age of 70 ½. Not being subject to RMD rules allows the Roth IRA to keep accumulating tax free income (free of capital gain or other taxes on its investment returns) and allows the account to continue to accumulate tax free income during the account owner’s life time. Learn more about the facts and fiction about IRA RMDs here.
Spousal Rollover: The Best Asset to Leave to Your Spouse
Second, a surviving spouse who is the beneficiary of a Roth IRA can continue contributing to that Roth IRA or can combine that Roth IRA into their own Roth IRA. Allowing the spouse beneficiary to take over the account allows additional tax free growth on investments in the Roth IRA account. Non spouse beneficiaries (e.g. children of Roth IRA owner) cannot make additional contributions to the inherited Roth IRA and cannot combine it with their own Roth IRA account. The non-spouse beneficiary becomes subject to required minimum distribution rules but can delay out required distributions up to 5 years from the year of the Roth IRA account owner’s death and is able to continue to keep the tax free return treatment of the retirement account for 5 years after the death of the owner. The second option for non-spouse beneficiaries is to take withdrawals of the account over the life time expectancy of the beneficiary (the younger the beneficiary the longer they can delay taking money out of the Roth IRA). The lifetime expectancy option is usually the best option for a non-spouse beneficiary to keep as much money in the Roth IRA for tax free returns and growth.
Tax and Penalty Free Withdrawals Before Age 59 ½ On What You Put In
Third, Roth IRA owners are not subject to the 10% early withdrawal penalty for distributions they take before age 59 ½ on amounts that are comprised of contributions or conversions. Growth and earning are subject to the early withdrawal penalty and taxes too, but you can always take out the amounts you contributed to your Roth IRA or the amounts that you converted without paying taxes or penalties (note that conversions have a 5 year wait period before you can take out funds penalty and tax free). This makes the Roth IRA the most powerful savings account out there because you can take out what you put in without penalty or tax for whatever reason you may have as hardship is not required. Traditional IRAs have no such benefits.
Roth IRAs are a great tool for many investors. Keep in mind that there are qualification rules to being eligible for a Roth IRA that leave out many high income individuals. However, you can convert your traditional retirement plan dollars to a Roth IRA (sometimes known as a backdoor Roth IRA) as the conversion rules do not have an income qualification level requirement on converted amounts to Roth IRAs. This conversion option has in essence made Roth IRAs available to everyone regardless of income.
by Mat Sorensen | Apr 19, 2016 | Uncategorized
Many self directed IRA investors misunderstand or are unaware of the protections afforded to their IRA (Roth or traditional) as it relates to creditors and judgments. This article seeks to address the key areas of the law that every self directed IRA investor should know.
First, your IRA is not always exempt from creditors up to $1Million. Many IRA owners believe that federal law protects their IRA from creditors up to $1M. While Section 522(n) of the federal bankruptcy code protects an IRA owner’s IRA from creditors up to $1M, this protection is only provided to IRAs when an account owner is in bankruptcy. If the IRA owner is not in bankruptcy then the creditor protections are determined by state law and the laws of each state vary. For example, if you reside are a resident of Arizona then your IRA is still protected from creditors up to $1M even without filing bankruptcy. The approach Arizona takes is the most common, however, many states protections for IRAs outside of bankruptcy are extremely weak. For example, if you are a resident of California then your IRA is only protected in an amount necessary to provide for the debtor and their dependents. That’s a pretty subjective test in California and one that makes IRAs vulnerable to creditors. If your California IRA is from a rollover of a company plan, you may have other protections. California residents should check out my prior article here.
Second, while your IRA can be exempt from your personal creditors, as explained above, it is not exempt from liabilities that occur in the IRAs investments. For example, if your IRA owns a rental property and something happens on that rental property then the IRA is responsible for that liability (and possibly the IRA owner). As a result, many self directed IRA owner’s who won real estate or other liability producing assets utilize IRA/LLC’s which protect the IRA and the IRA owner from the liability of the property.
Third, if the IRA engages in a prohibited transaction under IRC Section 4975 then the IRA is no longer an IRA and is no longer exempt from creditors. Despite the bankruptcy and state law protections outlined in my first point above, if a creditor successfully proves that a prohibited transaction occurred within an IRA then account no longer is considered a valid IRA and therefore the protections from creditors vanish. There seems to have been an increase in creditors who are pursuing IRAs, particularly self directed IRAs, and I have been representing more and more self directed IRA owners in bankruptcy and other creditor collection actions in defending against prohibited transaction inquiries.
Fourth, many proponents of solo 401(k)s have argued that investors are better off using a self-directed solo 401(k) plan instead of a self-directed IRA because solo 401(k)s receive ERISA creditor protection (federal law) that is better than most state law creditor protections afforded to IRAs. While it is true that ERISA plan protection is better then state law IRA creditor protection and courts have already held that while a Solo K plan is a qualified plan it is not subject to ERISA. Yates v. Hendon, 541 U.S. at 20-21. Since a Solo K plan is not subject to ERISA, its account holders cannot seek ERISA creditor protection and would instead be treated the same as IRA owners. In sum, there is no difference in creditor protection between a solo 401(k) account and a self-directed IRA. We love Solo 401(k) plans, we just aren’t setting them up instead of IRAs because of asset protection purposes.
In summary, the best way to protect your self directed IRA from creditors is to understand the rules that govern your self directed IRA and to seek counsel and guidance to ensure that your retirement is available for you and not just your creditors.
by Mat Sorensen | Apr 6, 2016 | Uncategorized
