A Self-Directed IRA is an IRA (Roth, Traditional, SEP, Inherited IRA, SIMPLE) where the custodian of the account allows the IRA to invest into any investment allowed by law. These investments typically include; real estate, promissory notes, precious metals, and private company stock. The typical reaction I hear from investors is: “Why haven’t I ever heard of self-directed IRAs before, and why can I only invest my current retirement plan into mutual funds or stocks?” The reason is that the large financial institutions that administer most U.S. retirement accounts don’t find it administratively feasible to hold real estate or non-publicly traded assets in retirement plans.
What Can a Self-Directed IRA Invest Into?
Under current law, a retirement account is only restricted from investing in the following:
Collectibles such as art, stamps, coins, alcoholic beverages, or antiques IRC 408(m);
And, any investment that constitutes a prohibited transaction pursuant to ERISA and/or IRC 4975 (e.g. purchase of any investment from a disqualified person such as a close family member to the retirement account owner).
The most popular self-directed retirement account investments include; rental real estate, secured loans to others for real estate, small business stock or LLC interest, and precious metals such as gold or silver. These investments are all allowed by law and can be great assets for investors with experience in these areas.
When self-directing your retirement account you must be aware of the prohibited transaction rules found in IRC 4975. These rules don’t restrict what your account can invest in, but rather, whom your IRA may transact with. In short, the prohibited transaction rules restrict your retirement account from engaging in a transaction with someone who is a disqualified person to your account. A disqualified person to a retirement account includes the account owner, their spouse, children, parents, and certain business partners. So, for example, your retirement account could not buy a rental property that is owned by your father since a purchase of the property would be a transaction with someone who is disqualified to the retirement account (e.g. father). On the other hand, your retirement account could buy a rental property from your cousin, friend, sister, or a random third-party, as these parties are not disqualified persons under the rules.
The rationale behind the prohibited transaction rules is that the federal government doesn’t want tax advantaged accounts conducting transactions between parties who are close enough to the account owner that there could be a transaction designed to avoid or un-fairly minimize tax by altering the true fair market value/price of the investment. The consequence of a prohibited transaction is disqualification of the retirement account as of January 1 of the year the prohibited transaction occurred. In a typical self-directed IRA investment, your IRA custodian holds your investment in their company name for your IRAs benefit (e.g. property is owned as ABC Trust Company FBO John Smith IRA) and receives the income and pays the expenses for the investment at the account owner’s direction and instruction.
What is an IRA/LLC?
Many self-directed retirement account owners, particularly those buying real estate, use an IRA/LLC as the vehicle to hold their retirement account assets. An IRA/LLC is a special type of LLC, which consists of an IRA (or other retirement account) investing its cash into a newly created LLC. The IRA/LLC is managed by the IRA owner and the IRA owner then directs the LLC investments and the LLC takes title to the assets, pays the expenses to the investment, and receives the income from the investment. There are many restrictions to the IRA owner being a manager (such as not receiving compensation or personal benefit) and many laws to consider so please ensure you consult an attorney before establishing an IRA/LLC. For more details on the IRA/LLC structure, the cases, and the structuring options, please refer to my prior blog post here.
When IRA-owned property is held for rent, the management of the rental property must be structured such that rental income is received by the IRA and expenses are paid by the IRA. The IRA owner and other disqualified persons (e.g. IRA owner, spouse, etc.) cannot personally be the “middle man” by paying expenses personally or by collecting the rent in their personal account and then forwarding the funds to the IRA. There are essentially three different methods whereby the IRA may be structured to properly collect rent and pay expenses.
Three Methods to Manage the Property
1. Manage directly through the IRA. Money goes to the IRA custodian and expenses are paid by the custodian at the direction of the IRA owner.
2. Property Manager. The IRA hires a property manager who manages the property and receives the income and pays property expenses. Cash flow is returned to the IRA.
3. IRA/LLC. Under the IRA/LLC, the IRA owner is the manager of the IRA/LLC and receives income and pays expenses from an IRA/LLC checking account. The IRA/LLC structure is very common in IRA owned real estate investments.
First, the IRA may be receiving the income directly and paying the expenses. This method involves a lease between the IRA and the tenant directly. Under this method, the tenant pays rental income to the IRA (e.g. ABC Trust Company FBO Sally Jones IRA) and sends the actual payment to the IRA custodian and the custodian then deposits that income into the respective IRA. If expenses are due, the IRA owner will need to direct the custodian to pay them by completing a written form (e.g. payment authorization letter) and instructing the IRA custodian as to the expenses to be paid from the IRA. There is usually a fee each time an instruction letter is issued to a self directed IRA custodian. This method can be tedious and can be fee intensive and as a result is not the most common way of managing a rental property held by an IRA.
Second, the IRA hires a property manager who receives the rental income to the property and pays the expenses to the property. The property manager cannot be a disqualified person to the IRA owner and the property manager will typically take a percent of the rental income collected as payment for their services. Under this method the IRA enters into an agreement with the property manager and the property manager then enters into leases with respective tenants. The IRA receives rental income minus property expenses and fees charged by the property manager.
Third, many IRA owners with rental property decide to use a structure known as an IRA/LLC. Under the IRA/LLC structure, the IRA invests into a newly created LLC and the IRA’s investment is then the ownership of the LLC. The IRA will invest an amount designated by the IRA owner into the LLC, and then funds are typically deposited into an LLC checking account at a bank selected by the IRA owner.
IRA/LLC Structure for Real Estate
The IRA owner then, as manager of the LLC, signs the contract for the LLC to purchase the real estate. The property should close in the LLC name with funds from the LLC bank account and the LLC then in turn rents the property, receives the income and pays the expenses all from the LLC checking account. The LLC is entirely owned by the IRA and all funds in the LLC checking account must eventually be returned to the IRA when the IRA owner desires to take a distribution.
Regardless of the method used to own and manage the IRA owned rental property, the property cannot be leased to a disqualified person. So, for example, the IRA cannot purchase a property and allow the IRA owner’s son to lease the property as that lease would be a transaction with a disqualified person which results in a prohibited transaction.
In addition to prohibited transactions that are involved in leasing the property to family members, the IRA owner should closely analyze any leasing arrangement to a company where the IRA owner or other disqualified persons are owners of the IRA or company. For example, any lease to a company that is owned 50% or more by the IRA owner or other disqualified persons would constitute a prohibited transaction. IRC § 4975(e)(2)G).
In summary, there are many different ways to manage a rental property owned by your IRA. Make sure you are implementing one of these methods and that you are managing the IRA’s income, expenses, and properties properly.
This article is an excerpt from Mat Sorensen’s book, The Self Directed IRA Handbook.
Can my IRA own substantially all of the ownership of an LLC? Can my IRA/LLC pay a salary to me for serving as the manager of the IRA/LLC? Last week the U.S. Tax Court issued an opinion in the case of Ellis v. Commissioner, T.C. Memo 2013-245 and answered both of these questions.
In Ellis, the Tax Court resolved two questions posed by the IRS. First, did Mr. Ellis engage in a prohibited transaction when his IRA acquired 98% of the membership interest in CST, LLC? And second, did Mr. Ellis engage in a prohibited transaction when CST, LLC (owned 98% by his IRA) paid him compensation for serving as the manager?
Analyzing Ellis v. Commissioner
As to the first question, the Tax Court held that Mr. Ellis’ IRA did NOT engage in a prohibited transaction when it acquired 98% of the ownership of a newly established LLC. The other 2% was owned by an un-related person who was not part of the case and whose ownership did not have an impact on the decision. The IRS contended that a prohibited transaction occurred when the IRA bought ownership of CST, LLC. The Court disagreed, however, and held that the IRA’s purchase of the initial membership interest of the LLC was NOT a prohibited transaction. The Court stated that the IRA’s purchase of membership interest in a new LLC is analogous to prior holdings of the Court whereby the Court held that an IRA does not engage in a prohibited transaction when it acquires the initial shares of a new corporation. Similarly, the court held that a new LLC is not a disqualified person to an IRA under the prohibited transaction rules and as a result an IRA may invest and own the ownership of the LLC. IRC § 4975(e)(2)(G), Swanson V. Commissioner, 106 T.C. 76, 88 (1996). Consequently, the Court’s ruling means that it is NOT a prohibited transaction for an IRA to acquire substantially all or all of the ownership of a new LLC.
As to the second question, the Tax Court held that it was a prohibited transaction for the LLC owned substantially by Mr. Ellis’ IRA to pay compensation to Mr. Ellis personally. The court reasoned that, “In causing CST [the IRA/LLC] to pay him [IRA owner] compensation, Mr. Ellis engaged in the transfer of plan income or assets for his own benefit in violation of section 4975 (c)(1)(d).” This type of prohibited transaction is often times referred to as a self dealing prohibited transaction and occurs when the IRA owner personally benefits from his IRA’s investments. The Court looked to the operating agreement of the LLC which authorized payment to Mr. Ellis for serving as the general manager and also the actual records of the LLC which showed the payments to Mr. Ellis. When using an IRA/LLC, one of the many important clauses in the operating agreement is one which restricts compensation to the IRA owner or any other disqualified person (e.g. IRA owner’s spouse or kids). Also, the actual payment and transaction records of the IRA/LLC will be analyzed so it is important that both the LLC documents and the actual payment records do not allow for or result in payment from the IRA/LLC to disqualified person (e.g. IRA owner).
It is also important to note that the Tax Court rejected Mr. Ellis’ argument that the payments were exempt from the prohibited transaction rules under section 4975 (d)(10). Section (d)(10) provides an exemption to the prohibited transaction rules for payments from an IRA to a disqualified person [e.g. IRA owner] for services rendered to manage the IRA. The Tax Court rejected this argument stating that the payments from the IRA/LLC were not for management of the IRA but for management of the IRA/LLC and its business activities. In this case, the IRA owner was actively involved as the general manager of the IRA/LLC which LLC bought and sold cars. As a result, the Court held that the payments were not exempt and constituted a prohibited transaction.
I was happy to read this case and find the Court’s conclusions because it matches the same opinion and advice we have been giving clients regarding IRA/LLCs for nearly ten years: that a newly established LLC owned by an IRA does not constitute a prohibited transaction but the IRA/LLC cannot pay the IRA owner (or any other disqualified person) compensation for managing the IRA/LLC.
Many business owners and investors doing business in multiple states often ask the question of whether their company, that is set up in one state needs to be registered into the other state(s) where they are doing business. This registration from your state of incorporation/organization into another state where you do business is called a foreign registration. For example, let’s say I’m a real estate investor in Arizona and end up buying a rental property in Florida. Do I need to register my Arizona LLC that I use to hold my real estate investments into Florida to take ownership of this property? The answer is generally yes, but after reviewing a few states laws on the subject I decided to outline the details of when you need to register your LLC or Corporation into another state where you are not incorporated/organized. (Please note that the issue of whether state taxes are owed outside of your home state when doing business in multiple states is a different analysis).
Analyzing the Need for Foreign Registration
In analyzing whether you need to register your out of state company into a state where you do business or own property it is helpful to understand two things: First, what does the state I’m looking to do business in require of out of state companies; and Second, what is the penalty for failure to comply.
State Requirements for Businesses
First, a survey of a few state statutes on foreign registration of out of state companies shows that the typical requirement for when an out of state company must register foreign into another state is when the out of state company is deemed to be “transacting business” into the other state. So, the next question is what constitutes “transacting business”. The state laws vary on this but here are some examples of what constitutes “transacting business” for purposes of foreign registration filings.
Employees or storefront located in the foreign registration state.
Ownership of real property that is leased in the foreign registration state. Note that some states (e.g. Florida) state that ownership of property by an out of state LLC does not by itself require a foreign registration (e.g. a second home or maybe land) but if that property was rented then foreign registration is required.
Here is an example of what does not typically constitute “transacting business” for foreign registration requirements.
Maintaining a bank account in the state in question.
Holding a meeting of the owners or management in the state in question.
So, in summary, the general rule is that transacting business for foreign registration requirements occurs when you make a physical presence in the state that results in commerce. Ask, do I have employees or real property in the state in question that generates income for my company? If so, you probably need to register. If not, you probably don’t need to register foreign. Note that there are some nuances between states and I’ve tried to generalize what constitutes transacting business so check with your attorney or particular state laws when in question.
Failure to File Foreign Registration
Second, what is the penalty and consequence for failing to file a foreign registration when one was required? This issue had a few common characteristics amongst the states surveyed. Many company owners fear that they could lose the liability protection of the LLC or corporation for failing to file a foreign registration when they should have but most states have a provision in their laws that states something like the following, “A member [owner] of a foreign limited liability company is not liable for the debts and obligations of the foreign limited liability company solely by reason of its having transacted business in this state without registration.” A similar provision to this language was found in Arizona, California and Florida, but this provision is not found in all states that I surveyed. This language is good for business owners since it keeps the principal asset protection benefits of the company in tact in the event that you fail to register foreign. On the other hand, many states have some other negative consequences to companies that fail to register foreign. Here is a summary of some of those consequences.
The out of state company won’t be recognized in courts to sue or bring legal action in the state where the business should be registered as a foreign company.
Penalty of $20 per day that the company was “transacting business” in the state when it should have been registered foreign into the state but wasn’t. This penalty maxes out at $10,000 in California. Florida’s penalty is a minimum of $500 and a maximum of $1,000 per year of violation. Some states such as Arizona and Texas do not charge a penalty fee for failure to file.
The State where you should have registered as a foreign company becomes the registered agent for your company and receives legal notices on behalf of your company. This is really problematic because it means you don’t get notice to legal actions or proceedings affecting your company and it allows Plaintiff’s to sue your company and to send notice to the state without being required to send notice to your company. Now, presumably, the state will try to get notice to your company but what steps the states actually takes and how much time that takes is something I couldn’t find. With twenty to thirty day deadlines to respond in most legal actions I wouldn’t put much trust in a state government agency to get me legal notice in a timely manner nor am I even certain that they would even try.
In addition to the statutory issues written into law there are some practical issues you will face if your out of state company is not registered into a state where you transact business. For example, some county recorders won’t allow title to transfer into your out of state company unless the LLC or corporation is registered foreign into the state where the property is located. It is also common to run into insurance and banking issues for your company until you register foreign into the state where the income generating property, employee, or storefront is located.
In summary, you should register your company as a foreign company in every state where you are transacting business. Transacting business occurs when you have a storefront in the foreign state, employees in the foreign state, or property that produces income in the foreign state. Failure to file varies amongst the states but can result in penalties from $1,000 to $10,000 a year and failure to receive legal notices and/or be recognized in court proceedings. Bottom line, if you are transacting business outside of your state of incorporation/organization you should register as a foreign entity in the other state(s) to ensure proper legal protections in court and to avoid costly penalties for non-compliance.
Many real estate investors and landlords often ask whether they should use an umbrella insurance policy or a LLC to protect them from liabilities that may arise on their rental property. An LLC protects the owner of the LLC from liabilities that arise on any property in the LLC and prevents a plaintiff from being able to go after the LLC owner personally. As a result, we often say that an LLC protects a business owner’s personal assets from the risks and liabilities of the LLC business. An umbrella policy is coverage above and beyond the typical property insurance and covers additional risks and adds additional coverage to a typical property insurance policy.
Issues and Factors
There are many issues and factors to consider in making this decision and there is no one-sized fits all recommendation. In many instances we recommend that you have both an LLC and an umbrella policy and in other instances we may recommend just an LLC or just an umbrella policy. The first factor to consider is the cost. The cost of an LLC in our office is $800 and on average you can expect about $200 in fees a year to keep that LLC active with the State (about $900 annually in California, each state is different). As a result, the major cost of an LLC is in the first year but you can plan on having about $200 in fees each year (each state is different) to keep your LLC active. If you have a partnership LLC then you also have the cost of a LLC partnership tax return but the LLC also provides a significant amount of partnership advantages and protections.
An umbrella policy on the other hand is typically paid for monthly. Let’s say you are able to get $1M in umbrella protection at a cost of $50 a month. That would run you about $600 a year. Insurance policies have benefits which include attorneys whom the insurance company will appoint and pay to defend you (and protect themselves from having to pay) but also contain certain exclusions to coverage that may leave you with no coverage for the liability you incur. Another important factor to consider is the type of property you own. If you own a multi-unit property or commercial property we would recommend having both an LLC and an umbrella policy because you have more liability exposure when you have more tenants. On the other hand, if you have a single family rental in an otherwise good neighborhood where you feel less likely to be sued then we may only recommend an LLC or an umbrella policy on its own. Bottom line, consider both an LLC and an umbrella policy in your analysis and get quotes and advice upon which to make an informed decision so that you are protecting your assets in the most efficient and effective way as possible.
The "Self Directed IRA Handbook" by attorney Mat Sorensen is the most comprehensive book ever written about one of the best investment and retirement savings tools ever created: the Self-Directed IRA. Mat has performed the impossible by effectively delivering complex information in an easily understandable manner for the layperson, while providing the necessary legal basis to suit the professional. Mat's book is a "must read" for investors, attorneys, CPAs, and other professionals and other interested individuals wanting to learn about all there is to know about Self-Directed IRAs.
Mat's books is a great reference guide for self-directed IRA investing – Best I’ve seen in 30 years of being in the business.
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CEO, Polycomp Trust Company
Pamela Constantino
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President, Polycomp Trust Company
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Mat is truly an expert on self directed IRAs, and his book is the one book that every self directed IRA investor should read.
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CPA, Attorney, Author
Richard Davis
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Real Estate Broker & Investor
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Attorney & Real Estate Investor
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Mathew is an excellent attorney, well versed in the Self-Directed IRA market…His ability to distil the complexities of the Self-Directed IRA so that the average person can understand them, and ensure that they don't get "tripped up" is second to none. Anyone interested in this Self-Directed IRA Market would do well to connect with Mathew and learn from the best.
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"Mat is an excellent attorney, well versed in the Self-Directed IRA market...His ability to distill the complexities of the Self-Directed IRA so that the average person can understand them, and ensure that they don't get "tripped up" is second to none.
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Founder and Retired CEO, PENSCO Trust Company
J.P. Dahdah
Mat’s book is the most practical and comprehensive self directed IRA guide in our industry. Reading this handbook should be the first step for any alternative asset investor, investment sponsor, or trusted advisor that seeks to become informed about how to maximize the value of IRAs.
