Posted November 16, 2015
There are self directed IRA rules, and several make sense but there are two insidious problems namely Unrelated Business Taxable Income (UBTI) and Unrelated Debt Financed Income (UDFI). These two issues are often missed by taxpayers (and accountants) where you might have to prepare and file a Form 990-T. What the heck is that? Keep reading.
Self Directed IRA LLC Background
Back in the day, which really wasn’t that long ago, if wanted to make a self-directed investment with an IRA you would-
- Create a self-directed IRA
- Move money into the IRA
- Have a custodian handle the transactions and be charged accordingly for their troubles
Investors got sick of this because it was akin to going to Mom and Dad every time you wanted to make an investment. Ergo, the self directed IRA LLC was spawned. In the new world, this is the scheme-
- Create a self-directed IRA
- Create an LLC that is owned by the IRA but is managed by you
- Avoid custodian issues since you now have checkbook control of the LLC, and can direct its purchases and dispositions as necessary
This is beneficial since it removes Mom and Dad watching over your shoulder (custodians) and the associated fees, and it can create a liability shield within your IRA. For example, your IRA puts 25% of its assets into your LLC and your LLC goes bankrupt, the remaining 75% of your IRA could theoretically remain safe.
Here are some more basics-
No S-Corps or Partnerships
The way these entities are structured, business profits are returned to the shareholders. Profits cannot fall into the hands of the IRA account owner. Tainting of retirement dollars is the big thing here. So, your best recourse is a C Corporation or a single member LLC.
The business cannot invest directly in collectibles, art, rugs, antiques, metals other than gold, silver and palladium bullion, gems, stamps, coins (except certain U.S.-minted coins), alcoholic beverages, and a few other tangible items related to personal property. Ok- there goes half your list for sure. Yup, cross palladium of your list.
In addition, friends, business associates and siblings may invest in the business via a self-directed IRA, but your parents, children or spouse may not. The strict arms-length perspective of the business dealings must be maintained.
Key Employee / Investor
You cannot be the key employee and key investor in the business. Nor can you own a controlling interest of the business. Basically, someone else has to have the right to hire or fire you such as a Board of Directors. The “someone else” is the grey area in all of this, and warrants more discussion.
Of course this is solved with an LLC being 100% owned by the self directed IRA, but if wanted to actually work for the company then it would have to be a C Corporation with a Board of Directors and all that jazz. Again, you need distance from the situation and it cannot be self-dealing. Bummer.
Checkbook IRA LLC
There are a ton of self directed IRA LLC providers touting a concept of checkbook control (and we referred to to it above). The philosophy comes from Employee Retirement Income Security Act (ERISA) rules that account / plan assets must be held in trust. However, ERISA regulations also state that an LLC owned by an IRA are exempt from ERISA’s trust requirement. And the Department of Labor (DOL) has similar language.
However the IRS has not adopted language to support this. Therefore, the IRS could argue that a checkbook IRA LLC assets are controlled by the IRA account holder, and therefore the assets have constructively been distributed to the account holder and subject to taxation and penalty. Yuck!
Word of caution- there is a ton of legal opinion that suggests the Self Directed IRA LLC contradicts current tax code. Do your homework, and make sure the trust company that handles your self-directed IRA or self directed Roth IRA has protection for you.
If it smells, if it appears to be self-dealing, if it appears too good to be true, pump the brakes and be careful. The self directed IRA rules are still murky and not all the government agencies have caught up.
Unrelated Business Taxable Income (UBTI)
UBTI is the first of two insidious problems beyond the self directed IRA LLC basics above. An IRA typically has a tax-exempt purpose but might have unrelated business taxable income if all of the following are true-
- Income is derived from trade or business activity, and
- that business activity is not substantially related to the exempt status, and
- the activity is carried on for the purpose of generating income
Under IRC Section 512(b) there are exceptions (note the second one)-
- Dividends, interest (including points), and royalties
- Rent from real property (note, real property not all property)
- Sales proceeds from real property (no flipping, no property held as inventory)
There was a concern by Congress where an IRA and an individual would have different advantages. For example, if you personally bought an LLC and ran a profitable flower shop, you would have to pay income taxes and in some cases self-employment taxes. But if this same LLC was owned by a self-directed IRA, then there could be certain tax advantages that are enjoyed by the LLC that an individual could not enjoy. And this really grows disparate with a self directed Roth IRA and in some cases a self directed 401k.
A self directed IRA LLC is not prohibited from creating unrelated business taxable income, but it must prepare and file Form 990-T and pay the associated taxes. Yes, you could be taxed twice, once within the IRA and again when you pull the money out. So, No, don’t buy a flower shop with your self directed IRA LLC without doing some due diligence.
The new way of investing through IRAs, LLCs and checkbook control, and not knowing the self directed IRA rules can get you in trouble. Big trouble, like having the entire IRA blow up and be considered a distribution with income tax and penalties. Sounds like fun.
Unrelated Debt Financed Income (UDFI)
The distant cousin to UBTI is unrelated debt financed income (UDFI). Ubtee and Udfee. Sounds like cartoon siblings. Ok, here we go. If you have $100,000 in your IRA and you earn 6%, how much to you make? $6,000.
But if you take this same $100,000 and buy a $300,000 rental property that has an overall rate of return of 6%, you earn $18,000. You have additional income solely based on leveraged financing that a normal IRA buying stocks and bonds cannot achieve.
Therefore the $12,000 ($18,000 minus $6,000) is considered unrelated debt financed income under IRC Section 514. Yes, you need to file a Form 990-T. Yes, it is taxable. No, we don’t care how mad you are. Just kidding, we do care but there is nothing we can do about it- hate the game not the player.
There is not a filing requirement if you don’t have over $1,000 in combined UTBI and UDFI, but we encourage it so you can carry forward losses to offset future income. The Watson CPA Group can assist you with preparing and filing Form 990-T Exempt Organization Business Income. Just give us a call.
A lot of this information was gleaned from research and experience. For some additional information, please refer to-
Thompson Hall Self Directed IRA LLC (Attorneys)
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