v What is a Self-Directed IRA?
A Self-Directed IRA is a type of IRA that allows the owner to have more control over his/her retirement funds. Typically, a Self-Directed IRA allows the account owner to direct the account trustee to make a broader range of investments versus other types of IRAs. Custodians and IRA owners can make traditional investments, such as stocks and mutual funds, yet it is not as well known that owners are allowed to use IRA funds to make non-traditional investments in real estate, precious metals, notes, private companies and more. The IRS has barred IRAs from making specific investments, such as “collectibles” (examples include works of art, gems, stamps, coins, alcoholic beverages). Investments made in “collectibles” exposes the amount of the investment to tax liability. The IRS has also listed “prohibited transactions” between an IRA and “disqualified persons” .
v Types of Self-Directed IRA Accounts
There are essentially three types of Self-Directed IRAs:
- 1. Financial Institution Offered Self-Directed IRA
This type of Self-Directed IRA is generally offered by larger financial institutions. The IRA holder is generally able to only make IRA investments offered by the financial institution.
- 2. Custodian Controlled Self-Directed IRA
The IRA funds are generally held with the IRA custodian and the IRA custodian (at the IRA holder’s direction) will then invest those IRA funds accordingly.
- 3. “Checkbook Control” Self-Directed IRA LLC
With a “checkbook control” Self Directed IRA, the IRA holder has total control over the IRA funds and no longer has to get each investment approved by the custodian of the account. All decisions are the IRA owner’s. When the holder finds an investment that he or she wants to make with the IRA funds, a check or wire from the Self Directed IRA LLC bank account can be made directly to the investment.
v What are some distinguishing features of a Self-Directed IRA LLC
- Access: With a Self-Directed IRA LLC, you will have direct access to your IRA funds allowing you to potentially make investments timelier. Managing the account as well as writing checks from the IRA are the responsibility of the owner as the manager of the LLC.
- Speed: A Self-Directed IRA LLC may reduce delays associated with a custodian controlled Self-Directed IRA account.
- Limited liability protection: By using a Self-Directed IRA LLC with “Checkbook Control”, your IRA may benefit in limiting the exposure of liability claims.
v What are some examples of prohibited transactions with respect to Self-Directed IRA’s?
The IRS has listed specific transactions that can result in adverse tax consequences to both the IRA and its owner, such as the IRA having an unexpected tax liability, or the possibility of the IRA losing its tax-exempt status.
These prohibited transactions include any direct or indirect:
- Sale or exchange, or leasing of any property between a plan and a disqualified (related) person; or a transfer of real or personal property by a disqualified person to a plan where the property transferred is subject to a mortgage or similar lien which the plan assumes, or;
- Lending of money or other extension of credit between a plan and a disqualified person;
- Furnishing of goods, services, or facilities between a plan and a disqualified person;
- Transfer to, or use by or for the benefit of, a disqualified person of income or assets of a plan;
- Receipt of any consideration for his or her own personal account by any disqualified person who is a fiduciary from any party dealing with the plan connected with a transaction involving the income or assets of the plan.
v With respect to a Self-Directed IRA, who is a “disqualified person”?
Examples include the owner of a plan, family members, administrator or fiduciary or any person providing services to the plan. In addition, any business entity, trust or estate in which the IRA owners owns either directly or indirectly 50% or more. Any officer, director, highly compensated employee or 10% or more shareholder of any entity described above would also be considered a disqualified person.
v Are taxes levied on Unrelated Business Taxable Income (“UBTI”)?
Most income from a self-directed IRA will be tax deferred or tax free. However, certain investments create taxable income called unrelated business taxable income (“UBTI”). UBTI is income from a trade or business regularly carried on by the self-directed IRA which is not substantially related to the exercise by the IRA of the IRA’s tax-exempt purpose. The tax code defines any active trade or business to be unrelated to the IRA’s purpose. UBTI does not include the following: dividends, interest, annuities, royalties, most rent from real estate, and gains/losses from the sale of real estate. The most common type of income that generally subjects a Self-Directed IRA to UBTI is generated from the following sources:
- Income from the operations of an active trade or business – i.e. a restaurant, service company, store, etc., and
- Business income generated via a pass-through entity, such as an LLC or partnership.
v How would an IRA have UBTI, and what is the potential tax exposure?
The following example illustrates how an investment of a self-directed can result in UBTI, and what the potential tax liability could be.
Sarah, as manager of her Self-Directed IRA LLC, invests $500,000 for a 25% interest in an LLC. Sarah does not participate in the management of the LLC. The LLC manufactured and sold athletic footwear. The LLC reported net income of $20,000 to each of the four members on Form K-1. Because the income from the LLC was not substantially related to the IRA LLC’s tax-exempt purpose, it is considered UBTI. IRAs are taxed at trust income tax rates. The initial $11,950 is taxed at rates between 15% -33% and income in excess of $11,950 is taxed at a 39.6% plus potential additional penalties and interest.
v Must an IRA that has UBTI file a Form 990-T?
Yes, all tax-exempt organizations with UBTI must file Form 990-T if the organization has more than $1,000 of UBTI gross income. Traditional IRA’s and Roth IRA’s are considered tax-exempt under IRC Sections 408(a) and 408A(b), respectively. The filing deadline for a calendar year-end IRA is April 15 of the following year.
Note: the fiduciary of the IRA account is responsible for filing Form 990-T if there is gross UBTI of $1,000 or more.
v Is an IRA (whether self-directed or not) required to obtain an Employer Identification Number (EIN)?
Yes, an IRA is required to obtain its own EIN for IRS reporting purposes. Examples of these reportable transactions include contributions and distributions to IRA accounts, and filing form 990-T to report UBTI and remit any tax due. An IRA never uses a social security number or the fiduciary’s EIN on any type of return being filed.
Note: the fiduciary of the IRA account is responsible for obtaining the EIN for the IRA.
v In summary, what do you recommend?
Any investor considering investing their retirement accounts in “nontraditional assets” should be aware of the potential pitfalls described above. Care should be taken when relying on the statements of custodians and self-directed IRA facilitators. It is not uncommon for these statements to be incorrect or incomplete. Your long-term plans envisioned for the self-directed may also be impacted if you encounter certain issues such as :
- Additional contributions or rollovers are contemplated (incorporating this into your current structure)
- What happens upon death (estate planning may add complexities and challenges to the situation)
- Should you want to make ‘in-kind’ asset distributions from the self-directed IRA
- Should you contemplate converting the IRA to a ROTH.
IRS scrutiny and tax court cases in the area of self-directed IRAs continue to increase and it is important to make sure you are not running afoul of any requirements. Please do not hesitate to contact our office should you have any questions regarding self-directed IRAs.