Part II is a continuation from yesterday’s October 14, 2013 post. See Part I HERE.
Nontraditional investments favored by many self-directed IRAs can lead to unexpected taxation of unaware IRA account holders.
Example 2: IRA-Owned LLC Invests in Real Estate Partnership
Setup. Mark, a retired airline pilot with $1.5 million in his 401(k) account, was afraid of another stock market meltdown and viewed real estate investments as a safer alternative and a diversification technique for his retirement savings. After learning about SDIRAs from a friend, he did some preliminary research online. Mark quickly found numerous IRA custodians and companies that promoted “checkbook control IRAs” (i.e., the SDIRA/LLC concept discussed above) and decided that the lower annual custodian fees and overall control made the SDIRA/LLC the best option for him.
Mark executed a partial rollover of his 401(k) account into his new SDIRA. Subsequently, the SDIRA invested all but $300 into a newly formed LLC, thus creating an SDIRA/LLC structure (it is typical to leave the smallest amount of cash in the IRA as possible). From there, the IRA custodian had very little involvement because all of the investments were made at the LLC level, with Mark facilitating transactions as the LLC’s sole manager.
Investment. Mark’s goal for his SDIRA/LLC was to invest in residential rental real estate, either directly out of the LLC or through a “project LLC” (i.e., a partnership) with other investors. Mark found a real estate investment group that frequently organized partnerships and promised a “passive” investment (i.e., no direct involvement by Mark). The group also told Mark that “our partnerships are perfectly acceptable self-directed IRA investments.” The real estate partnerships collected capital contributions from 20 investors and used the cash plus debt to purchase an apartment building. The apartment building was held as a rental property, with net income distributed to the investors, including Mark’s SDIRA/LLC, quarterly.
Legal and tax problems. As stated above, it is possible for an SDIRA to invest in almost anything, and thus the investment organizer’s statement that real estate partnerships are acceptable SDIRA investments is technically correct. However, this does not answer the question of whether there are more difficult legal or tax issues. For example, “rent from real property” is normally exempt from UBTI, and thus is not currently taxable when earned by an SDIRA or SDIRA/LLC. However, income from debt-financed property (whether held directly or indirectly by the SDIRA or SDIRA/LLC) is partially taxable under the UDFI rules because the income generated from the investment is not earned solely by investment of the SDIRA/LLC’s capital, but rather by bank (or private) financing.
Here, the yearly rental income that is allocated to Mark’s SDIRA/LLC is partially subject to tax under the UDFI rules. Fortunately, the tax consequences will likely be minimal due to the flowthrough of other tax items (e.g., depreciation) from the real estate held by the partnership. However, the SDIRA will likely be required to file a Form 990-T, and, even if no tax is due, it is likely a good idea to file the tax return so that the sale proceeds from the underlying apartment building (which will also be partially taxable due to the debt financing) are offset by the past losses.
Compliance black hole. The SDIRA/LLC structure in and of itself presents legal and tax compliance problems because the actual investments are outside of the IRA custodian’s view (however, as mentioned in Example 1, the custodian’s being directly involved is not a guarantee that legal and tax problems will not occur). This is particularly the case if the SDIRA/LLC is established by a low-cost promoter who cares more about “the sale” than providing the IRA account holder/LLC manager with appropriate advice. Also, because the SDIRA/LLC promoters are normally not law or accounting firms, they arguably should not be providing any advice whatsoever, and, even if they do, that advice cannot be relied upon by the IRA account holder. This has the potential to create a situation where an SDIRA/LLC is established for an IRA account holder who cannot handle the complexity of the structure and who has no way of finding help that he or she can reasonably rely upon.
Here, the LLC owned by Mark’s SDIRA will be considered a “disregarded entity” for federal tax purposes, and thus will not be required to file a tax return. In addition, if Mark is unaware that the debt financing at the real estate partnership level is triggering current tax consequences to his SDIRA, he will not file a Form 990-T either.
HOW TO PROTECT SDIRA INVESTOR CLIENTS
The above examples demonstrate some (but certainly not all) of the potential problems that clients could face if they decide to invest their retirement account in “nontraditional” assets. Protecting clients from the perils of the SDIRA compliance black hole requires several essential steps.
(1) Before doing anything, the client (and likely his or her CPA and attorney) needs to get up to speed on the unique SDIRA legal and tax complexities. Care should be taken when relying on the statements of custodians and SDIRA/LLC facilitators, as they often are incorrect, incomplete, and/or biased in a way that promotes the particular company’s best interest (e.g., custodians promote the SDIRA because it results in more ongoing fees; facilitation companies promote the SDIRA/LLC because a basic SDIRA alone cuts them out of the equation).
(2) The basic legal framework can sometimes seem relatively straightforward (e.g., no financial interactions with a disqualified person), but, as is often the case with tax law issues, the more subtle issues are misunderstood by casual observers (e.g., no direct or indirect personal benefits to a disqualified person). For example, see a recent Tax Court case in which two taxpayers personally guaranteed a loan to a company that their SDIRAs owned. The Court held that the loan guarantee was a prohibited transaction, which caused the accounts to cease to qualify as IRAs. As a result, the sale of the company stock held in the SDIRAs was directly taxable to the taxpayers (and each taxpayer was liable for an accuracy-related penalty of more than $45,000) [Peek, 140 T.C. No. 12 (2013)].
Tax advisers can also protect clients from the dangers of SDIRA or SDIRA/LLC investing by putting an intensive focus on recordkeeping and, specifically, making sure that “every dollar in and every dollar out” of the SDIRA or SDIRA/LLC is accounted for. This might sound straightforward, but when the client controls numerous entities and/or real estate properties and the SDIRA gets involved in a venture similar to one the client is involved in directly, things can get messy. Commingling of SDIRA and personal assets is almost surely a prohibited transaction, and even what might appear to be a “minor” prohibited transaction can invalidate the client’s entire SDIRA. What makes good recordkeeping even more challenging is the fact that many SDIRA account holders plan to invest using an SDIRA for 20 or more years. In other words, for many clients, getting their retirement funds out of the stock market and into nontraditional assets is not a one-time transaction—it is a fundamental change in their investment plan.
Tax advisers can also protect their clients by asking what their long-term plans are for an SDIRA. Many clients rush into SDIRA or SDIRA/LLC investments without considering any of the following issues:
• Will additional contributions or rollovers to the SDIRA be made, and, if so, how can those contributions be legally incorporated into the structure as a whole?
• What happens to the SDIRA’s investments if the client dies? (Note: Estate planning raises several challenges with SDIRAs, e.g., how illiquid assets are divided among beneficiaries; who will manage the assets; and whether the beneficiaries understand the legal complexities of the SDIRA/LLC and can manage them accordingly; etc.)
• What if the client wants to take a distribution of one of the SDIRA’s assets “in kind”?
• How is the SDIRA’s value determined for purposes of a Roth conversion and/or required minimum distributions (i.e., withdrawals that must be made after the client turns age 70½)?
These issues, along with many others, should be considered and understood before any steps are taken to form and/or invest using an SDIRA or SDIRA/LLC.
In short, the world of SDIRA and SDIRA/LLC investors is growing rapidly, and advisers must understand the potential pitfalls those investment vehicles pose for clients. The tax adviser’s role is particularly critical, given the lack of oversight by SDIRA custodians and SDIRA/LLC promoters and the potential for increased IRS scrutiny.
Self-directed IRAs (SDIRAs), in which investors choose their own, often nontraditional, investments, have grown enormously in popularity.
The custodians of these IRAs often leave investors on their own when it comes to compliance and tax issues, and many, if not most, investors are unaware that potentially significant issues can arise.
Unforeseen results can include the need to file a Form 990-T for the IRA and liability for tax on certain types of income that may be considered unrelated business income or unrelated debt-financed income.
SDIRA investments can result in taxpayers unwittingly engaging in prohibited transactions, which can disqualify the IRA.
Advisers should be prepared to help clients avoid some of these compliance problems by educating them about what investments are permitted in SDIRAs and what can raise tax compliance issues.
by Warren L. Baker, J.D. – edited and posted by Harold Goedde CPA, CMA, Ph.D. (accounting and taxation)