Nontraditional investments favored by many self-directed IRAs can lead to unexpected taxation of unaware IRA account holders.

The appeal of investing retirement funds outside of the typical securities market has driven a surge in the use of self-directed IRA (SDIRA) investment structures. These structures come in various forms, but they all start when an IRA account holder forms an SDIRA with a custodian (e.g., a bank or trust company) that is amenable to holding “nontraditional” types of investments. In other words, the feature that makes an IRA “self-directed” is not its general legal framework, but rather the fact that the SDIRA’s custodian permits a wide array of investments and maximum control by the account holder.

Investments within SDIRAs frequently include real estate, closely held business entities, and private loans and can include any other investment that is not specifically prohibited by federal law—anything other than life insurance and collectibles can be held in an SDIRA. The SDIRA itself can be structured as a self-employed plan (SEP), a savings incentive match plan for employees (SIMPLE), or a traditional or Roth IRA, and is normally funded by a transfer from an account holder’s other IRA or a rollover from a qualified retirement account (e.g., a 401(k)). However, one common theme is that the IRA account holder wants to diversify away from 100% stock market-based investments and/or believes that better investment returns exist outside the securities market.

Once the SDIRA is formed and funded, there are two general options for investing the SDIRA’s cash. The account holder can either instruct the custodian to execute an investment directly out of the SDIRA, in which case the SDIRA becomes the legal owner of the asset, or the account holder can invest substantially all of the SDIRA’s assets into a limited liability company (LLC). In the latter case, the SDIRA is usually, but not always, the 100% owner/member of the LLC (SDIRA/LLC). The SDIRA/LLC can then execute investments, generally with the LLC’s manager as the SDIRA account holder, and thus the LLC becomes the legal owner of the asset in question (e.g., real estate). Both investment methods are legally viable, but each leads to legal and tax challenges.

Based on the author’s conversations with thousands of SDIRA and SDIRA/LLC investors (and their advisers) throughout the country, without a doubt there are significant tax compliance problems within this colorful marketplace. In fact, it is likely that less than 50% of SDIRA and SDIRA/LLC investors handle the legal and tax issues correctly, and many of these investors are unaware that these problems even exist. Unfortunately, these pitfalls can result in the complete invalidation of the SDIRA due to a “prohibited transaction” and/or current tax consequences within the SDIRA itself.

The following two examples, which are based on real-life client scenarios (although details have been changed to protect client confidentiality), illustrate issues clients and their tax advisers must be aware of when investing using an SDIRA or SDIRA/LLC. Ideally, these traps are considered before venturing into the world of nontraditional retirement account investing.

Example 1: IRA Invests in Closely Held Business Entity (Toy Company)

Setup. Sarah was a high-net-worth individual and a valued client of a multinational bank’s private trust company. Although the trust company did not routinely facilitate the investment of IRA funds into nontraditional investments, Sarah requested that her IRA invest $500,000 into a new LLC.

The investment gave Sarah’s SDIRA a 25% ownership interest in the LLC, and the trust company held all of the paperwork for the LLC unit purchase on the SDIRA’s behalf. The LLC had three other owners, not related to Sarah, and none of the other investors were co-owners with her in any other business entity. Sarah was not involved in the LLC’s day-to-day operations and did not otherwise personally benefit from the investment.

Investment. The LLC designed, manufactured, and sold children’s toys. The toys quickly became hot sellers, and the LLC recorded a significant profit on its annual Form 1065, U.S. Return of Partnership Income. In turn, each investor, including Sarah’s SDIRA, was issued yearly Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc., which showed ordinary business income. In Sarah’s case, the K-1 forms were mailed directly to the trust company.

Legal and tax problems. Two fundamental legal and tax issues must be considered with any SDIRA investment. First, the SDIRA’s investment could raise a prohibited transaction problem under Sec. 4975. If the investment is not a prohibited transaction, the second consideration is whether the SDIRA’s investment results in current tax to the SDIRA as a result of unrelated business taxable income (UBTI) or unrelated debt-financed income (UDFI).

Sec. 512 imposes a tax on income earned by a tax-exempt organization in a trade or business that is unrelated to the organization’s exempt purpose (UBTI). Unrelated debt-financed income (UDFI) under Sec. 514 is income earned by an exempt organization from property used for a nonexempt purpose that has been acquired by incurring debt. Although the prohibited transaction analysis involves many intricacies and hidden traps, this example assumes, based on the fact that Sarah’s SDIRA investment did not directly involve or benefit a “disqualified person” (Sec. 4975(e)(2)), that the investment did not result in a prohibited transaction. The UBTI and UDFI issues, however, turn out to be much more problematic for Sarah.

Most IRA investments do not trigger current tax consequences, not because all income an IRA earns grows tax free, but because the types of income that an IRA typically earns are exempt from UBTI rules. For example, IRAs that invest in publicly traded securities (e.g., stocks, bonds, and mutual funds) do not owe current tax because gains from the sale of C corporation stock, dividends, and interest income are exempt from UBTI. For this reason, most IRA investors are unaware that an IRA can be required to file a tax return (Form 990-T, Exempt Organization Business Income Tax Return) and pay tax. The two key trigger events for current IRA tax consequences are (1) income from a business that is regularly carried on (whether directly or indirectly) and (2) income from debt-financed property.

Here, Sarah was shocked to discover, five years into the toy company’s operations, that her SDIRA not only owed taxes on the LLC’s yearly profit, but the tax rate on income over $9,750 was 35% (in 2005 when this tax liability was incurred) because IRAs are taxed at trust rates. (In 2013, trust income above $11,950 is taxed at the new, higher 39.6% rate.) Although Sarah’s SDIRA benefited from the profitable investment, the SDIRA owed hundreds of thousands of dollars in income tax, penalties, and interest.

Compliance black hole. Three factors contributed to Sarah’s failure to comply with her tax obligations:

(1) Sarah was unaware of and uninformed about SDIRA legal and tax issues before her SDIRA invested in the toy company. This normally occurs when an IRA account holder learns that an IRA can invest in almost any type of asset (which is technically true), gets excited about an investment opportunity, and then quickly sets up an SDIRA.

(2) The IRA custodian refused to take any responsibility and includes language with its IRA custodian agreement stating that all legal and tax consequences of the SDIRA’s investments are the IRA account holder’s sole responsibility. In fact, it is common for IRA custodians to receive tax documents (e.g., Schedules K-1) and send copies to the SDIRA owner without mentioning the potential UBTI tax consequences. Of course, the SDIRA custodian will claim that it cannot provide this guidance because it could be construed as legal or tax advice, but these same custodians actively promote the idea of nontraditional investing. The result is that SDIRA custodians frequently facilitate IRA investments that will undoubtedly trigger UBTI, but then avoid all responsibility when these tax consequences occur.

(3) Because an IRA is not generally required to file a tax return and IRA account holders and their advisers are normally unfamiliar with these issues, no one is likely to realize that a tax has been triggered—including the IRS.

See Example 2 and the remainder of the blog post in Part II tomorrow.

by Warren L. Baker, J.D. – edited and posted by Harold Goedde CPA, CMA, Ph.D. (accounting and taxation)

In accordance with Circular 230 Disclosure