Self-Directed IRA LLCs and Disqualified Persons
Prohibited transactions occur when a disqualified person deals with the assets of an individual retirement account (IRA) in a manner prohibited by law.
The owner of an IRA is a disqualified person. The IRA can lose its tax exemption if the owner, or any beneficiary of the IRA, engages in a prohibited transaction. If the IRS asserts that the owner or a beneficiary has performed a prohibited transaction, the IRS will deem the entire IRA as distributed to the owner. The owner will then have to report the amount of such distribution as ordinary income on his or her personal tax return.
Such distributed amount may also be subject to interest and penalties, including a penalty equal to 10% of such distributed amount if the IRA owner has not attained the age of 59 ½ on the day of the distribution. The IRS may not notify the IRA owner of a prohibited transaction until several years after it has occurred, which will result in the IRS assessing interest and penalties for each such year. As such, it is very important that IRA owners, and the beneficiaries of the IRA, carefully avoid any prohibited transaction.
The IRA owner is not the only person who can be penalized by the IRS for engaging in a prohibited transaction. §4975 of the Internal Revenue Code (IRC) imposes a 15% excise tax on each disqualified person, except the IRA owner, who engages in a prohibited transaction.
The tax is imposed on the value of the IRA assets involved in the prohibited transaction, and it can be imposed over several years. Even worse, IRC 4975 imposes an excise tax equal to 100% of the amount involved if the prohibited transaction is not corrected within a certain period of time.
IRA owners must also avoid prohibited investments, which could result in the IRA being distributed to the IRA owner to the extent of the purchase price of the prohibited investment.
IRC 4975 describes disqualified persons as:
(A) The IRA owner; the trustee, custodian, and administrator of the IRA; and any person paid for providing investment advice regarding IRA assets;
(B) Anybody providing services to the IRA. However, persons who provide legal, accounting, and other services necessary for the operation of the IRA are exempt from the definition of a prohibited transaction, as long as the compensation paid to them is reasonable;
(C) Each family member of the IRA owner. IRC 4975 defines a family member as a spouse, an ancestor, a lineal descendant, and any spouse of a lineal descendant. An ancestor includes anyone who precedes the IRA owner in lineage, such as the parents, grandparents, great-grandparents, and so on, of the IRA owner. An indirect ancestor includes aunts and uncles of the IRA owner. The lineal descendants of the IRA owner include the owner’s children, grandchildren, and great-grandchildren, and so on. The siblings, cousins, and in-laws of the IRA owner probably do not meet the definition of a lineal descendant, but it is nonetheless prudent for the IRA owner to include them in the definition of a family member. Finally, a spouse of a lineal descendant includes any spouse of the child, grandchild, great-grandchild, and so on, of the IRA owner. In summary, the following individuals should avoid participating in any prohibited transaction, as they could incur the above referenced excise tax of 15%/100%:
(i) Parents, grandparents, great grandparents, and so on, of the IRA owner,
(ii) Aunts and uncles of the IRA owner,
(iii) The spouse of the IRA owner,
(iv) The children, grandchildren, great grandchildren, and so on, of the IRA owner,
(v) Spouses of the children, grandchildren, great grandchildren, and so on, of the IRA owner, and
(vi) The siblings, cousins, and in-laws of the IRA owner;
(D) Any corporation, partnership, limited liability company, trust, or estate in which the IRA owner, any family member of the IRA owner, as defined above, or a service provider to the IRA, owns, directly or indirectly, 50% or more of:
(i) The combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of the corporation,
(ii) The capital interest or profits interest of the partnership or limited liability company, or
(iii) The beneficial interest of the trust or estate;
(E) An officer, director, manager, or any other person with similar authority and responsibilities, of any above corporation, partnership, limited liability company, trust, or estate; and
(F) A partner or joint venturer who owns 10% or more, in capital or profits, of any above corporation, partnership, limited liability company, trust, or estate.
Self-Directed IRA LLCs
Based on the above definition, disqualified persons include the IRA, the IRA owner, any LLC owned 50% or more by an IRA, and the managers of such LLC. So-called “checkbook” LLCs and self-directed IRA LLCs are typically 100% owned by the IRA and are therefore disqualified persons. The IRS will likely treat the IRA’s assets as fully distributed to the IRA owner if any prohibited transaction occurs between a self-directed IRA LLC and the IRA.
IRA owners must carefully plan each step of each investment strategy of the IRA, including each prospective investment of a self-directed IRA. Part of such planning includes determining whether any disqualified persons might be involved in the investment. For each disqualified person who might be involved in the investment, the IRA owner must determine whether the involvement might result in a prohibited transaction. If the investment might result in a prohibited transaction, then the investment must be avoided.
Michael Sewell, JD, MBA has formed more than 100 LLCs, including self-directed IRA LLCs, traditional LLCs, series LLCs, real estate brokerage LLCs, and “S corporation” LLCs. Sewell Law also provides professional litigation services. Contact Michael Sewell at (314) 942-3232 or firstname.lastname@example.org.
This article is for general informational purposes only, it does not include all of the laws and regulations related to the topics discussed in this article, and it is not intended as legal, tax, or investment advice. You should consult an attorney experienced with the topics discussed in this article about how this information might apply to your specific circumstances.
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