Self-Directed IRA LLCs and Prohibited Transactions
Prohibited transactions occur when a disqualified person deals with the assets of an individual retirement account (IRA) in a manner prohibited by law.
A prohibited transaction can have dire tax consequences for the IRA owner and for other disqualified persons involved in the prohibited transaction. For example, a prohibited transaction performed by the IRA owner or by any beneficiary of the IRA will result in the IRS treating all IRA assets as distributed to the IRA owner. The IRA owner would then be liable for the payment of all of the taxes, interest, and penalties related to the distribution. Additionally, the IRS might impose certain excise taxes on any other disqualified persons involved in the prohibited transaction. Prohibited investments likewise carry a significant tax consequence, but generally not to the full extent of prohibited transactions.
4975 of the Internal Revenue Code (IRC) defines a prohibited transaction as:
(A) A sale, exchange, or leasing of any property between the IRA and a disqualified person;
(B) The lending of money or extension of credit between the IRA and a disqualified person;
(C) The furnishing of goods, services, or facilities between the IRA and a disqualified person;
(D) A transfer to, or use by or for the benefit of, a disqualified person of the income or assets of the IRA;
(E) Any act by the IRA owner, whereby the owner deals with the income or assets of the IRA in his or her own interest or for his or her own account; or
(F) The receipt of any consideration by the IRA owner from any party dealing with the IRA in connection with a transaction involving the income or assets of the IRA.
Self-Directed IRA LLCs
If an IRA owns 50% or more of an LLC, substitute “IRA” in (A) through (F) above with “LLC”, except where it says “IRA owner”. Such LLCs are typically referred to as “checkbook” LLCs or self-directed IRA LLCs, depending on the amount of control the IRA owner has over such LLC. With this change, paragraph (A) above reads as: any sale, exchange, or leasing of property between the LLC and a disqualified person is a prohibited transaction.
Under paragraph (B) above, the lending of money or extension of credit between the LLC and a disqualified person is a prohibited transaction. For example, a loan by the LLC to the IRA owner is a prohibited transaction. Likewise, the IRA owner may not lend money to the LLC. An IRA owner will likely be seen by the IRS as extending credit to the IRA if the IRA owner personally guarantees a loan made to the LLC. IRA owners, and all other disqualified persons, should therefore never guarantee any loan or extension of credit to the IRA or to the LLC.
Under paragraph (C) above, the furnishing of any goods, services, or facilities between the LLC and a disqualified person is a prohibited transaction. For example, the IRA owner may not paint a house owned by the LLC. The IRA owner may not even loan a spray painter owned by the IRA owner to someone else to paint a house owned by the LLC. Likewise, the IRA owner may not use a spray painter owned by the LLC to paint his or her personal residence. Generally, any “sweat equity” provided by any disqualified person to the LLC owned house would likely be treated by the IRS as a service provided to the LLC by a disqualified person, resulting in a prohibited transaction. Sweat equity could also be treated as a non-cash contribution to the IRA, to the extent the service increases the value of the house, which is prohibited.
Under paragraph (D) above, the transfer to, or use by, a disqualified person of LLC income or of any LLC asset is a prohibited transaction. For example, a disqualified person living in, or vacationing in, a house owned or leased by the LLC is a prohibited transaction. Paying rent to the LLC in exchange for the disqualified person staying in the house only makes matters worse, as such is an impermissible contribution to the IRA.
Paragraph (E) above is very broad and is often used by the IRS to disqualify an IRA from its tax exemption. Compensation paid to the IRA owner by the LLC, typically for services rendered as the manager of the LLC, is likewise a prohibited transaction under paragraph (E).
Finally, paragraph (F) above prohibits an IRA owner from receiving any money, asset, or other benefit from the LLC through a third party. For example, a friend of the IRA owner cannot sell or otherwise transfer to the IRA owner a house that the friend purchased from the LLC. Likewise, the friend cannot lend money to the IRA owner that the friend borrowed from the LLC.
The above examples do not cover all of the prohibited transactions that can occur with an IRA owned LLC, including a self-directed IRA LLC or checkbook LLC. Therefore, IRA owners must carefully plan each step of each investment strategy of a self-directed IRA LLC. 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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