Special Matters Pertaining to Your SD-IRA

This is a collection of wisdom gleaned from the regulations and from helping hundreds of people walk through this process.

Restrictions on IRA investments:

  1. Life Insurance Contracts
    No portion of an IRA may be invested in life insurance contracts; IRA status will be lost if such an investment is made or if the written agreement which establishes the IRA does not specifically prohibit it. Code §408(a)(3)
  2. Collectibles
    An IRA’s acquisition of a “collectible” is treated as a taxable distribution to the IRA holder of an amount equal to the collectible’s cost. A “collectible” is defined to include a work of art, rug, antique, metal, gem, stamp, alcoholic beverage and, with certain exceptions, any coin. Code §408(m)(2). Although an IRA’s acquisition of a collectible will not cause the entire IRA to lose its tax-favored status, many IRA custodial agreements prohibit investments in collectibles. Anyone using a self-directed IRA should avoid collectibles.
  3. S Corporations
    An IRA may not be an S corporation shareholder. Code §§1361(b)(1)(B) and (c)(6); Rev. Rul. 92-73, 1992-2 C.B. 224. An IRA’s holding of shares in a corporation will not adversely affect the IRA or IRA holder, but may cause the corporation to lose its S corporation status.
  4. Prohibited Transactions
    Investments which are “prohibited transactions” may result in significant adverse income tax consequences to the IRA holder or other “disqualified persons” (you, parents, kids, spouses of any of the above) who participate in the transaction. IRC § 4975(c)(1) provides that a “prohibited transaction” includes any “direct or indirect”:
    1. sale or exchange, or leasing, of any property between a plan and a disqualified person;
    2. lending of money or other extension of credit between a plan and a disqualified person;
    3. furnishing of goods, services, or facilities between a plan and a disqualified person;
    4. transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;
    5. act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account; or
    6. receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.

Exclusive Benefit Requirement:

A basic requirement of an IRA is that it be created or organized for the exclusive benefit of the IRA holder or his or her beneficiaries. IRC §408(a). Certain types of investments may violate this requirement so as to cause the IRA to lose its tax-favored status. For example, an IRA’s interest-free loan to a friend of the IRA holder to assist the friend might be a violation of this requirement.

The Department of Labor believes that the use of the participant contributions to repay loans to the participants raises concerns under sections 403 and 404 of ERISA. Section 403(c)(1) of ERISA provides, in part, that:

The assets of a plan shall never inure to the benefit of any employer and shall be held for the exclusive purposes of providing benefits to participants in the plan and their beneficiaries and defraying reasonable expenses of administering the plan.

ERISA section 404(a)(1)(A) provides, in part, that:

A fiduciary shall discharge his [or her] duties solely in the interest of the participants and their beneficiaries and (A) for the exclusive purpose of (i) providing benefits to participants and their beneficiaries; and (ii) defraying reasonable expenses of administering the plan expenses of administering the plan.

It is the view of the Department that when the primary benefit requirement is not met, then there would also be a violation of the “exclusive purpose” and “solely in the interest” requirements of sections 403 and 404 of ERISA.

An individual setting up a self-directed IRA that owns an LLC participates as the beneficiary of their individual IRA and as the manager of the LLC. Given that the LLC is a plan asset, the manager has fiduciary duties to the IRA owner.

Thus if the manager makes decisions about the assets based on any loyalties other than for the exclusive benefit of the beneficiary the Dept. of Labor might find a violation EVEN IF ALL OF THE PLAYERS ARE THE SAME PERSON!

For example, what if the client loans money to someone who is not technically a disqualified person but is a relative such as a sibling and the client gives the borrower a good deal (rather than a fair market value deal to the benefit of the beneficiary):

The “Sibling Loans” could be considered by either the Department of Labor (DOL) or the Internal Revenue Service (IRS) to constitute a self- dealing prohibited transaction under IRC § 497S( c)( 1)(D) or (E) or the Exclusive Benefit rule. Such a determination depends on the particular facts and circumstances of each situation, and hence is difficult to predict.

The concern is based in part upon several DOL Advisory Opinions, none of which directly address a situation involving Sibling or more distant relative loans. For example, DOL Advisory Opinion 93-33A held a real estate rental transaction between an IRA owner and a school founded by the IRA owner’s daughter to constitute a IRC § 4975(c)(I)(D) or (E) prohibited transaction. DOL Advisory Opinion 88-18A also addresses the same fiduciary conflict of interest concern (proposed S500k loan to a corporation in which IRA owner had a 46.04% interest in voting power of the corporation would “likely result” in a (c)(I)(D) or (E) violation). The point of these authorities is that it is a violation of the prohibited transaction rules of IRC § 4975(c)(1),(D) or (E) if the IRA owner is placed in a position where he or she cannot exercise the fiduciary responsibilities of undivided loyalty to that person’s IRA that each IRA owner owes.

One conclusion of my research is that the exclusive benefit rule is likely not violated if all loans to individuals (who are not disqualified persons) are made for substantiated / documented fair market value.

Unrelated Business Taxable Income and Unrelated Debt-Financed Income

Certain types of IRA investments makes may generate “unrelated business taxable income” (“UBTI”) or “unrelated debt-financed income” (“UDFI”). The presence of UBTI or UDFI neither is prohibited nor will cause an IRA as a whole to lose its tax- exempt status, but will require the IRA to pay income taxes on the UDFI or UBTI.

Most self-directed IRA custodians require the investor (you) to file a tax return on behalf of the IRA if you create any income taxable to the IRA. Investors need to understand what events or investments will trigger taxable income for their IRA and whether their IRA account allows the creation of taxable income (some self-directed IRAs do not).

When you withdraw the funds you will still be taxed as personal income even for the income on which you pay these taxes. Check out other links in the SD-IRA tab for more information on taxation of IRAs.

Asset Protection Ideas:

In most States IRAs are immune from attachment in case someone acquires a judgment against you. Traditional IRA investments are not, typically, invested in anything that would trigger a lawsuit resulting in the loss of the investment. However, when someone takes IRA funds, invests them into an LLC, then takes the proceeds of the LLC and buys real estate, for example, their once completely protected funds are now exposed to potential lawsuit. The problem is compounded if an investor owns several pieces of real estate in the same LLC. Owning all assets in one LLC is not typically required by most IRA custodians.

Annual Valuations:

Your IRA is invested in shares of your LLC. Your IRA custodian must report annually to the IRS what your IRA is worth (including any distributions, contributions, rollovers). A valuation of your LLC’s assets may be required, depending on what your assets actually consist of. I highly recommend that you do not do this valuation yourself even if you are a professional investment valuator. Check with your custodian for their requirements on asset valuations.

IRS CIRCULAR 230 DISCLOSURE.

In compliance with requirements imposed by the IRS, you are hereby notified that to the extent this written communication addresses tax matters, it is not intended and cannot be used to avoid tax-related penalties under federal, state or local law.

By | 2016-10-13T09:06:06+00:00 July 18th, 2016|Self-Directed IRA, Tax Law|

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