Frequently Asked Questions

Yes! absolutely. The only things that the Internal Revenue Code prohibits for investment are certain types of collectibles, like stamps and art works, and life insurance contracts. The types of property in which you can invest are practically limitless otherwise. Everything else is fair game. Promissory notes, real estate, futures options, fishing rights, private offerings, cows, horses, the local laundromat…almost anything you can think of.

Now, a couple of cautions: You shouldn’t invest in “Sub-chapter S” corporations. An IRA owner of shares in that kind of tax-favored company would disqualify the company for the special tax treatment afforded by the applicable Code sections. Although nothing happens to the IRA, the other shareholders would be pretty perturbed.

Also, there are a lot of rules about WHO you can transact business with. Section 4975 of the Code prohibits investment of retirement accounts with “disqualified persons.” If you engage in a prohibited transaction with your IRA, it can be disqualified from its special “tax-free growth” treatment, and special excise taxes can be imposed on people who participate in the transaction. It’s important to have your transactions reviewed in advance by a qualified attorney.

In general, no. The account you have at Merrill Lynch, or Fidelity and most other financial institutions offer portfolios of publicly traded securities from which you can choose in making investment decisions. These are registered securities, in other words, securities and mutual funds registered with the SEC. Although some financial institutions advertise that they allow their account holders to “self-direct” their investments, what the mean is that you are free to pick from the portfolio of securities that they make available to you.

Self-directed retirement accounts, on the other hand, by definition, do not invest in publicly registered securities that are traded publicly. In order for a financial institution to offer securities that are not registered, they have to know you well enough to know whether the proposed investment is “suitable” for you, in other words, whether your other resources permit you to assume the risk that you will loose the money you invested, among other things. They also have to diligently review the offering to determine whether the materials you are being show contain all the appropriate information that you need to make a reasonable decision about whether to invest.

That’s the problem, though. If you told your financial institution that is the custodian of your IRA that you wanted to invest some of the money in a piece of real estate, for example, they may not know enough about you or your resources, or about the proposed investment, to determine whether the investment is suitable for you, so they could become liable to you if you loose your money. Consequently, your regular IRA custodian can’t let you hold “private” investments in your account.

To make a private investment, you need a special type of custodian, a self-directed retirement account custodian.

A single member LLC, whether it is owned by a retirement account, an individual or some other entity, is treated by IRS as “invisible” for Federal tax reporting purposes. The income and expenses of the LLC are reported on the owner’s Federal tax return. So, if you owned 100% of the LLC yourself, you would have to report the income and expense from the LLC’s business on your personal tax return, Schedule C of your Form 1040.

Your retirement account is treated as a “trust” for tax reporting purposes, and in general, trusts report their income an IRS Form 1041. Your retirement account is tax exempt, though, so it doesn’t have to report its income from the LLC’s business. That is, unless the business has unrelated business taxable income (UBTI). Typically, though, LLC’s owned by retirement accounts receive income that is exempt from the unrelated business income tax (UBIT), such as rents, interest, dividends, royalties and gains from the sale of assets held for investment (not inventory). Tax exempt entities, including retirement accounts, report their UBTI on an IRS Form 990T.

So, assuming your LLC didn’t generate any unrelated business taxable income, the short answer to this question is, “Nothing!”

Your state requirements might be different, so be sure to check with your accountant.

Generally, no. Under Section 4975 of the Internal Revenue Code, the excise tax imposed on the people involved in a prohibited transaction do not apply if the plan is disqualified under Section 408. Section 408 only applies to IRAs, Roth IRAs and “deemed IRAs.” It doesn’t apply to qualified (“ERISA”) plans. Section 4975 doesn’t disqualify a qualified plan if a fiduciary commits a prohibited transaction.

There is, however, one exception. Some 401(k) plans allow participants to keep individual accounts to which they can make voluntary contributions as if it were an IRA, in addition to the contributions generally allowed by participants and employers under Section 401(k). Those separate accounts are treated as if they were IRAs established under Section 408. So, if you are a participant in a 401(k) that allows you to have one of those accounts, and if the account’s assets are involved in a prohibited transaction, it could be disqualified under Section 408.

The Internal Revenue Code and various regulations set forth a lot of rules, and there are a few cases interpreting the rules, but there are still a lot of unresolved issues. (See our blog, for example.) On top of that, there are exceptions to the rules, exceptions to the exceptions to the rules, and exceptions to the exceptions to the exceptions to the rules. It’s hard, even for most professionals, to determine what the rules require in some situations.

It might be easier to think of it this way: The point of the rules is that you and your beneficiaries are only supposed to benefit from the use of your retirement account through qualified retirement distributions. So, as a rule of thumb, if you are directing your retirement account to be involved in a transaction that will benefit you, or a member of your family (other than siblings), directly or indirectly, through an entity or through an intermediary, it’s probably not OK.

We often have people ask us “Can I do this…?” We see it as our job to help people obtain their objectives, so a simple “yes” or “no” isn’t sufficient in most cases. That’s what the Initial Transaction Review (ITR™) is for. Check out the description under SDRAStartup Small Business Services™ in the Services menu.

There are two ways to value your LLC’s units. One would be to have a business appraiser establish a value, but that could cost several thousand dollars.

What the custodian wants is for you to add up the value of all of the assets held by the LLC, including any cash in accounts. Then divide that number by the number of units the retirement account holds. That gives you the pro rata value of all units.

How you determine the value of the assets held by the LLC depends on the type of asset held. Many LLCs owned by self-directed retirement accounts hold either investment real estate or promissory notes.

Within a year from when the LLC purchased real estate, the purchase price is a good indicator of the value of the property. Thereafter you might obtain a real estate appraisal, of check the town’s assessed values, as long as the assessed values are intended to reflect current market value.

For notes, add up the outstanding principal balance of notes held, then add the cash in the LLC’s bank accounts, and that gives you an accurate valuation of the assets held in the LLC.

“SDRA” is an acronym that stands for “self-directed retirement account.” A retirement account is “self-directed” when the investment choices are controlled by the account owner, not the account custodian. Self-directed retirement accounts can invest in anything other than collectibles and life insurance. You are not limited to the investment choices provided by broker-dealers, trust companies and banks. They require a specialized custodian that will hold title to the asset in which you invest. You can own real estate, small businesses, water rights, fishing rights, gold bullion, private partnerships and LLCs, and an almost infinite variety of other investments in a SDRA.

Many people use the term “self-directed IRA” for the same thing; but that’s just one type of tax free retirement account that can be “self-directed.” Roth IRAs. Solo(k) plans, and some employer-sponsored 401(k)s can invest in these privately available investments.

Why does my retirement account’s custodian want me to report the value of the LLC my retirement account owns as of the end of last year?

Every year your custodian will ask you to tell them the value of the LLC in which your retirement has invested as of December 31 of the prior year. That’s because the custodian has to report the value of your account, along with contributions and distributions to your account, to IRS by May 31 of the current year. All retirement account custodians are required to meet this reporting requirement.

This question comes up a lot from managers of LLCs in which their self-directed IRAs have invested, particularly LLCs that are wholly owned by their self-directed IRAs – single member LLCs. The answer to this question is “Yes, but be very careful.”

Section 4975 of the Internal Revenue Code prohibits the “…transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan….” Technically, that’s what you’re doing if you pay yourself anything from your IRA, other than distributions.

There are exceptions to the prohibited transaction (PT) rules, though. One of them allows the “receipt by a disqualified person of reasonable compensation… for the reimbursement of expenses properly and actually incurred…in the performance of his duties with the plan….” The IRS regulations clarify that the expense has to be a “direct” expense.

Three are really three requirements.

1. The Amount has to be “reasonable.”

IRS regulations don’t really tell us what “reasonable” means, except to say that it depends on the facts and circumstances in each case. In the law, the term “reasonable” is often used when the legislative body wants to leave it up to the courts or administrative bodies to decide how a law applies, because it can be impossible to anticipate every circumstance to which a statute applies.

The easy way to avoid that is to reimburse yourself for amounts paid directly to others for which transactions by the general public establish the reasonableness of the amount, such as state entity filing fees. Since literally thousands of people pay state entity filing fees, it would be difficult for IRS to argue filing fees were “unreasonable.” On the other hand, if you reimburse yourself for, say, the services of a plumber in connection with a building your IRA owns, you’d have to be sure you could establish that the plumber’s rates and charges were within the range of charges by other plumbers in the area for similar services.

2. The expense has to be “properly and actually incurred.”

Section 4975 sets forth the “properly and actually incurred” standard. IRS regulations clarify that such expenses also have to be “direct.” An expense is not “direct” if you would have had the expense anyway – if the service to the IRA had not been provided—or if it represents only a part of total overhead costs. An example of that would be your home office. Although you can use your home office to pay bills for your self-directed IRA’s single member LLC, for example, you can’t charge your self-directed IRA a portion of the cost of maintaining your home office. You would have incurred those costs even if you weren’t paying the self-directed IRA’s bills from your home office.

3. The expense has to be incurred in the performance of your duties as a fiduciary of your self-directed IRA.

You are a fiduciary of your self-directed IRA because you exercise authority or discretionary control over the management or disposition of your self-directed IRA’s assets. If your self-directed IRA’s LLC owns a building that requires plumbing repair, for example, it’s your job as the LLC’s manager to hire a plumber that charges a reasonable amount for the services required. On the other hand, if you hire the plumber to do work in two buildings, one of which your self-directed IRA doesn’t own, you are not hiring the plumber entirely in the performance of your duties of as a fiduciary of your self-directed IRA. If the plumber doesn’t separate out his or her charges for the work done on your self-directed IRA’s building, your reimbursement might not qualify for the exception.

A common example is a question we get from an IRA owner who is the manager of an LLC owned by his or her self-directed IRA. Paying state annual filing fees is important because it maintains the legal status of the LLC. It’s easy to pay the fee online using a charge card. Many single member LLCs don’t have a charge card, though, so the Manager might pay the expense with a charge card, and get reimbursed by the LLC by check. So, it would be OK to reimburse yourself for the charge for the state filing fee, but not for the interest expense incurred monthly on your charge card.

Summary

Here are some suggestions we generally give to our SDRAServices™ clients:

• Don’t reimburse yourself for any type of expense when the amount isn’t established to an unrelated third party. That way the “reasonable” requirement is generally met.
• Be sure to keep the written records of each reimbursed expense from third parties such as invoices you paid.
• Avoid reimbursement situations as much as possible. Let your self-directed IRA or single-member LLC pay the expense directly.
• Make sure the reimbursement doesn’t cover anything but expenses you have incurred for your self-directed IRA.

Mostly no, but in some circumstances yes.

When you establish any IRA account with a custodian you sign the custodian’s version of an IRS form – Form 5305. The instructions to the form specifically say that the IRA owner’s social security number “will serve as the identifying number for his or her IRA.” Mostly an IRA doesn’t need a taxpayer identification number because it doesn’t employ anyone (so it doesn’t need an Employer Identification Number), and it’s a tax free account, so generally it doesn’t have to report its income and pay taxes to IRS.

The question comes up a lot for self-directed IRAs, though.

Bank Accounts and the Single-Member LLC

The single-member LLC (also sometimes called a “check book LLC”) is a common strategy for self-directed IRA owners. If your self-directed IRA invests in real estate, for example, a single-member LLC with you as its manager can make it much more convenient to collect rents and pay people who service the property. Otherwise, your tenants have to be instructed to send their checks to the custodian, your custodian has to maintain liability, property and casualty insurance, and every time the plumber has to be paid, you have to instruct the custodian to send a check.

If you want your single-member LLC to purchase the property, your self-directed IRA has to invest the necessary cash in the LLC, and for that your LLC needs a bank account.

The bank, however, won’t open a new account without a taxpayer identification number. Whether the depositor is an individual or a business entity, the bank needs to report interest and other information to IRS, and for that it needs an identification number for the LLC.

When you apply for the LLC’s identification number (which you can do online), IRS wants to know who the owner is, and requires the owner’s taxpayer identification number. Since the owner is your self-directed IRA, the online application requires you to give an identification number. That’s when the IRA’s owner’s social security number is used. It’s not necessary to get the IRA a separate taxpayer identification number for that.

Filing Form 990-T for Unrelated Business Taxable Income

Although your IRA is generally exempt from income tax on its earnings, there are exceptions. When your self-directed IRA receives “unrelated business taxable income” (sometimes called UBTI) from its investment, the income is taxable.

For example, if the investment is in real estate subject to a mortgage, a portion of the income from the investment is taxable income, and the self-directed IRA has to pay “unrelated business income tax” (sometimes called UBIT). UBTI is reported to IRS on an IRS Form 990-T. That’s when the self-directed IRA needs a taxpayer identification number.

Summary

For most purposes a self-directed IRA doesn’t need a taxpayer identification number apart from its owner’s social security number; but when it has to report UBTI and pay income tax, it has to have its own taxpayer identification number.