Creating Private Investments Using

Qualified/IRA FundsPresentation at Union League Club, Entrepreneur Group & Real Estate

Group

David Lynam, Principal, Lynam & Associates

Introduction

Self directed IRAs have proven to be a powerful investment tool for many investors.

While they aren’t for everyone, they are an excellent tool for individuals who have profitable investment opportunities in non-traditional investments.

Self directed IRAs allow for greater control and enable an individual to invest into assets they know.

IRA/LLC Investment Structure

IRA invests into a newly created limited liability company (LLC)

IRA owner cannot use an existing LLC that they personally own

IRA owns membership units in the LLC

IRA/LLC is subject to the prohibited transaction/self dealing rules

LLC buys real estate (or other asset)

Benefits of IRA/LLC Investment Structure

Protects IRA owner, IRA & custodian from liabilities and claims arising from assets inside the LLC

Important for: Rental real estate

Real estate rehab projects

Other investments which can create potential liability

Ex., slip-and-fall accident at rental property the injured party would be forced to sue the IRA/LLC but could not sue the IRA, the IRA owner, or the custodian of the IRA.

State and federal bankruptcy laws ONLY protect IRA from creditors of IRA owner

Checkbook control

Establishing IRA/LLC

1. Engage an experienced attorney to prepare the IRA/ LLC documents and provide a written opinion as to the legality of the IRA/ LLC.

1. Required by most self directed IRA custodians

2. Some custodians also require an attorney or CPA to be listed as a designated advisor to the IRA owner with regard to prohibited transactions and operational compliance

2. Appropriately plan for the investments the IRA/ LLC intends to undertake.

3. Decide which state to establish the IRA/ LLC

1. Where does the IRA owner reside?

2. Where does the IRA owner intend to acquire assets?

4. Verify that your self directed IRA custodian will allow you as the IRA owner to serve as manager of the IRA/ LLC, or whether an independent manager is preferable

Establishing IRA/LLC

5. Appropriately plan for who the owners of the IRA/LLC will be

1. Best to determine upon setup and formation of IRA/LLC

6. Complete set of LLC documents

1. Articles of organization w/IRA as member & owner as manager

2. Operating agreement tailored to IRA being a member

3. Tax ID or EIN with IRA as owner

4. Subscription document and agreement (optional)

5. Buy direction letter

6. Opinion letter or designated advisor agreement

IRA/LLC & the Prohibited Transaction Rules

Who an IRA cannot transact with, IRC § 4975

IRA holder and his/her spouse

Lineal ascendants (parents, grandparents, etc)

Lineal descendants (children, grandchildren & their spouses)

Any entity in which any disqualified parties have 50% or more interest

You cannot buy, sell, lease, or exchange property you currently own to your IRA (or vice versa)

You cannot stay, vacation, or personally use an IRA-owned property

You cannot personally extend credit to the IRA (or vice versa)

You cannot personally provide goods or services to the IRA (or vice versa)

You cannot receive ANY consideration as a result of the IRA (or vice versa)

IRA/LLC & the Prohibited Transaction Rules

A prohibited transaction could occur:

During the creation of the LLC

In the change of ownership

In the management of the IRA/ LLC, or

In the investments or transactions that the IRA/ LLC enters into

Repetto, et al v. Commissioner, T.C.M. 2012-168 (U.S. Tax Ct. 2012)

3 Types of Prohibited Transactions

Per Se Prohibited Transactions

When IRA engages in a transaction with a disqualified person

Dealings vs. transactions

Extension of Credit Prohibited Transactions

IRA debts cannot be secured, guaranteed, or extended from the personal assets of the IRA owner

Self-Dealing (Conflict of Interest) Prohibited Transactions

CATCH ALL

When disqualified person benefits from IRA’s investment

Ellis v. Commissioner, T.C.M. 2013-245 (2013) IRA acquired 98% of newly established LLC that was owned 2% by unrelated

person and was in the business of buying and selling cars

IRA owner was actively involved and paid as the general manager of IRA/LLC

(1) Prohibited transaction when the IRA bought LLC ownership? NO

Tax Court: …IRA’s purchase of the initial LLC membership interest was not a prohibited transaction because it’s analogous to when an IRA acquires initial shares of new corporation

RULE: IRA can acquire substantially all or all of the initial membership interest of an LLC in exchange for a cash investment.

(2) Self dealing when IRA owner was paid compensation to manage IRA/LLC? YES

Tax Court: payments were not for management of the IRA but for management of the IRA/LLC and its business activities; prohibited transaction resulted in termination of IRA and distribution of 100% resulting in taxable income and penalties

RULE: prohibited transaction to pay IRA owner compensation for managing the IRA/LLC

IRA Owner or Disqualified Person as Manager In the basic IRA/ LLC structure:

IRA is the 100% owner/member of the LLC

IRA owner is manager

The payment of salary to the IRA owner, even indirectly by an IRA owned LLC, is a prohibited transaction.

The plain language of the reasonable compensation exemption to the prohibited transaction rules found in IRC § 4975 (d)( 10) is that the exemptions apply to all prohibited transactions including self dealing and per se prohibited transactions.

The IRS and the Tax Court, however, seem to view the matter differently and have taken the position that any compensation, whether reasonable or not, from the IRA/ LLC to the IRA owner results in a prohibited transaction.

LLC documents must include a restriction

We recommend an independent manager when possible

IRA Owner or Disqualified Person as Manager If necessary to use disqualified person, should restrict extent of services provided

Only administrative and investment oversight functions:

Signing contracts or agreements as manager of the IRA/ LLC

Paying bills, receiving income, and signing checks as the manager of the IRA/ LLC business bank account

Making decisions as to investments, expenses, tenants, vendors, employees, contractors, and other business activities

Should NOT provide services that would result in a contribution of value

Example: IRA/ LLC owns property that is being renovated. If the IRA owner does the physical work to remodel the kitchen, then such work could be deemed a contribution of value from the IRA owner to the IRA.

Contributions are governed by IRC § 408(a)(1) which states that “… no contribution will be accepted unless it is in cash….”

A contribution other than cash is considered an excess contribution and is subject to penalties.

We recommend an independent manager when possible

Why do we care about prohibited transactions? If prohibited transaction was caused by IRA owner:

Disqualification of the IRA and distribution of the entire account taxes and/or penalties

Accuracy related penalty on gains earned by IRA assets AFTER the prohibited transaction

If prohibited transaction was caused by party other than IRA owner:

Initial excise tax of 15% on the amount involved (to be paid by the disqualified person)

Additional tax of up to 100% on the amount involved if the prohibited transaction is not corrected within the taxable period or within 90 days after the IRS mails the notice of deficiency

Prohibited transactions in a 401( k) or other qualified plan:

15% penalty on the amount involved

Potential 100% penalty if the prohibited transaction is not corrected

Why do we care about prohibited transactions? The statute of limitations may be 3 years, 6 years, or unlimited

3 years after tax return disclosing the prohibited transaction; IRS Form 5329 (transaction w/owner or other fiduciary) or IRS Form 5330 (not a fiduciary) to declare prohibited transaction and pay applicable taxes and penalties

SOL extended up to 6 years when there was a substantial omission from the return that related to the prohibited transaction

Since the filing of IRS Form 5329 rarely happens, the legal statute-of-limitations for most prohibited transactions is indefinite.

Indefinite SOL when false return, a willful attempt to evade tax, or no return

IRA/LLC Tax Reporting & Maintenance

1 IRA single-member LLC disregarded for tax purposes

IRS Pub 3402 (2012) and Tres. Regs. § 301.7701-3

IRA/LLC does not need to file a federal tax return

Multiple IRAs federal partnership tax return

Annual Requirements:

State registration

Asset Valuation

Income and expense records (in case of audit)

Minutes

IRA/LLC & Non-Recourse Loans

An IRA/ LLC can obtain a nonrecourse loan

The same nonrecourse loan restrictions apply to the IRA/ LLC as apply to the IRA

Unrelated debt financed income tax (UDFI) is also applied in the same ways

Most major loan programs offered to self directed IRAs have the same terms and funding requirements when an IRA/ LLC is used instead of an IRA.

Additional Investments from Wife’s IRA to LLC? Question: If I set up an IRA/LLC now with my IRA owning 100% of the

IRA/LLC, can my wife’s IRA later invest into that same IRA/LLC?

A. No, the transfer of ownership from your IRA to your wife’s IRA would be a prohibited transaction.

It is possible to have each IRA invest at the formation of the IRA/LLC and to take ownership at formation according to the amounts invested from each IRA (rather than it transferring from one to the other).

The Multi-Member IRA/LLC Investment Structure Benefit = Multiple IRAs or individual investors can pool investment

capital

Must be properly established and administered

Federal partnership tax return (US 1065) must be filed annually

Ownership Allocation should be based on the amount of $$$ invested

Do NOT allocate for services or for “finding the deal”

IRA must receive same % per $ as an individual investor

Do NOT special allocate profits and losses b/t IRA and disqualified person

Additional Investments into the LLC?

DOL Advisory Opinion 2003-15A

Numerous Verizon retirement plans were invested into a company and owned various portions of ownership

Question: Whether additional contributions and distributions between the company and the different retirement plans would result in a prohibited transaction.

“transactions between the Verizon Plans [retirement plans] and the CIV [company, e.g. IRA/ LLC], including the initial and subsequent contributions to the CIV by the Verizon Plans and distributions from the CIV to the Verizon Plans, would not be prohibited under section 406( a) of ERISA [or under IRC § 4975].

While this specific factual scenario was discussed under ERISA, the rules under ERISA are nearly identical to the rules for IRAs under IRC § 4975, and the DOL stated in its opinion that its opinion should be read with the same effect under IRC § 4975.

Additional contributions must be pro-rata

Prohibited transaction where ownership changes b/t a disqualified person and an IRA

Cash Deal from Multiple IRAs

Bob & Emily both open self-directed IRAs

Bob transfers $50k from another IRA

Emily transfers $50k from another IRA

Bob & Emily create a new limited liability company (LLC)

Cannot use an existing LLC that either of them personally own

IRAs contribute $$$ for LLC interests

LLC is owned by both IRAs

LLC buys property

LLC manages property, collect income, pays expenses

IRA/LLC Do’s

Provide Annual Valuations to the custodian

Make distributions from LLC pro-rata according to ownership %s

Perform rigorous due diligence on investments in which LLC intends to

invest

Set up separate bank account and maintain separate bookkeeping

Unless your Company is a “Single-Member-LLC,” file your annual

partnership tax return for the Company (Form 1065)

Report any UBTI or UDFI that arises from the operations of your

Company (reported on Form 990 for IRAs and form 5500 for 401(k)s.

Update your Beneficiary Designation forms with the custodian

Consult with your CPA or Attorney for your specific situation in order to

avoid prohibited transactions or unintended tax consequences

Checklist: IRAs and Real Estate Is the contract and deed/title in the IRA’s name?

Did the IRA custodian sign the contract and legal agreements for the IRA, or, where applicable, did the manager of the IRA/ LLC sign them?

Did the IRA owner refrain from using personal expenses in purchasing and maintaining the property?

If the IRA obtained a loan to purchase the property, was the loan nonrecourse, and is the IRA owner aware of possible UDFI taxes on any net profits from the debt?

Is the IRA custodian, the property manager, or a properly established IRA/ LLC, receiving the rental income and paying the expenses for the property?

Does the IRA have sufficient capital available to cover an unexpected property expense?

Is the IRA owner holding the property for investment, and are the IRA owner and other disqualified persons avoiding personal use or benefit from the property?

Was the broker or agent in the transaction (when applicable) a non-disqualified person? Did the IRA owner refrain from personally benefitting from the IRA’s purchase?

UDFI (unrelated debt financed income) Tax/ UBIT (unrelated business income tax)

Tax on investments in trade or business

Does not apply to dividends, interest, royalties, or capital gains

Exclusive Benefit Rule

The Exclusive Benefit Rule requires that all investments from a retirement account be made for the benefit of the retirement account. IRC § 408( a)

IRA investments must be made at fair market value at the time of the investment.

Special consideration or unfair terms for the IRA will violate the exclusive-benefit rule.

A fair return commensurate with the prevailing rate must be provided.

At arm’s length

Step Transaction Doctrine

The prohibited transaction rules cannot be avoided by using a “straw person” in the middle of a transaction between a disqualified person and an IRA. These arrangements violate the step transaction doctrine.

When the extra step is being created and implemented solely to defeat the tax code and serves no other economic purpose in the transaction.

In Conclusion

Self directed IRAs are a powerful investment tool for investors with profitable investment opportunities in non-traditional investments.

High-profile figures have built significant IRA holdings by making self directed IRA investments

Ex. Mitt Romney, former CEO of Bain Capital and Presidential Candidate

Invested his IRA into early stage or turn-around private businesses that were not publically traded

His non-traditional IRA value was reported in 2012 at $20 to 100 million

Questions?Union League Club of Chicago, Entrepreneur Group & Real Estate

Group

David Lynam, Principal, Lynam & Associates