Limited Liability Companies as a Self-Directed IRA Strategy
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What is an LLC?
LLC is an acronym for limited liability company. It is a legal structure that limits the legal responsibility of the people within it. In the same manner as incorporation, the creation of this legal entity shelters its owners from being personally responsible for the company’s debts and obligations. LLCs have the added benefit of being taxed at the individual tax rate, as opposed to the corporate rate.
A person with an ownership interest in the LLC is called a member. Investments in the LLC are referred to as membership interests or units. In specific states where LLCs are legally considered securities, the people and/or entities wishing to invest in them are required to meet certain state regulations before doing so.
Why have an LLC in an IRA?
There are 3 primary benefits to owning the assets in your SDIRA through an LLC:
- Faster transactions. Typically, executing transactions such as purchasing assets through your retirement account requires going through an IRA custodian. This means that paper work or electronic communication must be completed, and other transactions such as sending proceeds to the seller are all at the mercy of how quickly it can be processed. With an LLC, you can skip all of this by establishing checkbook control with your IRA. (Read more below). Since the IRA invests in funding and LLCs, the funding is deposited in the LLC’s checking account, and funds are readily available to execute transactions. Bypassing the custodian via this arrangement allows for the investor to act swiftly. Transactions become as simple and convenient as writing a check.
- Fewer administrative fees. By not going through your IRA administrator for every transaction, you save the typically associated processing fees. Checkbook control will save you money, leaving more funds available to invest toward your retirement. As the IRA’s investment is the LLC, and not the underlying investments of the LLC, there is also a cost savings where IRA recordkeeping fees are concerned. For example, if the LLC purchases multiple properties, the fees will be based on one investment (the LLC), and not the multiple underlying investments within the LLC.
- Many investors have also used LLCs as liability protection for investments held under their IRA. Consult with your legal advisor to determine whether you would benefit from the liability protection of establishing an LLC to hold your IRA investments.
Does having an LLC in an IRA deliver greater tax benefits?
Using an LLC in your self-directed IRA does not provide any additional tax advantages. Your IRA invests in and owns the LLC. An IRA is a tax-deferred entity, so there is no taxable event in your IRA when investing directly or through the LLC. It is vital however, that any income from the LLC be paid back to the IRA, which holds membership with the LLC to avoid taxation. Income from the LLC cannot be paid directly to you.
As mentioned previously, LLCs provide pass-through tax treatment and are not taxed at the corporate level. Thus, profits flow through to IRAs or other self-directed savings accounts.
Depending on the type of income received by the LLC, income received by the IRA may be subject to unrelated business income tax (UBIT). Since the IRA owns the LLC, an IRA may have to file a tax return if the income it receives is taxable. The IRS form used to file the IRA’s tax return is called the IRS Form 990-T. Taxable income received by an IRA, which is considered a trust, is taxed at trust tax rates. Income derived from a Trade or Business is taxable to the IRA. Income received from an investment that is leveraged will have the leveraged portion taxable as well. Other incomes such as interest, rents, royalties are not considered taxable income to the IRA. The IRS Publication 598 sheds additional light on this topic.
What is UBIT, and why would my IRA owe that tax?
UBIT stands for “unrelated business income tax.” It is a tax the IRS imposes on investments owned by charities or accounts that would otherwise be tax exempt, like IRAs. The most common triggers for UBIT are businesses, like a limited partnership or LLC, that are conducted within a tax-exempt retirement account and real estate owned by an IRA that is debt-financed. For UBIT to apply, the income generated must meet all of the following criteria:
- It is derived from a trade or business activity. For example: the sale of goods or services.
- The business occurs regularly. For example: you receive monthly or quarterly income.
- The business activity is not related to the tax-exempt status of the account.
Read more about UBIT here.
Are there limits on what an IRA-owned LLC can invest in?
The IRS allows an LLC to own the same types of investments as any self-directed IRA, from real estate to precious metals to private placements. The three exceptions for any self-directed IRA apply: you cannot invest in collectibles, s-corporations or life insurance.
How do you create an LLC?
The process includes writing an LLC operating agreement and filing paperwork with the state where the LLC is to be domiciled. An annual fee may apply, depending on the state in which the LLC is established.
It is wise to work with legal counsel that is familiar with state laws governing this type of entity. Working with legal counsel that is familiar with the IRA rules and can build parameters into the LLC’s operating agreement that would prevent the LLC from conducting prohibited transactions is also advisable.
Are there transactions that cannot be made through an LLC owned in a self-directed IRA?
Yes. LLCs owned by IRAs are subject to Federal Tax Law and the prohibited transactions therein. The IRA is prohibited from engaging with a disqualified person or entity.
- If you already own a business registered as an LLC, it may not be advisable to buy shares in that business using IRA funds. Your ownership and control of the business makes the business itself, a disqualified entity (person).
- You may not receive any direct benefit from the LLC (other than the benefit of using it to save for retirement). Thus, you cannot be paid for performing services for the LLC.
- You may not personally guarantee a loan to or for the LLC in which the IRA invests.
Can an LLC partner with other people or entities?
Yes, with limitations. Partnering with other people or entities can be a great way to raise additional capital. You can partner with another IRA or another LLC. The percentage of ownership is calculated by how much each entity puts into the LLC.
You can even partner with a disqualified person, if you do it when the IRA LLC is first created. Be sure to involve your tax or legal advisor before proceeding with this type of an arrangement to avoid unnecessary consequences.
Your IRA invests $40,000 into the LLC and your spouse’s IRA contributes $60,000. This makes it a 60/40 ownership split. All incomes and expenses must be paid proportionately to and from each IRA.
What is checkbook control?
Checkbook control is the ability to manage your self-directed IRA funds with the ease and convenience of a checkbook. Rather than contacting your account administrator to direct your IRA funds, you simply write a check to manage your assets.
Since the LLC in your self-directed IRA is its own entity, it is allowed to have its own checking account. If you are named the managing member of the LLC, you will be in charge of the business checking account, which is funded by the cash (uninvested funds) in your IRA. You will hold the checkbook linked to the business checking account of the LLC, which is in turn linked to your IRA funds.
This strategy may offer significant advantages, in the way of speed and convenience. You can manage your self-directed IRA funds with ease when you set up an LLC with checkbook control.
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