Jeff Nabers’ Self Directed IRA & Solo 401(k) Blog

As a follow up to “Where to find reliable information”, I want to let you know about another seemingly unscrupulous self directed IRA/401k promoter… Waterford Financial Group (www.thetrueira.com). Again, I’ve never spoken with them or dealt with them in any way, but one visit to their web page is cause for alarm. At the time of this writing, their web site links to various advisory opinions, private letter rulings, and field service advisory letters from the IRS & DOL (the DOL rules on IRA/401k prohibited transactions and exemptions).

The page in question lists summaries of these letters. It is important to first acknowledge that their “About Us” page says:

“Waterford Financial Group is a national marketing and financial services company with a consortium of tax professionals and Tax Attorneys on staff. Our purpose is to educate individuals and other professionals about the many benefits contained in the tax code.”

I always find it odd that companies spotlight all the tax attorneys on their staff without naming those attorneys or substantiating their claim in any way. If you’re browsing my blog posts, I hope I don’t come across too negative, but my pet peeve is predatory practices… and this is not minor issue when it comes to messing with people’s wealth.

Back to the Waterford Financial Group web page: They link to a DOL opinion with the description:

“Here’s a ruling where an IRA owner had his IRA make a loan to a corporation owned 47% by him. Sure beats dealing with a bank.”

The description infers that the proposed loan is acceptable and compliant. So no need to actually read the document since their staff full of tax attorneys probably wrote the description, right? Wrong. If you just scan the actual document you will find (more…)

By far, one of the most luring propositions is

Fund your dream business with your retirement fund

“But, how?” you ask, “isn’t it a prohibited transaction to invest your plan (IRA/401k) into something that involves myself as disqualified person?”

Yes. As a general rule, it is prohibited for your plan to invest in a business that you own or run. An exception to that rule is what is promoted through:

• Benetrend’s Rainmaker
• Guidant Financial’s Audeo
• ERSOP
• and others

The arrangement works with a prohibited transaction exemption [IRC 4975(d)(13)] for what is called “qualifying employer securities”. This is how these arrangements are structured:

1. A C Corporation is formed
2. This new corp then sponsors a qualified plan (such as a 401k or profit sharing plan)
3. The customer’s existing retirement funds are transferred into the new plan
4. The plan then purchases a significant portion of the new corp’s stock as qualifying employer securities

Ordinarily, this would be a PT, but based on the special exemption, it is okay that the plan is buying shares in the participant’s company, the participant is paid a salary from the company which is funded mostly from the plan, and the participant works for the company which is owned mostly by the plan.

For this “qualifying employer securities” arrangement to exist, the plan documents must allow for investment into QES and the corporation’s bylaws must allow for QES and a corporate resolution must be made to approve the QES transaction.

Theoretically this can be a very powerful concept. In my honest opinion, however, this arrangement is often being promoted regardless of suitability.

Sales Pitch A - Access your retirement funds NOW

“Do you want to benefit now from your retirement funds before age 59 ½? Just use this QES arrangement!” Let’s examine this further below in some examples. I hate to spoil it for you, but of all the options to receive your retirement funds earlier than 59 ½, the QES arrangement results in maximum taxation.

Sales Pitch B - Make your business income tax deferred

This is simply a half truth. The business income is taxed at the corporate level. Let’s examine:

QES funds legitimate business, but there’s no profit

Jerry wants his retirement funds NOW, but he’s only 45. He doesn’t want to pay distribution taxes & penalties, so this sales pitch appeals to him. He sets up a Rainmaker plan, but his business never makes a profit. That’s okay, he thinks, because I really just wanted access to my retirement funds. But at what cost was this access granted? Firstly, the only money he makes is what his corporation pays him through a W-2. So he pays taxes on this personal income after all that work to “get around the distribution taxes”. Any money he has spent on trying to get the business off the ground would likely exceed the 10% penalty he would have incurred for just directly distributing from his retirement accounts. Plus, he’s spent $4,000 to $5,000 to setup the arrangement in the first place.

Conclusion: He would probably receive less money (net of taxes) through his QES arrangement than he would through direct plan distributions.

QES funds questionable business, but there’s no profit

Joyce wants her retirement funds NOW, but she’s only 50… so she sets up an ERSOP. She never really tries very hard to make the business successful, so her situation is just like Jerry’s except she hasn’t spent that much money on business expenses outside of paying herself a salary. She still ends up paying taxes on her personal income. She thinks she’s clever because she kept her expenses low, but all in all the IRS & DOL may question whether this business was truly created with the intentions of making or selling products or services for a profit. If they conclude “no”, then the entire arrangement may be deemed a “sham” and past due taxes, interest, and penalties assessed.

Conclusion: Joyce’s income (which comes from retirement fund money) is taxed as ordinary income. She receives no tax beneift. Further, she is operating a sham entity that will upset the IRS in an audit.

QES funds legitimate, profitable business

Jill has a great business idea, uses the Guidant’s Audeo QES arrangement to fund it, and lo and behold, it’s a success! As the first example with business income,

• She is still paying ordinary income taxes on the compensation she personally receives (She did not circumvent the taxes she would have paid to distribute her retirement funds to herself)
• Her plan receives its income after corporate taxes are paid. This means her plan’s income will be taxed once at the corporate level and once again later at distribution. This is just bad planning that results in maximum taxation.

Conclusion: Jill still paid taxes on her personal income (that came from her retirement money and its further returns) and the income of her retirement plan is subjected to corporate taxes. This strategy accomplishes little to nothing in the way of tax minimization.

A better way to access your funds NOW

Did you know that you can distribute your retirement funds to yourself at any age without triggering the 10% penalty? All you have to do is agree to abide by a regular payment schedule until you either turn 59 ½ or take distributions for 5 years… whichever is longer. There’s plenty of strategies to follow that make these schedules flexible for anyone who has a fair amount of retirement funds. More on this in a later post…

Sales Pitch C - Quit your job and follow your dreams

Like most people, you probably have a dream or two about starting a business that you would love running. I think this plays a bit strongly on most people’s emotions. Most people are tired of working for someone else, and they want the flexibility and freedom that can be made possible by starting a small business.

The problem is that 90% of small businesses fail in the first 7 years. 90% of the survivors fail in the second 7 years. This famous Department of Commerce study tells us that if you are starting a small business, you have a 99% chance of failing. How do you like those odds? They are worse than the odds you get from a casino… many times over. To complicate matters, many people cite that the #1 reason for small business failure is not enough capital. Now, my goal isn’t to deter you from starting a business. For me, starting and running businesses has been extremely gratifying. I’ve started over a dozen businesses, some of them were profitable successes, but probably the most (more…)

There’s a questionnaire that I go through with my new customers over the phone, and in it I ask if forced appreciation is part of their investment strategy. Often I hear a response of “huh?”

Forced appreciation belongs mostly to the world of commercial real estate. It’s natural for the new real estate investor to gravitate towards residential because everyone understands it. We all live in a home and pay a mortgage or rent payment. Prices fluctuate due to supply and demand, and we understand this. What many don’t understand is that commercial property is the investor’s preferred real estate. Why do I say this? I thought you’d never ask…

Property prices are always truly decided by the buyer and seller. But market value can be determined by a property appraisal. Here’s where residential and commercial RE appear to come from different planets. Residential property is almost always appraised by comparable sales. In other words, the market value is whatever everyone else is paying in that area for that type of property in that type of condition. The purpose of residential property ownership is living space. So “type of condition” means the physical condition of the structure & its fixtures. Bank lending plays an important role in how appraised value and actual purchase price interact. Most residential property is purchased with mortgage financing. Residential appraisals are based on what others are paying for similar properties, and the lender ends up only lending if the purchase price of the subject property (which is the loan collateral) isn’t much higher than the appraised value. So, when you are in the market to buy or sell, you’ll generally need to buy or sell for a price close the the appraised value.

When investing, the two things that indicate the performance of your property owned are cash flow and gains or losses upon liquidation. In residential real estate, your gain or loss upon liquidation is determined almost entirely by what other people are paying for similar properties at that time. So what’s wrong with that? Well, for starters (more…)

The plan asset rule, among other things, is used to determine whether or not a retirement plan is involved in a prohibited transaction.

A PT happens when a plan enters into a transaction with a disqualified person. In our previous post, we covered how to make a list of disqualified persons for a specific plan. This included determining whether a partnership, LLC, corporation (or other entity) is a DQP itself because of significant ownership by other DQPs.

A prohibited transaction occurs when all three factors are present: a DQP, a plan, and a transaction between the two. So, from the previous post we know how to determine if an entity is considered to be a DQP itself. But how do we know if an entity is considered to be a plan?

Plan asset look-through

…is the term DOL uses (The U.S. Department of Labor, DOL, is the government entity that solely has the authority and responsibility to interpret prohibited transactions code). If a situation does have plan asset look-through it means that you look through an entity to the plan and consider the assets of the entity to be the assets of the plan itself. This also means that when you do have plan asset look-through, that entity is treated as if it is the plan itself for PT purposes. That would mean that that entity could not transact with a disqualified person.

When is there plan asset look-through?

The first hard and fast rule is that when an entity is owned 100% by a plan, there is plan asset look-through. So if your Solo 401(k) was 100% owner of an LLC (or any other type of entity) then that LLC would be seen as if it were the plan itself for purposes of PT determination.

The second rule is that when a plan owns 25% or more of an entity, there is plan asset look-through. I know you have a scrunched up face right now because the second rule seemingly makes the first rule unnecessary. This second rule isn’t hard and fast like the first rule. This rule does not apply if you have an “operating company”.

What is an operating company?

This is where the fun starts.

An operating company is one that primarily makes or sells a product or service other than the investment of money.

A real estate operating company is one where at least 50% of its assets (valued at cost) are invested into managed real estate or real estate development, provided that the entity is directly engaged in the management or development activities.

So, back to plan asset look-through… If you have an operating company, the there is only look through if a plan owns 100% of the operating company. If you don’t have an operating company, there is look through if the plan owns 25% or more of the company.

At first glance you may think “wow, there are some major benefits to investing in an operating company”. I partially disagree. Firstly, your plan is intended (more…)

The most notable difference between endeavors down the path of using a self directed IRA versus traditional investing is the unique rules that apply to the former. The extremely simple rule is that an IRA (specifically) cannot buy life insurance or collectibles (such as rugs, works of art, alcohol, bullion).

The more involved rule is known as “no self dealing” and is described in Internal Revenue Code section 4975. This rule basically says that for each retirement plan/account, there is a list of “disqualified persons” with whom that plan cannot do business. These DQPs include:

1. The accountholder/participant and any other fiduciary (person who makes investment decisions for the plan)
2. Companies who provide services
3. A member of the family of #1 or #2 above (family defined as spouse [husband/wife], ancestor [parents, grandparents, etc], lineal descendants [children, grandchildren, etc], and spouses of lineal descents)
4. A corporation (or other entity) that is 50% or more owned (directly or indirectly) by #1, #2, or #3 above
5. An officer, director, 10% or more owner, or highly compensated employee of #4 above.
6. A 10% or more (in capital of profits) partner or joint venturer of #4 above

Every self directed IRA/401(k) investor should make this DQP list before making any investments.

Too many people seem to think of the list as only “the accountholder and his family”. As you can see it is a bit more involved than that. This doesn’t require calculus, but you should actually write out the list step by step to ensure that it is complete. This list can actually get quite extensive if you, your family member, or anyone who provides services to your plan has ownership in several companies.

So, what is a prohibited transaction?

In a nutshell, when a DQP transacts with a plan it is a prohibited transaction (abbr “PT”). The trick here is what is considered to be a “transaction”. This is generally defined in IRC 4975 as when one of the following happens between a plan and DQP directly or indirectly:

• sale, exchange or lease of property
• lending of money or extension of credit
• furnishing of goods, services, or facilities

So I consider that to be the general rule. There are a couple of special rules and they (more…)

In a world where we see stories unfold such as:

• Enron
• WorldCom
• Tyco
• Subprime mortgage crisis
• Mutual fund mortgage overexposure and misreporting
• Fannie Mae & Freddie Mac accounting scandals
• Insolvency of Investment Bank Bear Stearns

…most Americans are running low on trust when it comes to financial service companies. Who can you trust?

This is an especially important question in light of my recent post about misinformation in the self directed IRA community. My answer: yourself. That is what self directed investing is all about. You have control of your assets.

With the checkbook control provided by an IRA LLC, there is no potential for fraud unless your IRA rollover is handled by someone other than a bank or trust company (aka custodian). With a Solo 401(k) you don’t even have to transfer your assets through a custodian in the first place.

Q: What should I be concerned about?

A: Prohibited transactions and tax compliance, although it is simple to address both concerns. You can search Google for “self directed IRA prohibited transactions” and “IRA UBIT tax” to learn about the basics of both topics. If a service provider claims (more…)

I ran across something today that may surprise you. I was reminded of why I founded the IRA Association of America. I hear some of the craziest things from prospects and new customers, such as

“My understanding is that my IRA can loan money to a Corporation I own part of.”

“I’ve heard that my company can do business with my IRA if things are structured right.”

First of all, these statements are both incorrect, and would each result in a prohibited transaction, triggering hefty tax penalties. Now, when I hear these type of statements I wonder where they come from. I’ve always figured that they must originate from various new, inexperienced companies with educational materials that are simply inaccurate. Today, I found out that I’m half correct. It is coming from inaccurate materials and sources, but to my surprise, these sources aren’t always new and inexperienced.

This post is in reference to an LLC facilitator called CHECKBOOK IRA located at www.checkbookira.net and www.checkbookira.com. These guys may be familiar to you because, at the time of this writing and for the past several years, these web sites come up in search engine results for terms like “ira llc” and “self directed ira”. Now, I’ve never met or spoken with the owner, Steve Sheperd, so I can only comment based on the information on his web sites.

Currently, if you go to CHECKBOOKIRA.net and click “legal rulings” it links to a ruling that says “Your IRA can make a loan to a company owned less than 50% by the IRA owner.” This caught my attention because the claim was contrary to the understanding given to me from seasoned Department of Labor agents. So I clicked the link and read the entire document. (It’s important to note that (more…)

I just got done interviewing John Rubino, co-author of The Collapse of the Dollar - Make a Fortune by Investing in Gold & Other Hard Assets, and it was quite interesting. Rubino stated that:

Over the last 7 years the stock market has dropped [as significantly] as it did during the Great Depression.

“WHAAAT?!!” you say. He explains that our perception of this strong bear market has been softened by the declining value of the dollar. In the spirit of comparing apples to apples, we must first consider that in the late 1920’s and early 1930’s the dollar was fixed to gold. So, in essence, the stock market’s decline was measured in gold. According to Rubino, you would see a depression-like chart if you were to measure the past few years of the stock market in gold.

The most convincing thing about his perspective is that he accurately predicted the burst of the housing bubble… in 2003. He forecasted that those who would suffer the most from the popping bubble would be homebuilders’ stocks, Fannie Mae & Freddie Mac, and real estate prices in “hot” (at the time) areas. He even went on to explain that the contributing factions would spill over into other parts of the economy including financial services companies, and banks themselves. At that time, the idea of one of the country’s largest investment banks (Bear Sterns) becoming insolvent sounds crazy, but Rubino warned us all with How to Profit from the Coming Housing Bust: Money-Making Strategies for the End of the Housing Bubble. In fact, if you would have followed his advice to the “T”, you would have profited immensely , provided that (more…)

For many real estate investors, leverage is a key factor to their plans for profits - leverage in the form of mortgage financing. When you introduce mortgage financing into Self Directed IRA ownership of real estate, a special tax called Unrelated Business Income Tax (UBIT) is triggered. The tax often isn’t detrimental as will be covered in another post, but nonetheless it reduces the profit.

For the self employed, a fantastic development has occurred over the past few years - the Solo 401(k). One distinct advantage of the Solo 401(k) over an IRA is that it is not subject to paying UBIT on profits from financed real estate. Eliminating UBIT by using a Solo 401(k) eliminates the need to file a return (Form 990-T) as well as the accompanying tax. Sound pretty good so far?

The difficulty in recent times has been obtaining nonrecourse financing. The leader of NR financing in the Self Directed IRA industry for the past few years has been North American Savings Bank. Last year, they took the familiarity of IRA lending and applied it to Solo 401(k). Unfortunately for many Solo(k) investors, this has only been available to plans who choose to name a custodian as trustee of the plan. Qualified plans (which is what all 401k plans are) are different than IRAs in that they are not required by law to (more…)

I work in the field of Self Directed IRAs & 401(k)s. Based on the phone calls and emails we receive, by far the most discussed topic is checkbook control. Some people want it; others don’t. Some service providers support it; others discourage it.

What is it?

What most people are referring to when they say checkbook control is an investment structure that is formed as follows:

1. A person opens an IRA account at a self directed custodian and transfers other retirement account funds into it.
2. The accountholder has a Special Purpose LLC created and names themselves as LLC manager.
3. The accountholder directs their custodian to invest some or all of the IRA funds into the newly created LLC.
4. The LLC further invests its funds, often into real estate, private companies, or mortgage notes. The LLC is owned by the IRA, but managed by the IRA accountholder. Because the manager is the authorized signor on all LLC accounts, this is known as checkbook control.

The legitimacy of this structure was verified in a tax court decision.

Why would somebody WANT checkbook control?

• Eliminate transaction based custodian fees
• No delay for custodian to process the transaction
• Remove custodian’s prohibition on certain legally allowable investments
• Invest in stock market with margin
• Invest in foreign assets with more ease

Why would somebody NOT want checkbook control?

Here’s where the confusion and disagreement occurs. The argument against checkbook control is based on compliance, mostly with prohibited transactions, which in a nutshell are “self dealing” transactions. Self dealing means the accountholder causing the retirement account to buy, sell, or otherwise enter into a transaction with a disqualified person. This category of people includes the accountholder, most of his relatives, and anyone who provides services to the retirement account. So the argument goes like this:

“Prohibited transactions are costly. Without a custodian overseeing your transactions, you are at higher risk of doing a prohibited transaction and paying large tax penalties as a consequence.”

I always do my best to maintain an objective, balanced viewpoint. In light of the above argument, I formed the opinion that it’s good for some people to have checkbook control and risky for others. Therefore, whether checkbook control is appropriate is dependent on the circumstances of the accountholder. I operated under this thinking for over a year…

Then I learned more about the actual matter at hand.

… and have come to a completely different conclusion. Here are the newly discovered facts: (more…)