What’s so special about the IRA LLC? June 9, 2008
Posted by Jeff Nabers in Self Directed IRA/401k.Tags: self directed, ira, custodian, prohibited transaction, llc, ira llc, irs, compliance, limited liability company, minutes, operating agreement, special purpose, compliant, facilitator
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Ahhh… the single most mis-answered question in the self directed IRA world:
Customer: I’ve noticed it costs more to setup an IRA LLC than it does a general purpose LLC. What’s so special about the IRA LLC?
LLC Facilitator: The Operating Agreement has special language. Putting together an IRA LLC without this magical language will result in a prohibited transaction and hefty taxes.
This is untrue. While it’s advisable to include special language in a special purpose LLC (one that is intended to be owned by an IRA and managed by the IRA accountholder), the absence of such language will not create a prohibited transaction in itself. Believe it or not…
Any newly created LLC can be used with an IRA!
…without necessarily creating a prohibited transaction. The sales pitch that you need the special purpose operating agreement is bogus.
That said, it is still advisable to have an IRA LLC established for you by a company experienced and competent in such facilitation. Not because you have to, but because you should want to. Why?
You want things to look good in the event of an IRS audit
This is probably the main reason why you should have an IRA LLC formed for you by a specialist instead of doing it yourself. If you get audited, the IRS is going to have a first impression about your IRA LLC structure. If it looks like you did everything compliantly and your documents pro-actively address most compliance issues, the IRS’s first impression may be friendly. If it looks like you just threw the LLC together with little regard for compliance, this may negatively affect the IRS decision of how long and excruciating the whole ordeal will turn out to be. This is an important issue. Notice I said “looks like”. Regardless of how compliant you are, the IRS can still make your life a living hell for a couple years. I’ve never heard of an IRA LLC triggering an audit, but once one starts you should want to make them happy. Having a nice neat record book (as provided by an IRA LLC facilitator, with documents that explain exactly what you did and why it was compliant) will probably make the IRS happier than an incomplete record book or one that contains mistakes.
I spoke with a gentleman earlier today who was forming his IRA LLC himself based on research he did on the internet for 6 months. He called me because he was trying to find someone to pay a small fee to for signing some of his LLC documents as organizer. In the event of an audit this guy’s situation may very well induce the full wrath of the IRS. Imagine the field agent reviewing all of his financial information:
IRS Agent: What’s this?
Guy: It’s my IRA LLC.
IRS Agent: Looks like a prohibited transaction. We’re gonna look into this.
[to "Organizer" listed on documents]
IRS Agent: So I understand you organized Guy’s LLC.
Organizer: No, I just signed as organizer for a fee. He did everything himself.
[IRS agent begins to transform like the Incredible Hulk]
Immediately, the IRS could feel that Guy is trying to deceive them. The strange part is that I don’t even understand why he wants to do it this way. He doesn’t have to have somebody else form his IRA LLC. If he’s organizing it, I think he should sign as organizer. If someone else is, they should sign as organizer. Anything else may be deceptive and will probably only serve as a means to appear like someone who is not being up front and honest to the IRS.
I can’t help but to think how much more profitable Guy’s investments would be if he spent less of that 6 months’ time learning how to form an IRA LLC himself and more of the time finding, researching and evaluating investment opportunities.
Summary
You can form an IRA LLC yourself. It doesn’t require a special document to be compliant with laws and regulations. The formation process does, however, need to be followed in a particular way. If formation tasks are done in the wrong order or if certain parts of documents are filled out incorrectly, it can create a prohibited transaction. Or, also undesirable, it can create a nasty IRS audit. Therefore, I don’t think it’s worth saving a few bucks to form it yourself. Currently, most IRA LLC facilitators charge $2,500 to $3,000 to setup an IRA LLC. This is similar to the amount of money you would pay in taxes in the event of an accidental distribution (resulting from a prohibited transaction) for an IRA worth about $9,000. Add zeros as necessary to project your tax incentive for having your IRA LLC formed for you.
Coming up… How to choose an IRA LLC Facilitator.
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Jeff,
I want to establish an IRA-owned LLC to make short-term real estate loans. I’m looking for clear guidance about what I can do as both IRA owner and LLC Manager. The LLC must perform certain tasks before a loan is made, and administer the loans after they are made. If I’m perform these services (without compensation from the LLC) I want to be sure that these are not “prohibited transactions”. Can you offer some guidance here?
Jeff,
Thanks for sharing your story and this blog post. I heard of a guy that created a bank account at his local bank, set up a traditional off-the-shelf LLC that he picked up from the local bookstore and then set up a bank account in the name of his LLC. He called the account his ROTH IRA LLC account.
Quickly, I should mention that this guy figured out how to do this after spending months researching IRA LLCs.
When asked why he called his LLC a Roth IRA LLC account? He said in a bragadocious kind of way that the money in the account belonged to the LLC and the money in the bank account had already been taxed, so therefore, it just made sense that he had set up a Roth IRA LLC on his own.
Clearly this is a prohibitive transaction if he does not pay taxes on the gains earned with his LLC structure.
It is hard to imagine this might happen, but it can happen when people try to set up IRA LLCs by themselves. I liken this sort of thing to folks who watch sky diving for months and then decide to try it out for themselves without packing a parachute. They have a great take off and enjoy the exhilaration of the ride until the earth breaks their fall. I am sure we will see this individual paraded in front of the news cameras sometime down the road if he is ever blindsided by an IRS audit.
Keep up the good work! In the end, you will keep a lot of people out of trouble with the IRS!
OK, I know you can answer this question with a “NO, you can’t do that”, but, please evaluate the logic on the following.
Scenerio 1:
I have a self directed Roth IRA at a broker, and I trade futures. The account is traded online by me. Theoretically, I buy when I think the contracts are going up, and sell at a profit. This is not considered a PT, right?
Scenerio 2: I have a self directed Roth IRA with an LLC. The LLC sells widgets. I can buy a widget for $1 in the name of the LLC. As a manager of the LLC, I find someone who will pay $2 for that widget. I advertise the widget in the classifieds(paying with the LLC acct), and I don’t charge any expenses to the LLC for phone or travel or business meals, etc. and I don’t receive any compensation.
What’s the difference in managing my trading acct, and finding a product for the LLC and then finding a buyer? I’m performing the same function for both Scenerios.
@Frank - call me with details. 877-903-2220.
@Dale - In scenario 2 you are buying and selling inventory which is something that relates to operating a trade or business. Two issues… #1 you are working for the business (a PT), and #2 you may owe UBTI tax on the income of that business. It’s not an exact science, but the IRS has some logic in how they determine if something is a passive investment or a trade/business. Part of that logic is the presence of advertising. I can elaborate in a future post. Also, FYI… It may also be possible for Scenario 1 to be interpreted as a business if you spend a lot of time doing it, trade many assets, and hold the assets for short periods of time. This could bring the same UBTI & PT problems into play.