Internal Revenue Service (IRS) regulations require that either a qualified trustee, or custodian, hold the IRA assets on behalf of the IRA owner. Generally the trustee/custodian will maintain the assets and all transactions and other records pertaining to them, file required IRS reports, issue client statements, assist in helping clients understand the rules and regulations pertaining to certain prohibited transactions, and perform other administrative duties on behalf of the self-directed IRA owner for the life of the IRA account. The custodian of a self-directed IRA may offer a selection of standard asset types that the account owner can select to invest in, such as stocks, bonds, and mutual funds, but, by definition, permits the account owner to make other types of investments, including loans. The range of permissible investments is broad but regulated by the IRS.
- 1 Prohibited asset types
- 2 Prohibited transactions
- 3 Permitted investments
- 4 IRA LLC
- 5 See also
- 6 References
- 7 External links
Prohibited asset types
Internal Revenue Code Section 408 prohibits IRA investments in life insurance and in collectibles such as artwork, rugs, antiques, metals (there are exceptions for certain kinds of bullion), gems, stamps, coins (there are exceptions for certain coins minted by the U.S. Treasury), alcoholic beverages, and certain other tangible personal property.
IRS regulations prohibit transactions that are an improper use of the value in the account or annuity by the account owner, the account owner's beneficiary, or any other disqualified persons, as defined under Internal Revenue Code Section 4975. In essence, IRA prohibited transactions are transactions that Congress has deemed inappropriate between IRAs and certain people associated with those IRAs. The IRS prohibited transaction rules apply to Individual Retirement Accounts, such as Traditional IRA, Roth IRA as well as SEP plans and SIMPLE IRA plans. These rules are generally designed to prevent self-dealing or conflict of interest transactions, which are transactions that directly or indirectly benefit the IRA holder or a disqualified person, and not the IRA or plan. Disqualified persons include the IRA holder, a fiduciary (e.g., the IRA holder or plan participant) and members of the IRA holder’s family, such as your spouse, ancestor, lineal descendant (e.g. children), and any spouse of a lineal descendant. In addition, other disqualified persons include:
- Service providers of the IRA (e.g., custodian, CPA, financial planner, or trustee);
- An entity (such as a corporation, partnership, limited liability company, trust or estate) of which 50% or more is owned directly or indirectly or held by a fiduciary or service provider;
- An entity that is a 10% or more partner or joint venturer of with an entity that is 50% or more owned directly or indirectly or held by a fiduciary or service provider;
- Additionally, in the case of a SEP or SIMPLE IRA:
- The Employer;
- 50% or more owner of the Employer;
- Officers, directors, 10% or more shareholders, and highly compensated employees of the Employer;
- An entity 50% or more owned by the Employer;
- 10% or more partner or joint venturer of the Employer.
The following are examples of prohibited transactions with an IRA:
- Borrowing money from it.
- Selling property to it.
- Receiving compensation for managing it
- Receiving compensation from an entity, which is considered a disqualified person.
- Personally guaranteeing an IRA loan
- Using it as security for a personal loan.
- Buying property for personal use (present or future) with IRA funds.
- Providing services to an IRA investment, such as real estate, if not covered by Treasury Regulation Section 54.4975-6
- Receiving a credit card from a self-directed IRA LLC
- Using it to a pay for a personal expense
- Living in a property owned by the self-directed IRA
The self-dealing and conflict of interest types of prohibited transactions, as outlined in IRC sections 4975(c)(1(D) and 4975(c)(1)(E), are the broadest and most reaching categories of prohibited transaction. A self-dealing or conflict of interest transaction can occur even if the disqualified person owns less than 50% of an entity or an investment. To trigger a self-dealing or conflict of interest transaction, the IRS simply has to show that a disqualified person received some direct or indirect personal benefit. In Rollins v. Commissioner, T.C. Memo 2004-60, Mr. Rollins, a CPA used his 401(k) Plan funds to lend money to three companies in which he was the largest (9% to 33%), but not controlling, stockholder. The companies had 28, 70, and 80 other stockholders respectively. The loans were at market rate and each company’s assets secured. The IRS maintained that the plan loans were prohibited transactions under Code Section 4975(c)(1)(D) (transfer or use of plan assets for the benefit of a disqualified person) and Code Section 4975(c)(1)(E) (dealing with plan assets for the fiduciary’s own interest). Mr. Rollins stated that the borrowers were not disqualified persons and therefore no prohibited transactions occurred. The Tax Court held that a Code Section 4975(c)(1)(D) prohibition did not require an actual transfer of money or property between the plan and the disqualified person. The fact that a disqualified person could have benefited as a result of the use of plan assets was sufficient. The Tax Court held that transactions were used by Rollins for his benefit, using assets of the plan. The Tax Court held the loans to be “self-dealing” since Mr. Rollins couldn’t prove the loans were not a use of plan assets for his own benefit.
If the account owner or beneficiary engaged in a prohibited transaction, the account is treated as distributing all its assets to the IRA holder at their fair market values on the first day of the year in which the transaction occurred. The distribution would be subject to any taxes or penalties associated with an early distribution. Generally, a 10% early withdrawal penalty and treatment of the distribution as ordinary income for the purposes of income taxes. The penalty for engaging in an Internal Revenue Code Section 408 prohibited transaction differs from the Internal Revenue Code Section 4975 penalty. If IRA assets are invested in collectibles or life insurance, only the assets used to purchase the investment are considered distributed, not the entire IRA.
Examples of self-dealing include:
- Having your IRA purchase real estate that you own or use.
- Issuing a mortgage on a relative’s new residence purchased by a family member who is a disqualified person as listed above.
- Granting a child a second mortgage for the down payment on his or her first home.
- Buying stock from the account owner involving IRA funds and a disqualified person.
- Purchasing stock in a closely held corporation in which the account owner has a controlling equity position.
- Purchasing restricted stock from a family member who is a disqualified person listed above.
The Internal Revenue Code does not describe what a self-directed IRA can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 and 4975 prohibit Disqualified Persons from engaging in certain types of transactions. Some of the additional investment options permitted under the regulations include real estate, stocks, mortgages, franchises, partnerships, precious metals, private equity and tax liens. Real estate may include residential and commercial properties (U.S. & Internationally), home flipping, farmland, raw land, new construction, property renovation, development, and passive rental income. Real estate purchased in a self-directed IRA can have a mortgage placed against the property, thus lowering the amount of total cash needed for a purchase; however, neither the IRA nor the account owner of the IRA can have personal liability on the mortgage. This type of mortgage is often referred to as a nonrecourse loan. Note – using a nonrecourse loan for a real estate transaction or margin with a security purchase can trigger a tax since the income would be considered “Unrelated Business Taxable Income” (UBTI or UBIT). Business investments may include partnerships, joint ventures, and private stock. This can be a platform to fund a start-up business or other for-profit venture that is managed by someone other than the account owner of the IRA. Note – using a self-directed IRA to invest in an active trade or business via a passthrough entity, such as an LLC or partnership can trigger a tax as the income generated would be treated as UBIT. Other alternative investments include: commodities, hedge funds, commercial paper, foreign stock, royalty rights, equipment & leases, American depository receipts, and U.S. T-bills.
Valuation of investments
The concept of "fair market value" arises in other areas of taxation, including gift tax and estate tax. For all tax purposes, "fair market value" is based on a traditional "willing buyer - willing seller" standard. Specifically, the fair market value of an item of property is "the price at which the property would change hands between a hypothetical willing buyer and a hypothetical willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts."
The standard of "fair market value" is an objective test using hypothetical buyers and sellers; it is not a personalized one that envisions a particular buyer and seller. All relevant facts and elements of value as of the applicable valuation date must be considered in every case. And the determination of value must be made as of the valuation date without regard to hindsight. Knowledge of future events that might affect value cannot be attributed to the hypothetical willing sellers and buyers.
A self-directed IRA can also hold precious metals such as gold, silver, palladium, and platinum. The regulations pertaining to investing in precious metals can be found in Section 408(m)(3) of the Internal Revenue Code. Most government minted coins (American Eagles, Australian Nuggets, etc.) are permissible. Bullion is also permissible if it meets a standard level of fineness, and is produced by a COMEX or NYMEX approved refiner. In order for coins to be held inside an IRA, coins must satisfy a certain level of pureness in their mineral content so that they are not viewed as a type of collector’s coin. As a result, Krugerrands and the old Double Eagle gold coins are disallowed because they do not meet this standard. When a retirement account invests in precious metals, the metals are typically held by a third-party custodian. However, based on the wording in Section 408(m), it appears that an IRA holder may be permitted to personally hold and possess IRS approved coins, although there is no formal IRS guidance. The fineness standards specified by the IRS are:
- Gold .995%
- Silver .999%
- Platinum .9995%
- Palladium .9995%
Some of the more popular precious metals products held within IRAs include: American Eagle, American Buffalo, Australian Kangaroo/Nugget, Austrian Philharmonic, Canadian Maple Leaf, Australian Kookaburra, Mexican Libertad, Isle of Man Noble, and Australian Koala coins. Bars and rounds meeting minimum fineness requirements are permissible as well.
An IRA can purchase any type of real estate as long as the provider (aka custodian) of that IRA handles real estate . IRA providers that handle real estate are often called self-directed IRA providers. Eligible real estate assets include, but are not limited to, residential, commercial, undeveloped land, agricultural, and mineral rights. The IRA can buy the property outright, meaning the IRA is the title holder. If the IRA does not have the full purchase price, the IRA can partner with a person, company/entity or another IRA, or it can secure a non-recourse loan to buy real estate.
Whether the IRA is whole or part owner, IRA funds are used for purchase, maintenance, and expenses. When the property generates cash either with rental income or from sale, those funds go directly back to the IRA. That cash can then be used to buy other assets.
The IRA holder selects the property, negotiates the terms of the deal, and directs his or her SDIRA provider to send money from their account to secure the purchase. The IRA provider is the legal signer for the IRA; so all documents associated with the offer and purchase, as well as subsequent documents associated with the ownership of the property, must go through the provider.
The IRS prohibits certain actions. Neither the IRA holder nor any disqualified persons to that plan may live in or vacation in the property. The IRA holder makes all the decisions about how the asset is maintained but can’t do the work themselves. Internal revenue code section 4975 sets forth rules about disqualified persons and prohibited transactions.
IRA funds are allowed to be invested in private companies. The IRA ownership of private equity is usually expressed as a percentage of ownership in the company or as a number of shares of stock. Some IRA providers, commonly referred to as self-directed IRA providers, handle this type of investment, but not all.
The IRS puts a few restrictions on private equity investments that can be made by an IRA. The IRA cannot purchase stock that the IRA holder already owns. Earnings from the entity may be subject to Unrelated Business Income Tax (UBIT) if the company has earnings from debt or has earnings from the sale of products or services.
In most cases, neither the IRA holder nor any disqualified persons to the plan can be employed by the company while the IRA has an equity position in that company. Also, the IRA cannot be a general partner in an LP or LLP, nor can it invest in an S-Corp.
The IRS also allows IRAs and other retirement accounts to make loans. The IRA holder assumes the responsibility of choosing the borrower, the principal amount and interest rate, length of the term, payment frequency and amount of the loan. The holder also negotiates whether or not the note will be secured.
Self-directed IRA investments are often chosen by the IRA holder's expertise in a certain area of investing. Some of the more unique investments that have been made by IRA holders include:
- Golf courses
- Hardwood trees
- High rate auto paper
- Freight truck fleets
- Alternative investment funds
- Race horses
- Seismic data sets
- Mineral rights
In an effort to reduce fees, paperwork, processing delays, and title issues as well as to provide the IRA holder with greater investment control, some self-directed IRA investors choose to employ a Limited Liability Company (LLC) IRA structure. An LLC is a passthrough entity for tax purposes but respected as a corporation for limited liability purposes. In other words, the LLC does not pay any federal income tax on income it receives, but instead, the LLC members (owners) would be responsible for paying tax. However, in the case of a self-directed IRA, since an IRA is exempt from tax pursuant to Internal Revenue Code Section 408, by using an LLC to make IRA investments, in general, no federal income tax would apply to any income or gains generated by the IRA LLC. In addition, the members of the LLC are offered limited liability protection. As a result, the LLC is the most common type of special purpose entity used in connection with making retirement investments. In such a structure the account holder directs his or her IRA custodian to invest into a limited liability company in return for a percentage interest in the LLC that the account owner or a third-party manages himself or herself. The self-directed IRA LLC manager (i.e. account owner) can then execute transactions for the IRA LLC without the involvement of the IRA custodian, thus reducing fees and eliminating custodian transactional fees and delays. Since an LLC is treated as a passthrough entity for Federal Income Tax purposes, the profits of the LLC pass through to the IRA, which is exempt from tax under Internal Revenue Code Section 408 (408A in the case of a Roth IRA). A number of tax attorneys believe that this IRA LLC strategy has been legitimized through a tax court case: Swanson v. Commissioner, 106 T.C. 76 (1996) and IRS Field Service Advice Memorandum 200128011, which mirrors the facts and confirms the Tax Court’s conclusion in Swanson.
Since Swanson, the validity of the self-directed IRA LLC structure has not been questioned by the IRS. In fact, on October 29, 2013, the Tax Court in T.L. Ellis, TC Memo. 2013-245, Dec. 59,674(M), held that establishing a special purpose limited liability company (“LLC”) to make an investment did not trigger a prohibited transaction, as a newly established LLC cannot be deemed a disqualified person pursuant to Internal Revenue Code Section 4975. Some refer to this structure as "checkbook control" because the IRA account holder often has sole signing authority for the LLC and its bank accounts.
Tax filing requirements for an IRA LLC
For a self-directed IRA LLC that is owned by two or more IRAs, a Partnership Tax Return (IRS Form 1065) is required to be filed. In addition, most states will also require the multiple-member LLC to file a state partnership tax return. Note – a self-directed IRA LLC owned by just one IRA is treated as a disregarded entity for Federal Income tax purposes and no Federal income tax return is required to be filed.
IRA LLC law
Although Swanson v. Commissioner doesn't directly relate to a single member IRA LLC, but instead merely sets a precedent that an individual can manage and control an entity owned by an IRA or IRAs that they are a disqualified person to, there are other cases, private letter rulings and IRS Memorandums that corroborate the validity of using retirement funds to invest in a special purpose entity, such as an LLC, wholly owned by an IRA. The recent Tax Court case Peek v. Commissioner, 140 T.C. No. 12 (May 9, 2013) reinforced the ability for a retirement account investor to use retirement funds to invest in a wholly owned entity without triggering a prohibited transaction. In the Peek case, the U.S. Tax Court ruled that a taxpayer’s personal guaranty of a loan by a corporation owned by the individual’s IRA is a prohibited transaction under section 4975(c)(1)(B). The Tax Court found that the taxpayers had provided an indirect extension of credit to the IRAs, a prohibited transaction under Internal Revenue Code Section 4975 that disqualified the IRAs. The Tax Court did not, however, have an issue with the taxpayer forming a special purpose corporation to make the investment as well as serve as director and registered agent of the corporation.
For more information on IRA LLC law see:
- U.S. Code Title 26 Section 408 and 4975
- Ancira v. Commissioner 119 T.C. No. 6 (2002)- Ancira acted as a conduit for her self-directed IRA custodian
- Swanson v. Commissioner 106 t.c. 76 (1996) - Swanson directed his IRA to invest in a company in which he controlled and was also owned by the IRAs of his 3 children.
- DOL Advisory Opinions 97-23A and 2005-03A - The Department of Labor takes the position that if an asset is owned 100% by a plan, that asset becomes the plan
- IRS Field Service Advice 200128011 - IRS Confirms: "The type of investment that may be held in an IRA is limited only with respect to insurance contracts, under section 408(a)(3), and with respect to certain collectibles, under section 408(m)(1)
- Peek v. Commissioner, 140 T.C. No. 12 (May 9, 2013) - a taxpayer’s personal guaranty of a loan by a corporation owned by the individual’s IRA is a prohibited transaction under section 4975(c)(1)(B).
- Individual Retirement Account
- Comparison of 401(k) and IRA accounts
- Roth 401(k)
- Rollovers as Business Start-Ups
- Self-invested personal pension in the United Kingdom
- "Investor Alert: Self-Directed IRAs and the Risk of Fraud". Securities and Exchange Commission. September 2011. Retrieved 24 March 2013.
- Bowman, Kip. "Internal Revenue Code Section 4975". Kip Bowman. Retrieved 16 May 2013.
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- Reg. § 20.2031-1(b)
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