Entity Investments in Your IRA – Advantages, Cautions and Legal Considerations

This article is part of a series of articles discussing some issues arising when investing your IRA into an entity, such as a limited liability company, corporation, limited partnership, or trust.  Other articles in this series include prohibited transactions and disqualified person, unrelated business income (UBI) and unrelated debt-financed income (UDFI) as it relates to entity investments, the plan asset regulations and other regulations which may apply, and formation and management issues, including the “checkbook control” LLC which has become so popular in the self-directed IRA industry.

There are advantages, cautions, and legal considerations when investing in an entity within your IRA.  Advantages of having your IRA own an entity include:

1)         Your IRA’s funds may be held in the entity’s name at a local bank.  This can be an advantage when getting cashier’s checks for the foreclosure or tax lien auction, paying earnest money or option fees, or paying contractors who prefer local checks, among other things.

2)         Certain types of investments, such as real estate closings or investments at foreclosure auctions, may in some circumstances be easier to facilitate through an entity.

3)         Investing your IRA’s funds through an entity may give your IRA some asset protection.  Always check with local legal counsel!

4)         In certain limited circumstances, you may be able to act as a manager, director or officer of your IRA-owned entity without compensation.

5)         If the entity’s shares are all that the IRA owns, administration fees may be lower.

6)         If the director, officer or manager is a trusted friend, you may more easily control what happens with your IRA’s funds.

Cautions when investing your IRA through an entity include:

1)         Check with your CPA or tax advisor on the local, state and federal tax implications of the entity you want your IRA to invest in.

2)         Select competent legal counsel to guide you who is familiar with the restrictions imposed by the Internal Revenue Code, including the prohibited transaction rules of Section 4975, as well as the plan asset regulations.  Otherwise, you may inadvertently engage in a prohibited transaction.  Make sure that the investment in the entity is not prohibited in itself and also that the company is not structured in a way that the operations of the company will lead to a prohibited transaction.

3)         All fees for the formation of the entity and for the preparation of any necessary tax returns as well as any taxes due must be paid from funds belonging to the IRA.

4)         Unless the entity is taxable itself, to the extent it owns debt-financed property or operates as a business, unrelated business income tax (UBIT) may attach to the profits from the entity.  Remember, there is no distinction between general and limited partners.

5)         Your third party administrator generally does not review the formation document or the by-laws, operating agreement or partnership agreement.  The nature of a self-directed IRA is that the IRA holder is responsible for the contents of the agreement, and usually must read and approve the subscription agreement and operating or partnership agreement prior to the administrator signing.  Typically, the only review that is undertaken is to make sure that the ownership of the asset is correctly listed in the name of the IRA.  Also, bear in mind that the administrator does not review any investment for compliance with IRS guidelines, so the IRA holder and his or her advisers should be very familiar with any restrictions.

Other things for you and your legal counsel to consider include:

1)         You should review the entity agreements to make sure that an IRA or qualified plan is permitted to be a shareholder, member or partner.  The agreement should specify the voting procedure for shares held by an IRA or qualified plan.

2)         There should be no transfer or buy-sell restrictions that would restrict the shares if the IRA is distributed either because the IRA holder dies or because the shares are distributed as part of a Required Minimum Distribution (RMD), or if the IRA holder decides to move the shares to a different custodian or administrator.

3)         The IRA holder and other related disqualified persons generally cannot receive compensation from the company.

4)         Depending on the ownership percentage by the IRA and other disqualified persons, it may be a prohibited transaction to fund additional capital calls.  If so, only the amount of the initial commitment can be funded.  Many administrators or custodians have restrictions on future capital calls.  The concern is that if the IRA and other disqualified persons fund more than 50% of the entity the entity will become a disqualified person to the owning IRA and future capital contributions might be considered a “transfer to, or use by or for the benefit of, a disqualified person of the income or assets of the plan” in violation of Internal Revenue Code §4975(c)(1)(D).

5)         If the IRA holder is or may soon be subject to required minimum distributions, either the IRA holder must have sufficient resources left in the subscribing IRA or other traditional IRA’s to cover the RMD, unless there will be guaranteed sufficient distributions from the entity to fund the RMD.  Otherwise, shares of the entity may have to be distributed.  This would cause significant difficulties both for the IRA holder and for the entity.

6)         Because of the limited review by the custodian or administrator of the formation documents and the investment, the IRA holder and his or her advisor should do the normal due diligence on the company, including investigating all of the principals involved reviewing the financial strength of the company, verifying with the Secretary of State that the company is in good standing, and checking with the Securities and Exchange Commission , the Better Business Bureau and any other governmental or non-governmental agency to see if any complaints have been filed against the company.  The IRA holder is 100% responsible for evaluating the company and the investment.