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. In October I will be delivering one of the breakout sessions on entity investments at the Entrust Client Education Conference in Las Vegas,Nevada.
Many people are surprised to learn that, as discussed below, there are 2 ways in which an IRA’s investment in an entity may cause the IRA to owe tax on its income from that investment. This does not necessarily mean that you should not make the investment in the IRA. It does mean that you must evaluate the return on the investment in light of the tax implications.
The first situation in which an IRA might owe tax on its entity investment is if the entity invested in is non-taxable, such as a limited partnership or an LLC treated as a partnership for tax purposes, and the entity operates a business. Although investment in an entity which is formed for the purpose of capital investment, such as the purchase and holding of real estate, should not generate taxable income for the IRA (unless there is debt financing), any income from business operations would be considered Unrelated Business Income (UBI) for the IRA. UBI is the income from a trade or business that is regularly carried on by an exempt organization and that is not substantially related to the performance by the organization of its exempt purpose, with the exception that the organization uses the profits derived from this activity. Exclusions from UBI include dividends, interest, annuities and other investment income, royalties, rents from real property (but not personal property), income from certain types of research, and gains and losses from disposition of property (except property which is considered to be inventory).
Example. Ira N. Vestor has a large rollover IRA from a former employer and wants to help out his friend, Will B. Richer, who is starting a new restaurant business. Will offers Ira a 25% ownership interest in his new business, Eat Richer Restaurants, LLC. Ira believes Will is going to be a huge success, and wants to grow his IRA. The LLC will be taxed as a partnership. Ira will not be paid and will have no part in the management or operation of the business. Because the LLC is taxed as a partnership, the IRA must pay taxes on its share (whether or not distributed) of the gross income of the partnership from such unrelated trade or business less its share of the partnership deductions directly connected with such gross income.
A second situation in which an IRA may owe tax is when the entity invested in owns debt financed property. Anytime an IRA owns debt financed real estate, either directly or indirectly through a non-taxable entity, the income from that investment is taxable to the IRA as Unrelated Debt Financed Income (UDFI). Some key points to remember about UDFI include: 1) the IRA is only taxed on the debt financed portion of the investment income (see example below), 2) the IRA is allowed most of the normal expenses, depreciation (on a straight line basis) and similar items which are directly connected to the debt financed income in calculating its UDFI, 3) the tax on the gain or loss is determined according to the usual rules for capital gains and losses, and 4) there is no tax if the debt has been paid off for at least 12 months prior to the sale.
Example. Ira N. Vestor wants to use his IRA to invest in a limited partnership, Pay or Go, L.P., which will purchase an apartment complex. The lender requires a 20% cash down payment, and will not permit subordinate financing. Because the property is 80% debt financed, Mr. Vestor’s IRA will owe a tax on approximately 80% of its net profits from the limited partnership (the percentage subject to tax changes as the debt is paid down and the basis is adjusted). When the property sells, Mr. Vestor’s IRA will have to pay capital gains tax on the debt financed portion of the profits. Only the profits from the rents or capital gains from the sale that are attributable to the debt financing are taxable to the IRA. For example, if the gain on the sale of the apartment complex is $100,000, and the highest acquisition indebtedness in the 12 months prior to the sale divided by the average adjusted basis is 75%, then $25,000 of the gain is tax deferred or tax free as is normal with IRA’s, while the IRA would owe tax (not Mr. Vestor personally) on $75,000.
“But,” you ask, “if an investment is taxable, why make it in the IRA?” That is a good question. To figure out if this makes sense, ask yourself the following key questions. First, does the return you expect from this investment even after paying the tax exceed the return you could achieve in other non-taxable investments within the IRA? Second, do you have plans for re-investing the profits from the investment? If you re-invest your profits from an investment made outside of your IRA you pay taxes again on the profits from the next investment, and the one after that, etc. At least within the IRA you have the choice of making future investments which will be tax free or tax deferred, depending on the type of account you have.
Is there any way to get around paying this tax? The short answer is yes. Investments can often be structured in such a way as to avoid taxation. Dividends, interest, investment income, royalties, rents from real property (but not personal property), and gains and losses from disposition of property (unless the property is debt financed or is considered “inventory”) are all excluded from the calculation of UBI. There are many ways to structure your IRA investment to avoid taxation. Some examples of how you might structure a transaction in ways that are not taxable to the IRA include:
Example. Suppose in the Eat Richer Restaurants, LLC example above the LLC elected to be treated as a corporation instead of a partnership, or a C corporation was formed instead (IRA’s may not own shares of an S corporation). Because the entity has already paid the tax, the dividend to the IRA would be tax free or tax deferred. This may not be acceptable to other shareholders, however.
Example. Instead of his IRA investing directly in Pay or Go, LP, Ira N. Vestor could have made a loan instead. The loan could have been secured by a second lien on the property (which may not be permitted by the first lienholder, however). The loan could even be secured by shares of the LP itself, possibly with a feature allowing the loan to be converted at a later point to an equity position in the LP (a “convertible debenture”). Caution: With lending there may be state or federal usury limits on how much interest may be charged, and if the debt is converted into equity the IRA may then owe taxes at that time.
Example. Another choice for investing without the IRA paying taxes is to purchase an option instead. When your IRA owns an option to purchase anything, it can 1) let it lapse, 2) exercise the option, 3) sell or assign the option (provided the option agreement allows this) or 4) release the owner from the option for a fee (in other words, getting paid not to buy!)
A careful analysis of an investment which causes the IRA to owe tax will often lead to the conclusion that having your IRA pay taxes now may be the way to financial freedom in your retirement. Be sure to have your IRA pay the tax if it owes it, though. As I always say, “Don’t mess with the IRS, because they have what it takes to take what you have!”