One of the most popular ideas in the self-directed IRA industry today is the “checkbook control” IRA. You may have wondered what exactly it means to have “checkbook control” over your IRA’s funds. In this article we will examine the celebrated case of Swanson v. Commissioner, on which the idea of “checkbook control” is based. The entire text of the Swanson case is available on our website at www.QuestIRA.com.
The essential facts of Swanson are as follows:
1) Mr. Swanson was the sole shareholder of H & S Swansons’ Tool Company (Swansons’ Tool).
2) Mr. Swanson arranged for the organization of Swansons’ Worldwide, Inc. (Worldwide). Mr. Swanson was named as president and director of Worldwide. Mr. Swanson also arranged for the formation of an individual retirement account (IRA #1).
3) Mr. Swanson directed the custodian of his IRA to execute a subscription agreement for 2,500 shares of Worldwide original issue stock. The shares were subsequently issued to IRA #1, which became the sole shareholder of Worldwide.
4) Swansons’ Tool paid commissions to Worldwide with respect to the sale by Swansons’ Tool of export property. Mr. Swanson, who had been named president of Worldwide, directed, with the IRA custodian’s consent, that Worldwide pay dividends to IRA #1.
5) A similar arrangement was set up with regards to IRA #2 and a second corporation called Swansons’ Trading Company.
6) Mr. Swanson received no compensation for his services as president and director of Swansons’ Worldwide, Inc. and Swansons’ Trading Company.
The IRS attacked Mr. Swanson’s setup on two fronts. First, the IRS argued that the payment of dividends from Worldwide to IRA #1 was a prohibited transaction within the meaning of Internal Revenue Code (IRC) Section 4975(c)(1)(E) as an act of self-dealing, where a disqualified person who is a fiduciary deals with the assets of the plan in his own interest. Mr. Swanson argued that he engaged in no activities on behalf of Worldwide which benefited him other than as a beneficiary of IRA #1.
The court agreed with Mr. Swanson, and found that the IRS was not substantially justified in its position. The court said that section 4975(c)(1)(E) addresses itself only to acts of disqualified persons who, as fiduciaries, deal directly or indirectly with the income or assets of a plan for their own benefit or account. In Mr. Swanson’s case the court found that there was no such direct or indirect dealing with the income or assets of the IRA. The IRS never suggested that Mr. Swanson, acting as a “fiduciary” or otherwise, ever dealt with the corpus of IRA #1 for his own benefit. According to the court, the only direct or indirect benefit that Mr. Swanson realized from the payments of dividends by Worldwide related solely to his status as a participant of IRA #1. In this regard, Mr. Swanson benefited only insofar as IRA #1 accumulated assets for future distribution.
The second issue the IRS raises was that the sale of stock by Swansons’ Worldwide to Mr. Swanson’s IRA was a prohibited transaction within the meaning of section 4975(c)(1)(A) of the Code, which prohibits the direct or indirect sale or exchange, or leasing, of any property between an IRA and a disqualified person. Mr. Swanson argued that at all pertinent times IRA #1 was the sole shareholder of Worldwide, and that since the 2,500 shares of Worldwide issued to IRA #1 were original issue, no sale or exchange of the stock occurred.
Once again, the court sided with Mr. Swanson. The critical factor was that the stock acquired in that transaction was newly issued – prior to that point in time, Worldwide had no shares or shareholders. The court found that a corporation without shares or shareholders does not fit within the definition of a disqualified person under section 4975(e)(2)(G). It was only after Worldwide issued its stock to IRA #1 that petitioner held a beneficial interest in Worldwide’s stock, thereby causing Worldwide to become a disqualified person. Accordingly, the issuance of stock to IRA #1 did not, within the plain meaning of section 4975(c)(1)(A), qualify as a “sale or exchange, or leasing, of any property between a plan and a disqualified person”.
On the surface it seems like the court endorsed the idea of an IRA holder being the sole director and officer of an entity owned by his IRA. In other words, by having the IRA invested in an entity such as an LLC of which the IRA owner is the manager, the IRA owner gets to have “checkbook control” over his or her IRA’s funds. This sounds like a great idea. However, before jumping too fast into this area, there are some issues to consider.
One thing to remember is that the LLC does not insulate the IRA from the prohibited transaction rules. Amazingly, the IRS and the court in Swanson v. Commissioner ignored completely the fact that Mr. Swanson’s non-IRA owned corporation, Swansons’ Tools, paid commissions to Worldwide, thereby reducing Swansons’ Tools’ taxable income and indirectly benefiting Mr. Swanson. Especially after the recent case of Rollins v. Commissioner, it seems clear that this would be a prohibited transaction. In the Rollins case, Mr. Rollins loaned money from his 401(k) plan to corporations in which he served as president but of which he owned only a minority interest. The corporations were clearly not disqualified persons, but the court nonetheless held that there was an indirect benefit to Mr. Rollins, who was the largest shareholder and an officer of each corporation.
The IRS also might have argued that Mr. Swanson’s service as the president and sole director of Worldwide was a prohibited transaction as described in 4975(c)(1)(C), which prohibits the furnishing of goods, services or facilities between an IRA and a disqualified person. Although Mr. Swanson stated that Worldwide had no “active” employees, one has to wonder at what point the services rendered to an IRA-owned entity become a problem. Another question which was not raised in the Swanson case was whether or not an IRA owner having checkbook control over his IRA funds through a 100% IRA-owned entity violates IRC Section 408(a)(2), which requires that the custodian of an IRA be a bank or other qualified institution. Why have that requirement at all if the IRA owner can get around it merely by having his or her IRA own 100% of an LLC managed by the IRA owner?
Although the Swanson case appears to be good case law, a great deal of care is merited when relying on this case. Several questions which were not raised in the Swanson case remain unanswered. As noted by the court, Mr. Swanson was “following the advice of experienced counsel.” Even then, Mr. Swanson had to fight the IRS in tax court to win his case. For most people, even getting into a battle with the IRS is a losing proposition. Some people, perhaps through ignorance of the rules, appear to be abusing Swanson-type entities. For example, in IRS Notice 2004-8 on abusive Roth transactions, the IRS states that it is aware of situations where taxpayers are using a Roth IRA-owned corporation which deals with a pre-existing business owned by the same taxpayer to shift otherwise taxable income into the Roth IRA. If the IRS has become aware of the problem, there may come a day when they decide to go after these types of arrangements more actively.
When relying on the Swanson case to set up a checkbook control LLC or other entity, always use experienced legal counsel who is very familiar with how to set up this type of entity and who will be there to guide you on issues such as the prohibited transaction rules, the plan assets regulations, unrelated business income tax issues and the other rules and regulations which may apply. What happens after the LLC is formed is just as important as the initial setup and can get you into just as much trouble. To attempt a “checkbook control” entity without knowledge of all the rules and regulations or competent counsel to guide you is sort of like jumping out of an airplane without a parachute – it may be fun on the way down, but eventually you’re going to go SPLAT!