By Catherine Wynne
The Swanson Decision has been lauded as a “landmark decision” for the “checkbook control IRA”. An entire industry has been built around this decision and the internet has become the platform for launching products designed to give “checkbook control” and “reduction of custodial oversight” to the IRA holder based solely on this case. Briefly stated, checkbook control is accomplished by setting up a single member LLC which is purchased 100% by the IRA. The IRA holder is subsequently appointed the LLC manager after funding the LLC share purchase. The IRA holder has complete control over all monies of the LLC and therefore the IRAʼs monies.
Companies promoting the checkbook control concept have three things in common:
1. They rely entirely on the Swanson Case to justify the legality of the IRA/LLC arrangement
2. They capitalize on the IRA ownersʼ desire for complete control of IRA funds and disenchantment with the securities industry.
3. They promise “checkbook control” of these funds without the “interference” of an IRA custodian.
WHAT DID SWANSON DO?
Mr. Swanson caused a corporation called “Worldwide” to be created and his IRA purchased 100% of the outstanding shares of that corporation. After funding the IRA share purchase, Mr. Swanson was appointed president of the corporation which, in turn, did business with Swansonʼs company, “Swanson Tool”. Swanson Tool paid sales commissions to Worldwide. Note: Worldwide had no employees. The Swanson case attracted attention primarily because a) it was a single member entity where the IRA owned all shares; b) Mr. Swanson was appointed the president with complete control over all monies of the corporation; and c) Worldwide made lots of money in this arrangement.
WHAT WAS THE SWANSON DECISION?
Very few understand what the Swanson Decision addressed. Many think that this was a decisive case that certified the legality of the single member LLC for IRAs. It was not.
The facts are:
• The Swansons sought to recover legal fees from the IRS after a settlement with the IRS on a number of tax issues. The question put forth in this case was whether or not the IRS was overzealous in pursuing the Swansons during the negotiation and settlement process
in resolution of these tax issues.
• The entity purchased by the IRA was not an LLC at all but a foreign sales corporation.
• The case was decided at the administrative or lowest tax court level and was not appealed by the IRS.
• The IRS behaved badly in this case by misapplying the prohibited transaction rules and choosing to pursue the Swansons in spite of (The IRS admitted) hazy understanding of the facts of the case and application of the rules.
• The IRS confined the defense of their actions to only three potential prohibited transaction areas. They chose wrong.
WHAT WAS DECIDED?
Only one issue was decided: the Swansons were entitled to monetary relief for excessive legal fees resulting from the long, entrenched battle with the IRS. The issues viewed as “key” to the advocates of “checkbook control” rest on the three arguments the IRS chose to pursue in defense of their actions during the settlement process. The IRS believed that these three actions by Swanson constituted prohibited transactions under IRC 4975.
These issues were:
• Was the purchase of shares in the corporation by the IRA a prohibited transaction?
• Was the appointment of Mr. Swanson as president/ director of the entity a prohibited transaction?
• Was the payment of dividends by Worldwide back to the IRA account a prohibited transaction?
The court decided that none of these three areas constituted a prohibited transaction.
WHAT WAS NOT REVEALED BY SWANSON
The following issues, which directly impact the operation of the IRA-owned entity, did not come up in the Swanson Case but are of importance to anyone attempting to operate an IRA-owned LLC:
Subsequent funding of entity following initial funding: There appears to be no question that funding the LLC after the IRAʼs initial purchase of shares constitutes a prohibited transaction because the LLC becomes a disqualified entity after funding. IRA holder as manager: What can an IRA holder do as the manager of the LLC? This was not addressed in Swanson and still is not defined. The extent to which an IRA holder can work on behalf of the entity is still in question.
Arrangements: The IRS more recently has looked at entities set up specifically to avoid application of certain tests, such as fiduciary responsibility, and setting up entities as part of a pre-arrangement to avoid a prohibited transaction, as being invalid (C.F.R. § 2509.75-2(c)). What does the IRS view as an “arrangement”? What about circumvention of the custodian requirement set forth in IRC 408?
The IRA holder as manager and signer on the entity account can take money out of and put money into the entity and thus take distributions and make contributions to the IRA without the custodian reporting either of these activities to the IRS. The prohibited transaction rules, such as no personal use, no guaranteeing of credit, and no use of the IRAʼs asset for the IRA holders benefit all of these can happen without custodial involvement because they happen within the created entity.
WHAT CAN BE TAKEN FROM SWANSON
One thing we can rely on with regards to the Swanson Case is that the IRS is not going to make the same mistake twice. IRA investment in closely held or “checkbook control” LLCs, because of their high profi le, will loom large as an IRS target. When (not if) the IRS decides to challenge “checkbook control” IRAs, they will be ready. The questions not answered by the Swanson Case will most likely be the focus of any future IRS court case. Lastly, there is a limited understanding of prohibited transaction rules across the spectrum of IRA owners in self-directed investments. There is much inexperience with regards to the use and operation of business entities such as LLCs which may, in turn, result in inadvertent prohibited transactions because of confusion in the relationship between the individual, the LLC and the IRA member as three distinct entities.
In summary, the Swanson Case may only be the start of IRS scrutiny of self-directed IRA investments and single member LLCs in particular. Anyone entering into this type of IRA investment must understand the basis in law on which this type of investment structure is built, what the rules are with regards to both prohibited transactions and how to operate a registered business entity. Lastly, everyone needs to know what the Swanson Case did not do for us!
Catherine Wynne is a principal in New Direction IRA, Inc. New Direction, in Lafayette, Colorado, provides administration services as well as continuing education for tax and investment professionals and the general public.