When Does It Make Sense To Do A Joint Venture

Joint ventures might be difficult for some, but not for the experts! In this guest interview, tax attorney John Hyre joins me to shed light on joint ventures, when and how they work, actual case studies, and other helpful tips you should consider before entering into a JV with your Self-Directed IRA. If you have ever been curious about joint ventures and how they work, you’ll want to keep reading. 

Sarah: Today, I brought an expert with me. John, can you give me a little bit of your background? Who you are, how you got started?

John: I've been practicing tax law for 25 years. I have my own firm, and it's really small. The good news is you deal with me, and the bad news is you deal with me. I got into self-directed IRAs right around the time Quincy did. Of course, he went in deeper initially than I… And he just started filling my brain! I mean, I knew IRA things. I had just been in my first IRA audit. I have taken SDIRA’s to Tax Court…. At that time, I wasn't as focused on IRAs as I am now…. Ever since 2010, after I had my first audit and tax court case with self-directed IRAs, which is pretty rare experience, I've been much more heavily focused. Word got out. People are like, “Look, this guy's actually been there.” From then, it's just really snowballed to where, I would say, the practice used to be about 90% real estate. I'd say now it's about 50% IRAs, 40% real estate, 10% other, and people can find us. 

Sarah: What are some of those, real quick? 

John: There are several places:  taxreductionlawyer.com, as well as taxreductionclass.com.

Sarah: I appreciate you giving me a little bit of your background. So what we're going to be talking about today…those joint ventures. Let’s start from the basics. Tell us… what is a joint venture?

John: We're going to have a very broad definition. I think we're using the term joint venture in the normal human sense, not in the lawyer sense. Let me start with the less relevant definition… the lawyer sense of joint venture is really a very narrow thing where we agree for a temporary time to joint venture. Oftentimes, there's not even a separate entity set up. We just agree to partner for liability and tax purposes. That narrow version of a JV is not always desirable. The larger version of the term, which normal humans use, is anytime you partner with someone - even if it's in an LLC, a limited partnership, a corporation - you're partnering, not lending. I think that's the main distinction. You always start simple, and if the complexity pays for itself, you add complexity. But, if simple does the job, do simple. It's cheaper and easier. Lending is simpler and easier and cheaper, but it doesn't always get you what you want. That’s why, in some cases for example, where you want an ongoing business relationship or an ongoing share of the profits, you deal with the complexity of a JV. So, I'm going to say a joint venture is when people partner, usually through an LLC, sometimes through an LP or an LLP or sometimes just with a handshake.

Sarah: And what are your thoughts on that?

John: I don't recommend the handshake agreements, but I've seen it done. It makes me nervous, but I understand why people do it. They want to cut out some of the expense and they’re comfortable with the risk.

Sarah: Now, ok, you just mentioned risk. Can you talk about some of the dangers when doing a joint venture?

John: Sure. When you're a creditor and you're lending, it's simpler and cheaper. The agreements rarely need as much revision. Second, typically as a lender, you have a lien. I don't like unsecured loans. Sometimes they make sense. Oftentimes, it's a rip-off. I prefer secured loans. If you have security, it means that if something goes bad, you get the first shot at whatever's left. If you're going to do a loan, you control the process. It's your title company. You issue the instructions to make sure that you actually have a lien. Joint venture? You typically don't have a lien. I've seen some where people negotiate a lien as part of it, and that can get a little complex and ticklish, but it's not impossible. Typically, in a joint venture, you're putting up equity, so the risk of loss is greater… but the converse is usually true. In most cases, the potential profitability of a JV is greater than the note. Now, there are always exceptions.

Sarah: So then, what’s the upside?

John: Well, there's always a trade-off. That's life. Nothing's ever perfect. The operating agreement is more complex, but you can put almost anything in it. I mean, you can put some crazy things in terms of interest or depreciation deduction. You can say, “I get the first 20%, and then we split it 50/50, unless it's a Thursday, in which case you have to microwave a cat and you only get 10%.” I mean, I've just seen some crazy stuff in operating agreements! But, as long as everyone's an adult and has a clue, you can do that. So, the upside is flexibility. Sometimes you can structure things in a way that a note is just too rigid. A note doesn't really let you get to that structure. It’s a trade-off.

Sarah: So, you led me into this similar question perfectly. Why would somebody choose to do a joint venture?

John: Again, the note is cheaper, safer, but less flexible. I'll give you an example. The problem with a shared appreciation mortgage is that once someone pays off my principal, I stop participating in the profit. Let’s say they have an insanely profitable deal, and let's even say that I drafted it. So, I get half the deal, 50% shared appreciation mortgage, but they pay off the principal. Well, now I stopped participating. That makes me sad. With a joint venture, you can have a more permanent agreement. Now, we have to be careful in an IRA. Anything the joint venture does, your IRA did. Again. Anything the joint venture does, your IRA did. 

Sarah: That’s really important. I’m glad you said that. You must keep that in mind when you’re dealing with these entities. 

John: With most joint ventures, what we call “pass-throughs” (the limited partnerships, the LLC, the handshake partnerships), there's a potential for the joint venture to commit a prohibited transaction. If it does, it’s often also attributed to the IRA with negative consequences. Well, here’s the good news. The penalty with prohibited transactions, where your IRA blows up, is only if you commit the prohibited transaction. If someone else causes it, then there's just a 15% penalty on the transaction per year, which is way less most of the time. That's much better than your IRA going splat. Likewise, activities in a JV that would give rise to UBIT (such as borrowing) will cause UBIT in IRA or 401k owners of the JV.

Sarah: So when do you use the JV? 

John: It’s when debt won’t do, when debt doesn't get you what you want. I want to be in forever. I don't want them paying off my principal. I want the perpetual ownership. But is that worth the cost? Because there's the cost is dealing with people like me and there’s just more complexity in an operating agreement when compared to a loan. If there's enough money on the table, it often is worth it.

Sarah: So, with all the complexity… what due diligence needs to be taken, whether it's on the person or on the documents before getting into a joint venture?

John: First, you look at the person and the history. It's amazing how many people don't look at IRA money as real money, which is ironic because it's more precious than normal money, right? IRA money can be tax-free or tax deferred, unlike normal money. But some people - since they don't have it in their hand - they don't look at it as “real”, which is very dangerous. You have to actually take the time. If you're going to invest real IRA money, do a search - not just a local search of the courthouse records or the search where they live.  You want to get more. 

Sarah: Are there any ways you suggest doing due diligence to get more information? Not just surface level?

John: Background checks nowadays are so cheap. Information wants to be free! You can get so much: every address they've lived or worked at, social security number, everyone they're related to, and most importantly, a comprehensive list of both civil lawsuits and criminal issues across the country. At a minimum, ask around and search for the court records.

Sarah: I totally agree, and also look at the deal, I think. 

John: Yes. How many times have they done the deal? I tell people, “You don't experiment in your IRA”. If the person doing the deal is new to the deal and the terms sound great, or if they're willing to offer the sun and the moon and the stars… Why? Well, they've never done it. I don't think the IRA is the place to experiment. I would use your non-IRA money. I'm going to do a reference check, and if somebody gets offended, well fine. I say “You need to go get money somewhere else.”

Sarah: Exactly, I'm doing you this favor. You're not doing me the favor. Yeah.

John: Also, have safeguards. Have access to the bank account. If you invest in something and you're the capital investor, always have access to a live set of QuickBooks and a bank account that ties to the QuickBooks. It better be current… And your gut. When [you] get the sinking feeling something is going on, follow that feeling.

Sarah: At the very least, if you get the feeling, go out and do more due diligence! Any other things that you should be cautious about when doing joint ventures, when self-directed IRAs are involved?

John: What's the exit plan? What happens if things don't go according to plan? Obviously, the plan is not for things to go bad, but they could. Things could go wrong, so ask them, “Have you ever screwed up a deal?” List those bullet points. Now, if the answer is no, I get a little suspicious. If I hear, “I never screwed up,” my Spidey sense starts to tingle. 

Sarah: Right. It’s so important to lay out your exit strategy. While we’re kind of talking a bit about structuring, in your opinion, what's the best way to structure a joint venture?

John: The lawyer answer is “It depends.” Go for simplicity, like it was with a note. If it gets the job done as simpler, we're going to do simple. If a note is not good enough, then LLC, because that's my default. I can get out of an LLC much easier than is the case with a corporation (or LLC taxed as a corporation). Really, the entity choice is an LLC or a C corporation. Simplicity says we pick the LLC and it's the right choice maybe 97% of the time. My default choice will be an LLC. The complexity of the operating agreement will be driven by the size of the deal. Size matters. 

Sarah: You say your choice is an LLC or C corporation. Why is that?

John: Why do I prefer LLCs? They provide the asset protection shield. Unlike trusts, they're way simpler and way cheaper. I'm only going to use a C-Corp if there's a really good reason, which is usually UBIT, and I'm only going to use a trust if there's a really good reason to justify the added complexity, because I can form, run, and exit out of an LLC easier. If you make a mistake in an LLC, unwinding it is much easier than unwinding a C-Corp or a trust. 

Sarah: Makes sense. Now, I think we mentioned this, but let’s talk about disqualified persons. What if someone's trying to do a joint venture with a disqualified person?

John: Be really, really careful. Let me tell you what people hear: “You can do a joint venture with a disqualified person, subject to the details.” And the details matter a lot. Who's contributing money? I need to know precise details. Who’s going to be on the board of directors? Who's going to be an officer? Who's in charge? Who's getting paid? Now we have 30 to 40 questions. The biggest danger of partnering with a disqualified person is that you have to show that the disqualified person did not need the IRA to do the deal. That's a very simple example. The first thing we ask people is, “Is there a way to not do this deal with this partner?”

Sarah: How do people determine this?

John: So, we'll show how each of your IRAs could have partnered with someone else on the same terms, because the deal was so sweet. Show how somebody else would have been willing to do the deal, and write it down and record it. It has to be real. Actually lay out the deal and show how real people would have done the deal.

Sarah: And it's important to have that documented, like you said, in an email thread or something.

John: That's better evidence.

Sarah: Okay, say somebody, hasn't really done the appropriate due diligence or educated themselves on what’s allowed, and then they find themselves getting in trouble. How common is it to get in trouble? And what happens?

John: I don't know that I have a good statistical sampling for that. By the nature of my practice, I'm kind of like a cop who sees a lot of crime, so I think there are more criminals. I know it's frequent enough that a lot of really good people who put a big chunk of their life into their IRA, lost a big chunk. I know that there are a lot of predators and a lot of those predators are so good at appearing to be something other than sociopaths.

Sarah: I could definitely see that. I'm going to finish with just one follow-up question. What's one piece of advice that you would give someone, a new investor or an experienced investor, who's looking to do joint ventures with a self-directed IRA involved?

John: Be willing to pay the price. The price involves understanding IRAs. You guys do a lot of excellent education. Learn how to ask the narrow focus questions on the clock, while asking the big question as part of Quest’s educational presentations. There's a lot of upside, but joint ventures are an expensive way of doing business. Loans are much cheaper. I'm not saying joint ventures are bad. I'm just saying it's a more complex, expensive way to do things, so the upside really needs to be worth it. It comes back to your due diligence and making sure that the upside is there.

Sarah: Right. Don't experiment with your life savings. Definitely not.

John: Yeah! Experiment with the drinking money! 

Sarah: You’re so funny, John. Well, I really want to thank you for taking your time on a Friday. I really do appreciate it. You've been so fun to interview. I've interviewed quite a few people and I’ll just say, the banter has been really enjoyable! 

Joint venture can be good investments if the details make sense, and we hope this article has given you a bit of insight into how these deals work! If you ever have questions about how to do join ventures with your IRA, you can give a Quest representative a call at 281.FUN.IRAS, and we’ll be happy to help! To learn more about how to get started investing with a self-directed IRA, schedule a 1-on-1 consultation with an IRA Specialist.