How to Save for Retirement in Your 20s, 40s, and 60s

Saving for retirement can be overwhelming with all of the different investment options available. Some people will put off saving for retirement because they don’t want to make a mistake with their money or think they don’t have enough income to sacrifice each month to make the short-term hits worthwhile. Other people think that they can start saving for retirement later, but they are caught playing catch-up when later finally arrives. It doesn’t matter if you are just entering the workforce or are hoping to exit it soon, the worst thing you can be doing with your finances at any age is not saving for retirement. Below are a few suggestions on how best to utilize your resources throughout your life to successfully save for retirement.

What to think about in your 20s

This may seem like the most difficult age to start saving for retirement with all of the other financial responsibilities weighing people down, like student debt. However, saving a little bit consistently in your 20s will compound into a hefty sum by the time you’re ready to use it for retirement. Because you have time on your side when it comes to investing, you can afford to invest more of your money into riskier, but eventually highly rewarding, options such as stocks. Investing in a niche you’re comfortable with and learning to weather the economy’s ups and downs can help you reach your long-term financial goals more quickly.

If you’re lucky enough to work for an employer who offers matching contributions through a 401k plan, take advantage of the free money by contributing at least the maximum matching amount. You will also want to research the differences between traditional and Roth IRAs, especially if you qualify for both, and determine which will benefit you the most in the long-run. Even though it may seem difficult to start saving now, financial burdens only tend to increase the older you get.

What to think about in your 40s

This is the age where most people fall behind in their contributions for staying on track with their long-term goals. You may have children’s college tuition, aging parents, and other obligations to take care of. However, neglecting retirement contributions or, worse, borrowing from your retirement can have a significant impact on your overall total at retirement. For instance, contributing just $1,000 annually after age 40 versus an IRA maximum contribution of $5,500 throughout your whole life can cause you to lose out on hundreds of thousands of dollars by the time you reach retirement.

As you transition closer to retirement age, you should also think about transitioning some of your more risky stock options into safer investments such as bonds. The closer to retirement you get, the less risky you want to be with your hard-earned money.

What to think about in your 60s

You may be thinking about retirement more than ever at this stage in life, and hopefully you started taking advantage of catch-up contributions for both your IRA ($1,000 more per year) and your 401k ($6,000 more per year) at age 50 ½. Your house should be close to, if not fully, paid off so you don’t have to worry about that expense in retirement. Most of your funds should be in safer investments by now so you don’t have to rely on a turbulent market to swing in your favor when you need to start taking distributions. It’s important to meet with your financial advisor to create an action plan for required distributions and how they will affect your accounts. Lastly, you may want to consider delaying your social security benefits until age 70 to really maximize those payments once they start arriving.

Changing Jobs? Now Might Be The Time For A Self-Directed IRA

A recent study by the Bureau of Labor Statistics found that the average younger baby boomer (individuals born between 1957 and 1964) held more than 11 jobs when they were between the ages of 18 to 46. With the job market in much greater flux today, and more people working well into their 60’s (and beyond), it’s probably safe to assume that the number of jobs the average worker holds throughout their career is more likely to increase rather than decrease in the coming years.

Changing jobs can often be an exciting occurrence, but it’s also likely to involve some challenges as well. One of the administrative hassles of changing jobs is managing the employer-sponsored benefit plans that you may have been participating in when you were at those prior jobs. Most often these take the form of 401(k) plans, but they can include other types as well. Managing all of these different accounts can take a significant amount of your time, and it can be difficult to do so in the most efficient and financially productive manner.

That means that for most, they can greatly improve their retirement future by consolidating these various accounts into a single self-directed IRA.

Why choose to conduct your rollovers into a self-directed IRA, over a traditional IRA or even your new employer’s 401(k)? The biggest reason is investment choice.

The self-directed IRA is not a separate legal entity from the IRAs that you see advertised by banks and discount brokers. The difference is that a self-directed IRA custodian such as Quest Trust Company will allow you to invest in all the asset types that are authorized by law, while traditional custodians (such as banks and discount brokers) limit you to investment options that they can facilitate more easily – such as stocks and mutual funds. Even worse are 401(k) plan administrators who often limit a plan participant’s investment choices to a handful of sponsored mutual funds or other collective investment vehicles.

Having a self-directed IRA, and having other asset types, which include private equity and debt instruments, real estate, and even precious metals, provides you with much greater investment opportunities.
In addition, once you have a self-directed IRA setup, you’ll be able to roll over your various other retirement accounts into it as you change jobs over time.

If you choose a self-directed IRA that is set up as a Roth account, then you have a number of additional long-term financial advantages that you wouldn’t otherwise have with a lawyer- sponsored plan. Roth IRAs are not subject to the IRS rules on required minimum distributions, so you can let your investments continue to grow on a tax-free basis even past age 70½. Furthermore, Roth accounts provide significantly more flexibility when it comes to estate planning.

With all the other changes that you’re likely to be facing with a new job, take the extra step and set up a self-directed IRA. You may be surprised at how it can help with your retirement planning.

Checkbook IRA LLC Pros and Cons with Quincy Long Hosted by Cash Flow Depot (Teleconference)

A very popular idea in the self-directed IRA industry is to have what some have termed a “checkbook control” IRA. These have been under attack by the IRS. Click the link below to listen to Quest Trust Company President H. Quincy Long talk about the dangers of Checkbook Control IRA LLCs
Click Here To Listen

Checkbook Control IRA-Owned Entities Under Attack

By: H. Quincy Long

 A very popular idea in the self-directed IRA industry is to have what some have termed a “checkbook control” IRA.  Basically this involves the following steps:  1) an IRA is formed with a self-directed IRA provider; 2) a brand new LLC or other entity is formed with the IRA owner as the manager or a director and officer; and 3) the IRA custodian is directed to invest the IRA funds in the newly formed entity.  Voila! The IRA owner has checkbook control over his or her IRA funds and can do deals quickly without anyone looking over their shoulder to see that the rules are being followed.  Admittedly, this sounds like a wonderful idea from the IRA owner’s perspective, but it is fraught with danger and traps for the unwary, as some taxpayers are now discovering.  The IRS has been attacking this type of setup, especially when they involve Roth IRAs.

             The genesis for the idea is largely attributable to the case of Swanson v. Commissioner, a Tax Court case which was decided in 1996.  In that case, Mr. Swanson set up a self-directed IRA at a bank and formed a corporation of which he was appointed the director and president.  He then directed the bank to subscribe to the original issue shares of the corporation so that his IRA became the sole shareholder.  Subsequently Mr. Swanson transacted business between his IRA owned corporation and his privately owned corporation.  These transactions were prohibited transactions, but the IRS’ litigation position was limited to arguing that the purchase by the IRA of the original issue shares and the payment of dividends from the IRA owned corporation back to the IRA were prohibited.  Mr. Swanson had very good lawyers, and the IRS eventually conceded the case as it related to the alleged prohibited transactions.

The Swanson case certainly generated a lot of excitement, but a careful examination of the case reveals that the Tax Court ruling is limited.  Far from approving the entire concept of a “checkbook control” IRA owned entity, as some people allege, Swanson v. Commissioner can only be relied on for two concepts:  first, that the purchase of the original issue stock of the corporation was not a prohibited transaction because prior to the IRA purchasing the stock there were, by definition, no owners, which meant that there could not have been a transaction between the IRA and a disqualified person (the court ruled that the corporation did not become a disqualified person until it was funded, which raises other interesting issues); and second, that the payment of dividends from the IRA owned corporation back to the IRA was not a prohibited transaction as a direct or indirect benefit to Mr. Swanson, since the only benefit of the dividend payments accrued to his IRA and not to Mr. Swanson personally.  As the Tax Court noted in Repetto v. Commissioner, discussed below, in the Swanson case “the central issue was whether the IRS was substantially justified in its litigation position for the purpose of determining whether the taxpayer was entitled to an award of reasonable litigation costs.” Mr. Swanson recovered from the IRS litigation costs in the amount of $15,780.  Significantly, what was not at issue in the Swanson case was the fact that Mr. Swanson did benefit personally from the business transactions between his privately owned corporation and the corporation owned by his IRA, since these transactions were not addressed by the IRS in their litigation position.

On December 31, 2003, the IRS released IRS Notice 2004-8, entitled Abusive Roth IRA Transactions.  The notice generally covers a situation which is very similar to Mr. Swanson’s, in that it typically involves the following parties:  (1) an individual who owns a pre-existing business such as a corporation or a sole proprietorship, (2) a Roth IRA that is maintained for the taxpayer, and (3) a corporation or other entity, substantially all the shares of which are owned or acquired by the Roth IRA.  The privately owned business and the Roth IRA owned entity enter into transactions which are not fairly valued and thus have the effect of shifting value into the Roth IRA in an attempt to avoid the statutory limits on contributions to a Roth IRA.  Also covered by Notice 2004-8 is any transaction in which the Roth IRA corporation receives contributions of property, including intangible property, by a person other than the Roth IRA without a commensurate receipt of stock ownership, or any other arrangement between the Roth IRA corporation and the taxpayer or a related party that has the effect of transferring value to the Roth IRA corporation comparable to a contribution to the Roth IRA.  Under these circumstances the setup is deemed to be a listed transaction, which means that the taxpayers must disclose the transaction to the IRS or face significant penalties.  These transactions may be attacked in a number of ways, including as an excess contribution under Internal Revenue Code (IRC) Section 4973, or in appropriate cases a prohibited transaction under IRC Section 4975.

On April 24, 2009, the Office of Chief Counsel for the Internal Revenue Service released Chief Counsel Advice (CCA) #200917030.  Like Advisory Opinion Letters from the Department of Labor, a CCA does not set legal precedent, but nonetheless they are instructive on how the IRS views the topic and can be influential in the way a case is handled by the IRS and in Tax Court.  This CCA covered a situation in which the taxpayers, a husband and wife, set up a corporation owned by their Roth IRAs into which they would direct payments for consulting, accounting, and bookkeeping services they provided to other individuals and businesses.  The taxpayers provided services to various clients, including the company for which the husband worked but did not own, through the Roth IRA corporation, purportedly as employees of the corporation, but without compensation.  When the Roth corporation filed its corporate income tax return it properly disclosed the listed transaction.  However, the taxpayers did not disclose the listed transaction on their individual tax return.  Instead, they only disclosed an excess contribution to their Roth IRAs on IRS Form 5329, which they said had been removed so as to avoid the 6% excess contribution penalty.  The CCA indicated that in this case, like the transaction described in IRS Notice 2004-8, the structure of the transaction purportedly allowed the taxpayers to create a Roth IRA investment that avoids the contribution limit by transferring value to the Roth IRA corporation comparable to a contribution to the Roth IRA, thereby yielding tax benefits that are not contemplated by a reasonable interpretation of the language and purpose of Section 408A (the Internal Revenue Code section pertaining to Roth IRAs).  Effectively, the taxpayers in this case were transferring the value of their services to the Roth IRA corporation, which in turn paid dividends back to their Roth IRAs.

In the recently released Tax Court Memo 2012-168, Repetto v. Commissioner, the IRS argued and the Tax Court agreed that the Repettos had entered into a listed transaction as contemplated by IRS Notice 2004-8, but had failed to report it properly.  The Repettos formed a partnership called Ozark Future LLC with a builder, Porschen Construction, Inc., to build spec homes.  Eventually the Repettos formed a Subchapter S corporation called SGR and transferred their ownership in Ozark Future to the newly formed corporation.  In 2003 the Repettos met with the CPA for Mr. Porschen and another person who was both an attorney and CPA.  The attorney suggested that the Repettos form 2 corporations, each of which would be owned 98% by their respective Roth IRAs.  The new Roth IRA corporations would provide services to SGR, and the relationship with between SGR and Ozark Future would remain the same.  Although the Repettos did not have a good understanding of the structure, they agreed to have the attorney set it up.  In order to set this up with Roth IRAs, the Repettos made an excess contribution to their Roth IRAs.  After the Roth IRAs and the corporations were set up, SGR entered into 10 year agreements for the Roth IRA corporations to provide services to SGR at SGR’s place of business, which was the Repettos’ home, including bookkeeping, marketing and other administrative functions.  The Roth IRA corporation owned by Mrs. Repetto’s IRA paid her a small salary in 2004-2006, and also had a medical and dental care expense reimbursement plan beginning in 2004.  The total dividends declared to Mr. Repetto’s Roth IRA were $117,600 and the amount declared to Mrs. Repetto’s Roth IRA was $127,400.  The Tax Court relied on the substance-over-form and sham transaction doctrines to find that the service agreements were nothing more than a mechanism for transferring value to the Roth IRAs.  The service agreements did not change who provided the services to SGR, since the Repettos continued to do all the work as they had done prior to when the purported service agreements were entered into. In the end, among other penalties the Repettos had to pay excise tax penalties under IRC Section 4973 based on the value of their Roth IRAs at the end of each year, plus additional penalties for failure to timely file a return since they failed to attach Form 5329 to their tax return to report their excess contributions, plus more penalties for having failed to properly report their participation in a listed transaction.  The Repettos’ reliance on the CPA and attorney who set up the plan did not save them from the penalties, since the advice was from the promoters of the investment or advisers who had a conflict of interest.

As of the writing of this article, there is another case pending before the Tax Court (Peek and Fleck v. Commissioner) involving a Roth IRA owned corporation which was formed by the Roth IRAs of two otherwise unrelated parties.  The corporation was originally owned by traditional IRAs which were later converted into Roth IRAs.  The IRA owned corporation purchased an operating business which was sold some years later for a significant capital gain.  The IRS is alleging that the taxpayers, who were employed by the corporation, violated the prohibited transaction rules by 1) guaranteeing personally a note signed by the corporation owned by their IRAs, and 2) having their IRAs invest in the corporation pursuant to an understanding or arrangement that the corporation would thereafter provide benefits to them as individuals, including the payment of wages to them and lease payments for facilities from the corporation to an LLC owned by their wives individually.  I will update this article when the final decision comes out, but it looks bad for the taxpayers at this time, in my opinion.

It is noteworthy that in each of these cases the IRA owners were actively involved in business activities which allowed them to shift value to their Roth IRAs from their personal services.  Two other issues could arise from checkbook control IRA owned entities, but these issues have not been litigated as far as I know.  First, the direct or indirect provision of goods, services, or facilities between a plan (including an IRA) and a disqualified person (including the IRA owner), is a prohibited transaction under IRC Section 4975(c)(1)(C).  At some point the IRS may allege a prohibited transaction under this section for someone who is a manager or director and officer of a company owned by their IRA.  Second, IRC Section 408(a)(2) requires the trustee of IRA funds to be a bank or non-bank custodian.  It is possible that attempting to avoid the proscription against IRA owners handling their own IRA funds with the simple imposition of an entity might be some day be attacked as invalid by the IRS.

Perhaps the only good news is that none of the attacks on IRA owned entities mentioned in this article have dealt with a situation where the entity only made investments as opposed to running a business and where no prohibited transactions were otherwise involved.  Even in this “perfect” scenario there is danger, as the prohibited transaction rules are somewhat complex and the IRA owner may inadvertently cause the IRA owned entity to enter into a prohibited transaction with complete innocence.  Yet, as stated in the case of Leib v. Commissioner, “good intentions and a pure heart are no defense” when it comes to the prohibited transaction rules.

One thing which is patently obvious to me about this area – if you are going to have your IRA own a checkbook control entity, you and/or your advisor had better have a very good understanding of 1) the prohibited transaction rules under IRC Section 4975, 2) the Plan Asset Regulations contained in 29 C.F.R. §2510.3-101, 3) Interpretive Bulletin 75-2, which is contained in 29 C.F.R. §2509.75-2, and 4) at least when it comes to a business or debt financed property owned by an IRA or an IRA owned entity, how Unrelated Business Income Tax (UBIT) contained in IRC Sections 511-514 comes into play.  If you are being advised by someone to set up a checkbook control IRA owned entity and they cannot explain how these rules apply to your entity clearly and how they interact with each other, then run the other way.  To fail to understand completely the rules is like jumping out of an airplane without a parachute – it may be incredibly fun on the way down, but eventually you’re going to go SPLAT!

© Copyright 2012 H. Quincy Long.  All rights reserved.

“What the Swanson Case Did Not Do For Us”

By Catherine Wynne

BACKGROUND
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.

Self Directed IRA Myths – Groom Law Group

Written by Richard Matta of Groom Law Group

A search of the internet quickly reveals that there are hundreds, if not thousands, of websites promoting one of the hottest financial concepts – the so-called “self-directed individual retirement account.” These range from sites offering simple “hands off” custody and recordkeeping services, to traditional broker-dealers marketing trading accounts, to promoters of “how to” books, to what amount to little more than modern-day snake-oil sales pitches. Similarly, bookstore shelves are lined with guides to building IRA wealth through nontraditional investments.

Many of these products are quite legitimate, and the sponsors work hard to provide meaningful information to help accountholders distinguish between legally acceptable investment practices and activities that may result in unfavorable tax consequences or, worse, complete loss of the tax-advantaged IRA status. Sometimes it is simply impossible to cover a subject in a comprehensive manner, and the materials warn accountholders to hire knowledgeable counsel. Nonetheless, in the opinion of the author, most of these materials perpetuate certain myths – even among the lawyers – that range from merely incomplete to outright wrong.

Why? In part, because neither the Internal Revenue Service (“IRS”) – which has jurisdiction over IRAs themselves – nor the Department of Labor (“DOL”) – which has jurisdiction over prohibited transactions – has in the past devoted significant resources to IRA issues, nor have the two agencies devoted much effort to coordinating their views. Thus, while a great deal of learning has developed under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), in connection with qualified retirement plans, in many cases this information has not carried over to IRAs. Until the last few years, most IRAs were small, and were marketed as “retail” products by different channels (and sometimes different financial institutions entirely) from those that dealt with the “institutional” ERISA market.

What are some of these myths? Mainly, they are concepts that have arisen in connection with the establishment of a limited liability company (“LLC”) as a wholly-owned subsidiary of an IRA, for the purpose of making non-traditional investments – what are often called “alternative investments” on the institutional side – i.e., things other than traditional mutual funds, stocks and bonds such as venture capital, real estate, derivatives and the like. These myths include the following, all taken verbatim from various self-directed IRA websites:

There appears to be no question that funding the LLC after the IRA’s initial purchase of shares constitutes a prohibited transaction because the LLC becomes a disqualified entity after funding

Comment: As discussed below, we believe this is simply wrong.

“Once the LLC is funded, you no longer need the custodian to write the checks. The LLC can write its own checks, and since you’re the manager, you have control

Comment: Though this may be the right answer, the author has not seen a single IRS ruling that confirms this is correct in the case of an LLC owned 100% by an IRA. (Where the IRA owns less than 100%, the authorities are somewhat clearer.) The Swanson case, discussed below, emphatically does not support this conclusion. There are good legal reasons why this may be false.

If you and your brother had a company and you owned 49.5%, then your IRA could buy, sell or loan to it without penalty.”

Comment: Wrong – this is a highly risky proposition. Ironically, the DOL advisory opinion most frequently cited as support for the proposition that this is not prohibited actually says that a prohibited transaction is likely to result.

Can I make a loan to my brother, aunt, cousin or stepchild so that they can use the money as a down payment on a home? Yes. According to IRC 4975, siblings, aunts, uncles, cousin and “step relations” are not included in the definition of disqualified persons. Thus any dealings between your IRA and these would not be a prohibited transaction.” (A variation on this is that you can hire your brother to manage real estate owned by your IRA, and pay him a salary with IRA assets.)

Comment: Also wrong. This is related to the prior question about a company owned by the accountholder and his/her brother, and the answer is the same – it very well  could be a prohibited transaction. Getting it wrong means loss of the IRA’s tax exempt status.

Each of these myths is discussed in more detail below.

Several of these concepts derive from Swanson v. Commissioner, 106 T.C. 76 (1996), cited by at least one IRA custodian as a “landmark” decision around which “an entire industry has been built” but which, in the opinion of the author, was much ado about nothing. The IRS raised the wrong arguments and failed to raise the right ones, and the tax court appears to have arrived at the “right” answer only by accident, via a nearly incomprehensible analysis. As discussed below, one key “holding” of the court was not a holding at all, and is also inconsistent with later authorities. Swanson is a weak foundation on which to rest a multi-billion dollar industry.

Myth No. 1: An entity 50% or more owned by an IRA is a disqualified person

The issue here at first blush appears to be rather straightforward. According to the tax court in Swanson (or as best we can understand the court’s reasoning):

Step 1. The IRA accountholder in that case was a fiduciary with respect to his own IRA. As a fiduciary, he was a “disqualified person” with respect to the IRA.

Step 2. The accountholder was also a “beneficiary” of the IRA. As such, he was deemed “beneficially” to own the shares of a corporation that was owned 100% by his IRA.

Step 3. Under the attribution rules of Code section 4975, any corporation owned 50% or more by a disqualified person (directly or indirectly) is also a disqualified person.

Consequently, once the IRA acquired 50% or more of the corporation, any subsequent dealings between the IRA and the corporation would be a prohibited transaction. Straightforward, yes, but erroneous. The court’s analysis rests upon the following constructive ownership rule:

Stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust shall be considered as being owned proportionately by or for its shareholders, partners, or beneficiaries….

Swanson, 106 T.C. at 86, n. 15 (quoting Code section 267(c)(1)). Because the IRA was a trust, this means that the accountholder, as the trust’s sole beneficiary, was deemed constructively to own stock of any corporation held by his IRA. So far, so good. However, being a beneficiary alone did not make the accountholder a “disqualified person,” and neither would it make the corporation a disqualified person. Rather, the court found the accountholder was a disqualified person because he was a “fiduciary” with respect to his IRA. However – and this is an important but rather subtle point – a fiduciary acting only as such is not a disqualified person. A fiduciary is only a disqualified person when acting in his own interest, or in the interest of other persons, i.e. , “outside” the IRA.

This conclusion was spelled out rather plainly by the Department of Labor only one year after Swanson. And it is the DOL, not the IRS, that has primary jurisdiction to interpret these rules. Specifically, in 1997 DOL issued an advisory opinion to the Financial Institutions Retirement Fund regarding its holding of the stock of a wholly owned corporation named “Pentegra.” DOL Adv. Op. No. 97-23A (Sept. 26, 1997). The plan capitalized Pentegra with $400,000 in exchange for 100% of its stock. The plan’s trustees requested an advisory opinion that subsequent transactions between the plan and Pentegra would not be prohibited transactions. The concern was that because the trustees as plan fiduciaries held legal title to the Pentegra stock, 50% or more of Pentegra’s stock would be deemed “owned” by the trustees, causing Pentegra to become a party in interest and disqualified person with respect to the plan, under the exact same theory that was applied by the court in Swanson. DOL concluded that such ownership would not make Pentegra a party in interest (under ERISA) or disqualified person (under the Code):

Although, pursuant to ERISA section 3(14)(G), plan fiduciaries would hold all the value of Pentegra stock, they would hold such shares on behalf of the plan, not on behalf of themselves or a third party. As explained below, it is the opinion of the Department that, under the circumstances described, such transactions would not be prohibited because, under the terms of the “plan assets/plan investments” regulation (29 C.F.R. 2510.3-101), they would be treated as “intra-plan” transactions rather than transactions between a plan and a party in interest.

It is true that the Pentegra advisory opinion only addressed a 100% owned subsidiary (as did the Swanson case). However, nothing in the opinion suggested that it would not also apply where a plan owns 50% or more, but less than 100%, of the subsidiary entity (the 1980 DOL advisory opinion addressed a single fiduciary owning 100%, but on behalf of multiple plans). However, any remaining doubt was dispelled in a later opinion issued on behalf of Verizon Investment Management Corp. Adv. Op. No. 2003-15A (Nov. 17, 2003). In that case, Verizon set up an investment vehicle for various Verizon plans as well as plans of unaffiliated companies. The Verizon Master Trust, through its bank trustee (a fiduciary), owned more than 50% (but less than 100%) of the fund. Verizon sought confirmation that this ownership would not cause the fund to become a party in interest or disqualified person with respect to the Verizon plans. In confirming this conclusion, DOL noted that:

Consistent with section 3(14) of ERISA, a plan’s ownership of fifty percent or more of a partnership entity will not cause that partnership to become a party in interest with respect to that investing plan. In our view, the application of section 3(14)(G) should not change that result merely because a plan’s interests in a partnership are held by a fiduciary on behalf of the plan. Although [bank fiduciary] would hold more than fifty percent of the value of the [partnership] interests, it would hold such interests on behalf of the Verizon Plans, not on behalf of itself or a third party. As a result, it is the view of the Department that the [partnership] will not be a party in interest with respect to the Verizon Plans. Therefore, transactions between the Verizon Plans and the [partnership], including initial and subsequent contributions to the [partnership] by the Verizon Plans and distributions from the [partnership] to the Verizon Plans, would not be prohibited under section 406(a) of ERISA.

[Emphasis added.] Although the DOL cited only the relevant sections of ERISA, they noted in a footnote that this conclusion also extended to the parallel sections of Code section 4975, and thus it is directly applicable to LLCs or other entities owned by IRAs.

Myth No. 2: Putting your IRA assets into an LLC gives you “checkbook control.”

 Scores of websites tout the “Checkbook IRA LLC” or variations thereon as allowing the accountholder to take control of his or her IRA assets away from the custodian. Under this theory, the IRA accountholder directs the custodian to purchase “shares” (units) of the LLC, opens up a checking account in the name of the LLC, and thereafter simply signs the LLC’s checks without any participation of the custodian.

There are valid legal arguments why this might work if the IRA owns less than 100% of the shares of the LLC (which is a different and more complicated concept), but does it work where the IRA is the sole owner of the LLC? The answer is far from clear. IRS regulations state that an individual retirement account “must be a trust or custodial account” whose assets are “held by a bank” or by an approved non-bank custodian. Proponents of the LLC structure apparently argue that the “assets” of the IRA in this instance are simply the shares of the LLC (which are held by a bank), and that any checking account set up by the LLC belongs to the LLC, not the IRA. This is absolutely true under state law (and has important ramifications in terms of limited liability and asset protection.). But it does not follow that the IRS would agree for tax purposes. In fact, there are good reasons why it may not agree.

A similar issue arises under ERISA, and it is helpful to begin there. Under ERISA, assets of a retirement plan also must be held in trust. DOL has adopted “plan assets” regulations that determine under what circumstances you “look through” an entity (such as an LLC) to determine that its assets are deemed to be assets of a plan. These rules also apply to IRAs. In this case, the rules indicate that when a plan (including an IRA) owns 100% of the shares of an LLC, the LLC’s assets always are deemed to be assets of the plan (they may also sometimes be plan assets even if the plan owns less than 100%). Back to the trust rules – other ERISA regulations expressly state that in the case of a “plan assets” entity such as an LLC, assets held by the LLC (such as a checking account) are exempt from ERISA’s trust requirement.

The IRS has not adopted a similar exemption from the IRA trust/custody requirements. Nonetheless, most practitioners assume that the IRS would apply a similar analysis to IRA investments in plan assets vehicles, and there is certainly evidence that they have not challenged such investments in pooled plan assets funds (hedge funds, for instance).

However, there is a different reason to ask if the IRS would allow checkbook control in the case of a 100% owned LLC. The reason is simple – a single-member LLC that does not elect to be taxed as a corporation 5 is a “disregarded entity” for tax purposes. According to the IRS:

A disregarded entity is [one] that is treated as an entity not separate from its single owner. Its separate existence will be ignored for federal tax purposes unless it elects corporate tax treatment. In other words, for federal tax purposes – and we see no reason why this does not extend to the IRA custody rules – an IRA-owned LLC does not exist. Accordingly, in the eyes of the IRS, assets held in the name of the LLC are no different from any other assets of the IRA, and arguably remain subject to the IRA bank custody requirements.

What is the risk? In theory, the IRS could argue that “checkbook LLC” assets that are controlled by the IRA accountholder have been constructively distributed and are subject to immediate taxation.

Myth No. 3: So long as you own less than 50% of an LLC, you are not prohibited from transacting business between the LLC and your IRA 

In a 1988 advisory opinion, the DOL was asked whether a loan from an IRA to a corporation owned approximately 47% by the IRA accountholder would be a prohibited “lending of money or other extension of credit” under Code section 4975(c)(1)(B). Applying (correctly) the reasoning discussed above under Myth No. 1, the DOL concluded that the IRA accountholder was a “fiduciary” with respect to the IRA, and thus a disqualified person. However, DOL further acknowledged that the corporation was not a disqualified person because the accountholder owned (in his personal, rather than fiduciary, capacity) less than 50% of the corporation’s stock. Accordingly, DOL agreed that the loan was not a prohibited transaction under section 4975(c)(1)(B).

Citing this opinion, more than one website suggests that so long as you keep your ownership in an entity below 50%, you are free to transact business between the entity and your IRA.

However, although it is correct that the transaction was not a prohibited loan, it does not follow that it was not otherwise a prohibited transaction. To the contrary, the last paragraph of the advisory opinion reaches the opposite conclusion:

Accordingly, a prohibited use of plan assets for the benefit of a disqualified person under section 4975(c)(1)(D) or an act of selfdealing under section 4975(c)(1)(E) is likely to result if [the accountholder] directs the IRA to loan funds to the Corporation. [Emphasis added] It is not entirely obvious why DOL was not a bit clearer in pointing out that the applicant did not ask exactly the right question. One possible answer is that while the existence of a prohibited loan essentially is per se a prohibited transaction, whether a transaction involves a “use” of plan assets or “self-dealing” involves an element of subjective intent. However, if you caused your IRA to lend money (or buy, sell or lease assets, or pay fees) to a business in which you have any substantial interest, it is hard to imagine that it is not your intent to derive a personal benefit from the transaction. (Or at least it would be hard to prove.)

In a 2004 decision, the Tax Court concluded that a taxpayer engaged in a prohibited “use” of 401(k) plan assets when he cause the plan to loan money to three entities in which he owned minority interests (roughly 25 to 33%). Rollins v. Commissioner, T.C. Memo 2004-260 (Nov. 15, 2004). In a 1987 decision, the Second Circuit found (among other things) that the investment of a plan’s assets in a company in which two plan fiduciaries collectively owned approximately 11% (one was also president of the company) was an act of self-dealing. Lowen v. Tower Asset Management, Inc., 829 F.2d 1209 (2d Cir. 1987).

Can these cases be reconciled with Swanson, where the taxpayer caused a corporation he owned “outside” his IRA to pay commissions to a corporation owned by his IRA? Perhaps – one possible difference is that in Swanson the flow of funds was from the taxpayer’s personal account to his IRA, not the other way around. However, we may never know, as it is not clear that either the IRS or the court examined the underlying commission payments in that case except for unrelated business income tax purposes.

Myth No. 4: You are free to loan your IRA assets (sell or buy assets, etc.) to anyone so long as that person is not a disqualified person

 This is a variation on Myth No. 3. The idea seems straightforward enough: if a family member (or corporation, or LLC, etc.) is not a disqualified person, then it is not a prohibited transaction to use your IRA assets to loan money to, or buy property from, or pay a salary to, such person. True, the absence of a disqualified person means that there is no transaction “with” a disqualified person. But, the transaction can also involve “self-dealing,” which is a separate prohibited transaction.

How can it be self-dealing if the benefit flows not to me personally, but to my brother? Because the definition of self-dealing is far broader than is commonly understood. Code section 4975(c)(1)(E) provides that self-dealing means any “act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account .” [Emphasis added.] Regulations adopted pursuant to this rule note that:

These prohibitions [against self-dealing and kickbacks] are imposed upon fiduciaries [such as self-directed IRA accountholders] to deter them from exercising the authority, control or responsibility which makes such persons fiduciaries when they have interests which may conflict with the interests of the plans for which they act. In such cases, the fiduciaries have  interests in the transactions which may affect the exercise of their best judgment as fiduciaries. Thus, a person may not use the authority, control or responsibility which makes such person a fiduciary to cause a plan to pay an additional fee to such person (or to a person in which such fiduciary has an interest which may affect the exercise of such fiduciary’s best judgment as a fiduciary) to provide a service.

Treas. Reg. § 54.4975-6(a)(5). This regulation goes on to say that:

A person in which a fiduciary has an interest which may affect the exercise of such person’s best judgment as a fiduciary includes, for example, a person who is a disqualified person by reason of a relationship with such fiduciary described in section 4975(e)(2)(E), (F), (G), (H), or (I). [That is, certain disqualified persons such as family members and certain businesses in which the person is an owner, officer, director, etc.]

However, the mere fact that a family member or business enterprise is not a disqualified person does not mean that the accountholder does not have an interest in the person that may affect his/her best judgment as a fiduciary. The regulation clearly states that disqualified persons (including certain family members) are examples of persons in which you have an interest that may affect your judgment as a fiduciary. It does not follow that you do not have an interest in your brother, aunt, step-child, etc. DOL in one situation suggested that owning as little as 1.8% of a business was at least relevant to the question of whether a fiduciary had an impermissible interest. At best, some practitioners have suggested that the above regulation might shift the burden of proof from you (to prove you have no interest in a person) to the government (to prove that you do) – it is neither a bright line nor a safe harbor.

If I did make a loan to my brother, how could I prove that I did not have an impermissible personal interest in doing so? Perhaps I could demonstrate that that it was in the best interest of my IRA to make the loan, because he was a good credit risk and had other lenders lined up to make the same loan, or because he agreed to pay a higher-than-market rate of interest and provided excellent collateral. But, is it worth the risk, which could entail loss of the IRA’s tax exemption?

***

 Mr. Matta is a Principal with the Groom Law Group, Chartered. However, the views expressed herein are the personal opinion of the author and do not necessarily reflect official positions of his firm. The statements contained herein should not be considered legal advice and should not be relied upon by anyone without seeking advice of their own counsel. To comply with U.S. Treasury Regulations, we also inform you that, unless expressly stated otherwise, any tax advice contained in this memorandum is not intended to be used and cannot be used by any taxpayer to avoid penalties under the Internal Revenue Code, and such advice cannot be quoted or referenced to promote or market to another party any transaction or matter addressed in this memorandum.

 

Want to Build IRA Wealth Fast? Know Your Options

By H. Quincy Long for the Self-Directed Source Blog

Have you wanted to buy real estate in your IRA but think you don’t have enough money? Think buying a small property for all cash is your only choice?

Nothing could be further from the truth.

You can invest in real estate using your IRA without a lot of money in several ways, including buying property with debt, partnering with other investors (IRA or non-IRA money), or even utilizing seller financing.  However, in this article we will discuss one of the most powerful and grossly underutilized tools in real estate investing today – the option.

 Option Basics and Motivation

Let’s focus on some option basics. First, what is an option? Once consideration for the option is paid, an option is the owner’s irrevocable offer to sell the property to a buyer under the terms of the option for a certain period of time. The buyer has the right but not the obligation to buy. The terms of the purchase are binding on the seller at the discretion of the buyer.

Why would an owner agree to tie up his property with an option? Advantages to a property owner are many, and include: 1) the owner may be able to time his income for tax purposes, since option fees are generally taxable when the option is either exercised or expires (always check with your tax advisor); 2) if the owner needs money (for taxes, for example), an option may be a way to get money that he doesn’t have to repay, unlike a loan; 3) options are very flexible, and the owner may be able to negotiate an option which allows him to keep the property until a more opportune time – this is especially true of an owner in a pre-foreclosure situation.

Paperwork is Everything!

Options are extremely powerful and very easy to mess up. Get the paperwork right up front! So what forms do you use? The answer is my favorite as a lawyer – it depends! There is not and cannot be a “standard” option for all purposes. They are simply too flexible. You must decide on a specific use for the option and then be very specific, clear and complete about all the details. Remember, with options, you have to negotiate for both the terms of the option and for the terms of the purchase of the property.

Crucial Terms to be Negotiated and Documented

With a well written option, there is a fairly length list of terms to be negotiated and documented in the contract, including:

a)      Who is granting the option? Does it include heirs, successors and assigns?

b)      Who is receiving the option? Does it include assignees of the buyer, or is it an exclusive option to purchase by the buyer only?

c)      What property is being optioned? Property can be anything, including real estate, a beneficial interest in a land trust, a real estate note or nearly anything else.

d)     What is the consideration for the option? Remember, there must be some consideration for the option in the form of money, services or other obligations.

e)      How is the option exercised by the buyer? This is one of the easiest things to mess up in an option. If the procedure is not clear for exercising the option, it is an invitation to litigation!

f)       What will be the purchase price of the property if the option is exercised?

g)      How will the purchase price be paid when the option is exercised? Will it be for cash? Seller financing? Subject to the owner’s existing mortgage?

h)      Will the option consideration be credited to the option price or not?

i)        When can the option be exercised? For example, does the option holder have the right to exercise the option at any time during the option period, or can the option only be exercised after a specified amount of time?

j)        When will the option expire, and under what circumstances? The option should have a definite termination date, but might also include other circumstances under which the option terminates, such as a default under a lease.

k)      When it comes time to close, what are each party’s obligations? For example, who pays for title insurance, closing costs, etc? Are taxes prorated?

Possible Outcomes

Five potential outcomes exist once an option is created.  They are:

Expiration. When you have negotiated and executed an option agreement for your IRA, the first of several choices is to let the option expire on its own terms. Sometimes this is the best course of action if the deal is not what you expected, especially if you only paid a small amount for the option. The consideration paid for the option is retained by the seller.

Extension. If closing within the originally agreed upon timeframe in neither possible or practical, but you still desire to exercise the option, you may wish to negotiate an extension, either by paying additional option consideration, changing the price, or altering some other terms.  Be sure to document this extension as carefully as you did the original option.

Exercise. Another choice is that your IRA could exercise the option and buy the property. Since there are ways to finance property being purchased by your IRA, including seller financing, bank financing, private party financing or even taking over property subject to a loan, this may be a good strategy for your IRA, even if the IRA does not have the cash to complete the purchase. Be aware that if your IRA owns debt financed property, either directly or indirectly through an LLC or partnership, its profits from that investment will be subject to Unrelated Business Income Tax (UBIT). This is not necessarily a bad way to build your retirement wealth, but it does require some understanding of the tax implications.

Assignment. A fourth choice is to assign your option to a third party for a fee. Your option agreement should specifically allow for an assignment to make sure that there are no problems with the property owner. This is a great technique for building a small IRA into a large IRA quickly. I had one client who put a contract on a burned house for $100 earnest money in his daughter’s Coverdell Education Savings Account, then sold his contract to a third party who specialized in repairing burned houses for $8,500. In under one month the account made a profit of 8,400%, and all parties were happy with the deal! The account holder then immediately took a TAX FREE distribution to pay for his daughter’s private school tuition.

Cancellation. A fifth choice that sometimes is overlooked but ideal in the context of self directed retirement accounts (for capital preservation) is the ability to release the option back to the property owner for a cancellation fee. In other words, this is a way for your IRA to get paid not to buy! Let me give you an example of how this might work. Suppose you want to offer the seller what he would consider to be a ridiculously low offer. When the seller balks, you say “I’ll tell you what. You sign this option agreement for my IRA to purchase this property at my price, and we’ll put in the option agreement that I cannot exercise my option for 30 days. If you find a buyer willing to offer you more money within that 30 day period, just reimburse my IRA the option fee plus a cancellation fee of $2,500.”  Either way, your IRA wins!

The creative use of options is one of the most powerful ways to make your IRA or 401K grow astronomically. If used correctly, options maximize the leverage of a small account and offer significant flexibility for the option holder.

Six Widely Held Untruths About Self Directed IRAs

By H. Quincy Long for Self-Directed Source Blog

There is a lot of confusion over self-directed IRAs and what is and is not possible. In this article we will discuss six of the biggest self-directed IRA myths.

1)      Purchasing anything other than CDs, stocks, mutual funds or annuities is illegal in an IRA.

FALSE! According to the Internal Revenue Code for IRAs, the only disallowed investments are life insurance contracts and in “collectibles”, which are defined by the IRS to include any work of art, any rug or antique, any metal or gem (with certain exceptions for gold, silver, platinum or palladium bullion), any stamp or coin (with certain exceptions for gold, silver, or platinum coins issued by the U.S. or under the laws of any State), any alcoholic beverage, or any other tangible personal property specified by the Secretary of the Treasury (no other property has been specified as of this date).

With so few restrictions contained in the law, almost anything else which can be documented can be purchased in your IRA. A “self-directed” IRA allows any investment not expressly prohibited by law. Common non-traditional investment choices include real estate, both domestic and foreign, options, secured and unsecured notes, including first and second liens against real estate, C corporation stock, precious metals, limited liability companies, limited partnerships, trusts and a whole lot more.

2) Only Roth IRAs can be self-directed.

False. Because of the superior tax-free wealth accumulation in a self-directed Roth IRA, many articles are written on how to use a Roth IRA to invest in non-traditional investments. As a result, it is a surprisingly common misconception that a Roth IRA is the only account that can be self-directed. In fact, there are seven different types of accounts that can be self-directed. They include the 1) Roth IRA, 2) the Traditional IRA, 3) the SEP IRA, 4) the SIMPLE IRA, 5) the Individual 401(k), including the Roth 401(k), 6) the Coverdell Education Savings Account (ESA, formerly known as the Education IRA), and 7) the Health Savings Account (HSA). Not only can any of these accounts invest in non-traditional investments as indicated in Myth 1, but they can be combined to purchase a single investment.

3) I don’t qualify for a self-directed Roth or Traditional IRA because I am covered by a retirement plan at work or because I make too much money.

False. Almost anyone can have a self-directed account of some type! Although there are income limits for contributing to a Roth IRA (in 2011 the income limits are $179,000 for a married couple filing jointly and $122,000 for a single person or head of household), having a plan at work does not affect your ability to contribute to a Roth IRA, and there is no Roth IRA age limit either. With a Traditional IRA, you or your spouse having a retirement plan at work does affect the deductibility of your contribution, but anyone with earned income who is under age 70 1/2 can contribute to a Traditional IRA. There are no upper income limits for contributing to a Traditional IRA. Also, a Traditional IRA can receive funds from a prior employer’s 401(k) or other qualified plan. Additionally, you may be able to contribute to a Coverdell ESA for your children or grandchildren, nieces, nephews or even my children, if you are so inclined. If you have the right type of health insurance, called a High Deductible Health Plan, you can contribute to an HSA regardless of your income level. With an HSA, you may deduct your contributions to the account and qualified distributions are tax-free forever! It’s the best of both worlds. All of this is in addition to any retirement plan you have at your job or for your self-employed business.

4) If I want to purchase non-traditional investments in an IRA, I must first establish an LLC which will be owned by my IRA.

False. A very popular idea in the marketplace right now is that you can invest your IRA in an LLC where you (the IRA owner) are the manager of the LLC. Effectively you have “checkbook control” of your IRA funds. Providers generally charge thousands of dollars to set up these LLCs and sometimes mislead people into thinking that this is necessary to invest in real estate or other non-traditional investments. This is simply not true. Not only can an IRA hold title to real estate and other non-traditional investments directly with companies such as Entrust Retirement Services, Inc., but having “checkbook control” of your IRA funds through an LLC can lead to many traps for the unwary. Far from protecting your IRA from the prohibited transaction rules, these setups may in fact lead to an inadvertent prohibited transaction, which may cause your IRA to be distributed to you, sometimes with substantial penalties. This is not to say that there are not times when having your IRA make an investment through an LLC is a good idea, especially for asset protection purposes. Nonetheless, you must educate yourself completely as to the rules before deciding on this route. Having a “checkbook control” IRA owned LLC is kind of like skydiving without a parachute – it may be fun on the way down, but eventually you are likely to go SPLAT!

5) Because I have a small IRA and can only contribute $4,000, it’s not worth having a self-directed IRA.

False. Even small accounts can benefit from non-traditional investing. Small accounts can be co-invested with larger accounts owned by you or even others. For example, one recent hard money loan we funded had 10 different accounts participating. The smallest account to participate was for only $1,827.00! There are at least 4 ways you can participate in real estate investment even with a small IRA. First, you can wholesale property.  Simply put the contract in the name of your IRA instead of your name, and have the earnest money come from the IRA. Then, when you assign the contract, the assignment fee goes back into your IRA. Second, you can purchase an option on real estate, which then can be either exercised, assigned to a third party, or canceled for a fee. Third, you can acquire property in your IRA subject to existing financing or using a non-recourse loan from a bank, a hard moneylender, a financial friend or a motivated seller. Realize, however, that profits from debt-financed property in your IRA may incur unrelated business income tax (UBIT). Lastly, as mentioned above, your IRA can partner with other IRA or non-IRA investors.

6) An IRA cannot own a business.

False. A self-directed IRA is an astoundingly flexible wealth building tool, and it can own almost anything, including a business. However, due to the conflict of interest rules you cannot work for a business owned by your IRA and get paid. Some companies have a plan to start a C corporation, adopt a 401(k) plan, roll an IRA into the 401(k) plan and purchase employer securities to effectively start a new business, but this is not a direct investment by the IRA in the business and is fairly expensive to set up. Also, if your IRA owns an interest in a business, either directly or indirectly through a non-taxed entity such as an LLC or partnership, the IRA may owe Unrelated Business Income Tax (UBIT) on its profits from the business. A solution to this problem may be to have the business owned by a C corporation or another taxable entity.

Using Self-Directed IRAs and 401(k)s to Make More Money Now and to Build Your Retirement Wealth for the Future

By H. Quincy Long

Self-directed IRAs and 401(k) plans have been around for more than 25 years, but many people are just now becoming aware of how powerful this idea can be.  There are currently trillions of dollars in retirement plans.  Do you know how to unlock your own retirement funds as well as the retirement funds of those within your circle of influence for real estate related and other non-traditional investments?  Your knowledge of self-directed retirement plans can help make you money now as well as ensuring that you retire in style.

Plans available for self-direction.  A lot of retirement wealth is in traditional IRAs and employer sponsored plans.  If you leave an employer, the funds in the employer plan can be moved into a self-directed traditional IRA.  This includes money rolled over from 401(k) plans, 403(b) plans, 457 deferred compensation plans, and the federal thrift savings plan.  Self-employed people may have their own Individual 401(k) plan, which may even include the new Roth 401(k), no matter what their income level.  Other employer sponsored plans which can be self-directed are SEP IRAs and SIMPLE IRAs.

The king of all IRAs when it comes to building tax free wealth is the Roth IRA.  Even if you do not qualify for a Roth IRA due to income limitations currently, in 2010 the income limitation for conversions from a traditional IRA to a Roth IRA will be eliminated.  At that point even the very wealthy will be entitled to have a Roth IRA.  This is a great planning opportunity!

How does paying for your child’s education or your health care expenses with tax free income sound?  You can even self-direct a Coverdell Education Savings Account (ESA) or a Health Savings Account (HSA), and as long as distributions are for qualified education or health care expenses they are TAX FREE FOREVER.  With an HSA you even get a tax deduction for putting the money in!

Perhaps the best news of all is that you may combine your IRAs and other self-directed plans to make non-traditional investments.  Even better, you can invest your IRAs with other people’s IRAs or even non-IRA money of people you know.  The key element is that you must have your plans administered at a self-directed IRA company like Quest Trust Company, Inc.

Make money now.  We have all heard that knowledge is power.  Your knowledge of self-directed retirement plans can translate into money in your pocket today.  How?  It’s easy!  While it is true that you may not derive a current benefit from your own IRA’s investments, this does not mean that you cannot benefit right now from Other People’s IRAs (OPI).  Simply become knowledgeable about self-directed plans by reading books and attending seminars or workshops, then spread the good news!

Quest has many FREE seminars and workshops to help you and those whose IRAs you want to use to make money for yourself.  There are also numerous books on the market explaining the power of self-directed retirement plans, such as Hubert Bromma’s “Investing in Real Estate With Your IRA and 401(k)” which are selling quickly.  For more information on seminars and workshops in your area, visit the Quest Trust Company website at www.QuestIRA.com.  Even if you don’t have a dime of retirement funds yourself, you can use your knowledge to:

*          Borrow other people’s IRA money to do your deals today

*          Sell real estate, notes or other non-traditional assets to people’s IRAs

*          Make others aware of an opportunity to invest in your business (always be aware of securities laws when raising money)

Anytime you go to a gathering of people, there are most likely millions of dollars available for non-traditional investments in their retirement plans.  It is up to you to let people know about this powerful tool, and how they can take some or all of that anemic money and put it to work in a way that benefits both you and them.  You will look highly intelligent and will inspire confidence with your advanced knowledge.  You owe it to yourself to learn more today.  Quest can help.

Invest your own IRA in what you know best.  With all your knowledge of self-directed IRAs, you will most likely want to invest your own retirement funds in non-traditional investments as well.  What investments do you know the most about?  Almost without exception, you can invest in what you know best with your own IRA.  The law contains very few investment restrictions for retirement plans, but most custodians refuse to allow IRAs to invest in non-traditional investments such as real estate simply because they are not set up to handle them.  Not true with Quest!

Quest self-directed retirement plans are under the same laws as plans at any other custodian or administrator.  We are simply more flexible when it comes to administering non-traditional investments in your IRA or other self-directed plan.  Quest clients have used their retirement plans to purchase all of the following and much more:  real estate, both foreign and domestic, including debt leveraged real estate, real estate options, loans secured by real estate, unsecured loans, limited partnership interests, limited liability company shares, stock in non-publicly traded corporations, land trusts, factored invoices (including factored real estate commissions), tax lien certificates, foreclosure property, joint ventures, oil and gas interests and even race horse colts!  You are limited only by your imagination.

Ignorance may be bliss, but it will not make you wealthy.  Use your knowledge of self-directed IRAs to make money now, to help others build their retirement wealth as well as your own, and to retire in the style and comfort in which you would like to become accustomed.  Contact Quest today!

Why Your IRA May Owe Taxes: To Pay or Not to Pay? – That is the Question

By: H. Quincy Long

A. Introduction

Many people are surprised to learn that, as discussed below, there are 2 ways in which an IRA or 401(k) investment in an entity may cause the retirement plan to owe tax on its income or profits from that investment. This does not necessarily mean that you should not make an investment which subjects your retirement plan to taxation. It does mean that you must evaluate the return on the investment in light of the tax implications.

B. Unrelated Business Income (UBI)

The first situation in which a retirement plan might owe tax on its 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 retirement plan (unless there is debt financing, as discussed below), any income from business operations would be considered Unrelated Business Income (UBI) for the plan. 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.[1]

C. Unrelated Debt Financed Income (UDFI)[2]

A second situation in which a retirement plan may owe tax is when the plan or an entity invested in by the plan owns debt financed property. Anytime a retirement plan owns debt financed real estate (with a possible exception for 401(k) plans, discussed below), either directly or indirectly through a non-taxable entity, the income from that investment is taxable to the retirement plan as Unrelated Debt Financed Income (UDFI). The amount of income included is proportionateto the debt on the property. Your retirement plan is only taxed on the debt financed portion and not the entire amount of income.

Definition of “Debt Financed Property.” In general, the term “debt-financed property” means any property held to produce income (including gain from its disposition) for which there is an acquisition indebtedness at any time during the taxable year (or during the 12-month period before the date of the property’s disposal if it was disposed of during the tax year). If your retirement plan invests in a non-taxable entity and that entity owns debt financed property, the income from that property is attributed to the retirement plan, whether or not the income is distributed.

Calculation of UDFI. For each debt-financed property, the Unrelated Debt Financed Income is a percentage of the total gross income derived during a tax year from the property. The formula is as follows:

Average Acquisition Indebtedness x Gross Income from

Average Adjusted Basis Debt-Financed Property

Once the gross UDFI is calculated as above, your retirement plan is entitled to most normal income tax deductions including expenses, straight line depreciation and similar items that are directly connected with income from the debt financed property, plus an automatic deduction of $1,000.

Capital Gains Income. The good news is that if there has been no debt owed on the property for at least 12 months prior to the sale, there is no tax on the capital gains. However, if a retirement plan or a non-taxable entity owned by the retirement plan sells or otherwise disposes of debt-financed property and there has been acquisition indebtedness owed within 12 months prior to the date of sale, the retirement plan must include in its taxable income a percentage of any gain or loss. The percentage is that of the highest acquisition indebtedness with respect to the property during the 12-month period preceding the date of disposition in relation to the property’s average adjusted basis. The tax on this percentage of gain or loss is determined according to the usual rules for capital gains and losses. This means that long term capital gains are taxed at a lower rate than short term capital gains.

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.

D. Exemption From Taxes on UDFI for 401(k) Plans

One piece of great news for those with self-directed 401(k) plans is that plans under §401 of the Internal Revenue Code (IRC) enjoy an exemption from the tax on UDFI in certain circumstances. This exception to the tax is found in IRC §514(c)(9), and applies only to “qualified organizations.” Qualified organizations include certain educational organizations and their affiliated support organizations, a qualified pension plan (ie. a trust qualifying under IRC §401), and a title-holding company under IRC §501(c)(25), but only to the extent it is owned by other qualified organizations. IRAs are trusts created under IRC §408, not IRC §401, so the real estate exception to the UDFI tax does not apply to IRAs. The good news is that plans such as the Quest Individual (k) Plan do qualify for this exception under the right circumstances.

There are six basic restrictions which must be met for the exemption from the UDFI tax to apply. They are:

1) Fixed Price Restriction. The price for the acquisition or improvement must be a fixed amount determined as of the date of the acquisition or the completion of the improvement.

2) Participating Loan Restriction. The amount of any indebtedness or any other amount payable with respect to such indebtedness, or the time for making any

3) payment of any such amount, must not be dependent, in whole or in part, upon any revenue, income, or profits derived from such real property.

4) Sale and Leaseback Restriction. The real property must not at any time after the acquisition be leased by the qualified organization to the seller of the property or to certain related persons, with certain small leases disregarded.

5) Disqualified Person Restriction. For pension plans, the real property cannot be acquired from or leased to certain disqualified persons described in 4975(e)(2), with certain small leases disregarded.

6) Seller Financing Restriction. Neither the seller nor certain related disqualified persons may provide financing for the acquisition or improvement of the real property unless the financing is on commercially reasonable terms.

7) Partnership Restrictions. Partnerships must meet any one of three tests if the exemption from the tax on UDFI is to apply to the qualified organizations who are partners. First, all of the partners can be qualified organizations, provided none of the partners has any unrelated business income. Second, all allocations of tax items from the partnership to the qualified organizations can be “qualified allocations,” which means that each qualified organization must be allocated the same distributive share of each item of income, gain, loss, deduction, credit and basis. These allocations may not vary while the qualified organization is a partner in the partnership, and must meet the requirement of having a “substantial economic effect.” Third, and perhaps most commonly, the partnership must meet a complex test called the “Fractions Rule” (or the “Disproportionate Allocation Rule”).

Even with the restrictions, there are circumstances where this exemption can work. For example, one client rolled over her IRA into a 401(k) plan she created for her home based interior decorator business. The 401(k) plan then purchased 2 apartment buildings with non-recourse seller financing (which was on commercially reasonable terms). Not only is the 401(k)’s rental income exempt from the tax on UDFI, but so will the capital gains be exempt. If there is a concern about asset protection, a title holding §501(c)(2) or §501(c)(25) corporation can be formed, and the exemption will still apply.

But the best news of all is that we now have the Roth 401(k). Starting in 2006, if your plan allows it, you can defer part of your salary into a Roth 401(k). For 2007 and 2008, the maximum salary deferral into a Roth 401(k) plan is $15,500 ($20,500 if you are 50 or over). This doesn’t include the profit sharing contribution of the plan which can be up to 25% of the wages or net income from self-employment. Although the salary deferrals are post tax (meaning you still have to pay income, social security and Medicare taxes on the amount deferred into the plan), qualified distributions from the account are tax free forever. Unlike the Roth IRA, there is no maximum income restriction. Combining the power of an Quest self-directed Roth 401(k) and the real estate exception for 401(k) plans under IRC §514(c)(9) means you can use Other People’s Money to purchase real estate and NEVER PAY TAXES on the income and capital gains!

E. Frequently Asked Questions on Unrelated Business Income Tax (UBIT)

Q. If the profits from an investment are taxable to an IRA, does that mean it is prohibited?

A. Absolutely not! There is nothing prohibited at all about making investments in your IRA which incur tax.

Q. But if an investment is taxable, why make it in the IRA?

A. 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? For example, one client was able to grow her Roth IRA from $3,000 to over $33,000 using debt financed real estate in under 4 months even after the IRA paid taxes on the gain! Second, what plans do you have 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. Third, what would you pay in taxes if you made the same investment outside of the IRA?[3] The “penalty” for making the investment inside your IRA, if any, is only the amount of tax your IRA would pay which exceeds what you would pay personally outside of your IRA. Unlike personal investments, the IRA owes tax only on the portion of the net income related to the debt, so depending on how heavily leveraged the property is the IRA may actually owe less tax than you would personally on the same investment.

Q. If the IRA pays a tax, and then it is distributed to me and taxed again, isn’t that double taxation?

A. Yes, unless it is a qualified tax free distribution from a Roth IRA, a Health Savings Account (HSA) or a Coverdell Education Savings Account (ESA). The fact is that you still want your IRA to grow, and sometimes the best way to accomplish that goal is to make investment which will cause the IRA to pay taxes. Also, bear in mind that companies which are publicly traded also pay taxes before dividends are paid, and the value of the stock takes into consideration the profits after the payment of income taxes. In that sense, even stock and mutual funds are subject to “double taxation.” In my view, the double taxation issue should not be your focus, but rather merely a factor in your analysis. Is the IRA glass 1/3 empty or 2/3 full? At least the IRS is a silent partner.

Q. If the IRA makes an investment subject to tax, who pays the tax?

A. The IRA must pay the tax.

Q. What form does the IRA file if it owes taxes?

A. IRS Form 990-T, Exempt Organization Business Income Tax Return.

Q. What is the tax rate that IRAs must pay?

A. The IRA is taxed at the rate for trusts. Refer to the instructions for IRS Form 990-T for current rates. For 2005, the marginal tax rate for ordinary income above $9,750 was 35%. Capital gain income is taxed according to the usual rules for short term and long term capital gains. Remember, in the case of UDFI the IRA only pays tax on the income attributable to the debt and not 100% of the income.

Q. Where can I find out more information?

A. Visit our website at www.QuestIRA.com for more information. Also, Unrelated Business Taxable Income and Unrelated Debt Financed Income are covered in IRS Publication 598, which is freely available on the IRS website at www.irs.gov. The actual statutes may be found in Internal Revenue Code §511-514.

F. Solutions to the UBIT “Problem”

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 taxable income to the retirement plan. Some examples of how you might structure a transaction in ways that are not taxable to the retirement plan 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 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!).

G. Conclusion

From a financial planning perspective, the question becomes “Should I avoid doing something in my IRA which may incur UBIT?” Many people just say “Forget it!” when they learn a certain investment may subject the IRA to UBIT. Or worse yet, they ignore the issue and hope they won’t get caught. However, being afraid of UBIT is short sighted and ignores the opportunity it presents for building massive wealth in your retirement plan. Remember, making an investment which may subject the IRA to UBIT is not a prohibited transaction, it just means the IRA has to pay a tax. The best financial advice on UBIT is simple: “Don’t mess with the IRS!” If the IRA owes UBIT, make sure it is paid. After analyzing a transaction, you may come to the conclusion that paying UBIT now in your IRA may be the way to financial freedom in your retirement. Like I often say, “UBIT? You bet!”