Pros and Cons of Checkbook Control IRAs: Guest Interview with Attorney Jeff Watson

Estimated reading time: 12 minutes

As Self-Directed IRAs gain popularity in the investing world thanks to their many benefits, one type of account in the industry has taken the spotlight: the “checkbook control” IRA. Many people have heard of the benefits of this account, but have only scratched the surface. For this article, attorney Jeff Watson of WatsonInvested.com joins me to share some of the lesser known details about checkbook control and some considerations people may not be thinking about when choosing to have this type of account.

Sarah: Thank you for joining me today, Jeff. I’m excited to talk a little bit about checkbook control IRAs. For those that aren’t familiar, what is “checkbook control”?

Jeff: I believe there are actually two definitions of checkbook control. They are similar but different.  Checkbook control in the world of Self-Directed IRAs (SDIRAs), and we will just say all Self-Directed retirement accounts, refers to forming an entity such as an LLC or certain trusts. Your SDIRA then invests into that entity. That entity has opened up a business bank account, probably a checking account at a local financial institution, local to the account holder or whoever the manager of the LLC is going to be. That manager then receives physical possession of a checkbook, representing the authority to write checks with the money that, ultimately, is from a SDIRA (or HSA or CESA or SEP, etc.) That is the basic definition of checkbook control. Some people interpret checkbook control to go so far as to say that the account holder – the IRA account holder – is the manager of the LLC or the trustee of the IRA owned trust or the president or other officer of the IRA owned c-corporation. Then, as the account holder, they can direct their own retirement funds with the ability to sign a check or send a wire. That is the more zealous definition of checkbook control and that’s also the definition that gives me great pause. 

Sarah: Why do you think some people may see checkbook control as a controversial issue?

Jeff: There is a huge controversy in this space that is unfortunately not really talked about as much as it should be by those that zealously promote the “quickie” account holder checkbook control. When you are going to look at this, the first thing you have to do is ask, “If the IRA is investing in an LLC, is the operating agreement of the LLC written for the specific purpose of the LLC being owned by an IRA?” The vast majority of the checkbook control mills that you’ll see on the internet do not do a good job of that. I’ve read a lot of their documents, and I just walk away shaking my head. The same issue occurs with IRA owned trusts. Now, that leads us to this other next big concern. LLCs are operated by a manager. That is the legal title that we have use throughout the United States for the person who directs the operations of a Limited Liability Company, an LLC, just like we use the title trustee as the person who has authority to direct the functions of a trust. That person is a human being. If you are the account holder and you are serving as the manager of your IRA owned LLC or you’re the trustee and serving as the trustee of your IRA owned trust, how are you personally NOT providing both a service and a direct benefit to your retirement account? Go take a look at three different code sections. 26 USC 4975 (e)(2)(F) and 4975 (c)(1)(C). Those three section of the code have to do with both direct and indirect benefit, as well as, providing a service, facilities, goods, resources, etc. Those are things that are prohibited by the tax code for an account holder to do for their own IRA, HSA, etc. I’ve not heard anyone give me a good answer as to how you are not personally both providing a service to your SDIRA by being the manager of the SDIRA LLC and providing a direct benefit, but I’m just the guy they come to after they make a mess asking, “How am I going to fix this?” 

Sarah: So, if there are all these potential issues, what would make some want a checkbook control IRA?

Jeff: Speed. Speed of implementation. They believe that the only way they can obtain some of the investment advantages that they are looking for and ease of the investment transaction speed is to have this type of checkbook control. There are some types of investments that I would agree that, yes that is right.  Yes, it is easier with checkbook control for you to tell the manager of your IRA owned LLC that yes, it is okay to go ahead and pay that contractor for the work done on the rental house owned by that LLC or trust that’s owned by your IRA. That’s a little faster and a little bit easier rather than going through a custodian. When you are in a competitive bidding situation such as an auction or when you are in a situation where you must have same day funds, then it is definitely something to do. There’s something interesting there. Today, in our banking world, to say that you are able to have “same day funds” you can’t use a check. You have to be wiring or using ACH, just saying. The way the banking system is going with the movement of money, with more and more movement of electronic money, checks are becoming more and more disadvantaged.

Sarah: I like that you mentioned that. It’s definitely something to consider.

Jeff: Now, I will tell you that I do this. I have an IRA owned trust. My self-directed Roth IRA owns a trust. I am not the trustee. But I do that, because it is the easiest way for me to deal with a rental property owned there and do some of the lending investments that I do. I can have loan pay off on Monday, and I can reinvest that money by Wednesday. I am faster than any custodian out there. I got it. But, if I’m also the guy that people across the USA go to when they need to fix their mess with their IRA but I don’t have personal control, makes you wonder why. It’s like asking, why doesn’t that doctor do the surgery on himself? Maybe because they recognize the real risks. 

Sarah: Going right along with understanding those “risks”… What are some ways that people who may want a checkbook control IRA can ensure that they are being safe and abiding by these rules? I know we talked a little bit about those.

Jeff: Let me tell you some things that I think you must do. 1), you must become familiar with prohibited investments. What are the prohibited transactions? You must become familiar with who is a disqualified person or party or entity. If you don’t understand those three things, you will make an absolute screaming mess. It will be painful and expensive. 2), you need to become aware of what the rules are that are published by the IRS in 26 USC 408, 408a, and 26 USC 4975 that apply to a Self-Directed retirement account. Then, because it is also a checkbook control entity – a trust or an entity that is owned by more than 50% by IRAs – you also need to make sure you are familiar with the Department of Labor Plan Asset Rules. I’m just going to assume that the Department of Labor Plan Asset Rules apply to any IRA owned entity that I touch. That way, I am never left questioning if those rules apply. I’m just going to assume it does and then I act with a greater degree of care; I’m more careful. 

Sarah: What are some other concerns people may have? 

Jeff: There are two things that I would caution you about: Ego and haste. You have a tremendous temptation once you have checkbook control, because now you have the results of decades of contributions to a company 401k. You have money that you can deploy. Well, it took you decades to build that money up. Don’t be in a hurry to go invest it. You need to have a set of checks and balances. What are your checks and balances for determining if it is a good investment, or if all of the necessary and proper due diligence has been done? Quest Trust Company can’t do your due diligence for you, but if you’re investing directly through Quest, you have an element of time. It can give you time to slow down and think about it. Most of the time when I see someone make a bad investment with their SDIRA, particularly those with checkbook control, their always in a hurry. They say, “It’s a great deal and I have to do it now”. The con artist is using urgency as a tool. 

Sarah: You are absolutely right. We talk about due diligence, and how con artists will use tricks like urgency to pull people in and it can be a problem. 

Jeff: Well, they appeal to greed and fear, the two strongest human emotions when it comes to money. Don’t be in a hurry to get rich! Slow and steady consistency wins the race. You’ve taken a couple decades of monthly contributions to your company 401(k). That’s not in a hurry. You did that the right way. 

Sarah: Do you have any other advice for those considering checkbook control?

Jeff: Okay great. So, you understand the rules. You’ve decided you are going to do investments that are suited to checkbook control, specifically to do auction type bidding or you are extremely competent in private lending and so there for you know that funding quickly will be fine. Great. Now, make absolutely certain that the operating agreement for your LLC is properly set up. Make absolutely certain that if you’re going to go in the form of an IRA owned trust that the trust agreement is clearly and carefully written for not only the fact that the trust is owned by IRAs, but for the type of investing it’s going to be doing, also. You just can’t go on the internet and find some free template, fill it out, and think you’re good. 

Sarah: So, where would someone go to find a good resource to ensure they aren’t just pulling things from the Internet, like you say? Because Quest can’t give tax, legal, or investment advice, where would someone go for this help?

Jeff: There are resources… You can read some articles or watch some videos that I’ve put up about it (such as WatsonInvested.com), and if you’re still interested, you can set up a paid consultation. There are other resources like IRAlawyer.com. Pay attention to the free videos that Quest and other resources make available. Read, absorb, and listen to all the amazing free content that is out there. The rules haven’t changed. The rules about prohibited transaction rules you learn about in the videos are still applicable. 

Sarah: You’re right. Things this important don’t just fly by the wayside. 

Jeff: Exactly. And what I’m about to tell you next is completely antidotal. Some have said that in some work in dealing with the IRS on Self-Directed IRAs, that the IRS is not interested in checkbook control IRAs where the account holder is NOT the manager. If the account holder IS the manager, they are much more interested, because they feel like there is a greater potential of something being done wrong and a better chance of them successfully auditing and levying. Even if it is half right, it’s sound. The thinking behind it is, if the account holder is smart enough to know that they shouldn’t be the manager of the LLC owned by their IRA, then they are probably smart enough to know the rest of the rules and probably didn’t make a mistake. 

Sarah: Yes, I could see how that would make sense.

Jeff: Has this been published? No.  Is it accurate authoritative information? I don’t know. But does it makes sense?

Sarah: Understood. Definitely something to think about. Those are just some thinking points that people should be considering and be aware of as potential issues. Do you have any other bits of advice for those considering checkbook control?

Jeff: I’m going to give you one other disadvantage. If you take all of the available capital in your IRA and you move it to that LLC, you’re creating a potential problem. 1) You’re going to have this mental roadblock to making consistent monthly contributions still to the IRA. There is a mental roadblock there. There shouldn’t be, but there is. And 2), you have to be absolutely 100% certain you put enough capital into that checkbook control entity so that the rules on recapitalizing don’t come back to bite you. If it’s a single LLC owned by an IRA, you probably can put more capital. If it’s a multiple member LLC, it’s a one and done! You can fund it one time and only one time. 

Sarah: And how could this be a problem?

Jeff: I’ve seen people come together and form and LLC 50/50, 2 IRAs, go buy a rental property and then need more money. If they would have bought that rental property in the accounts that funded the LLC, then as they make more contributions to the accounts, they’ve got more money available to deal with the rental property.

Sarah: That’s a huge disadvantage, for sure.

Jeff: It’s a huge disadvantage if people aren’t thinking ahead. This goes back to: if you are going to do checkbook control, you have to have a really solid business plan. You really are creating a business. You’re forming an LLC, and that LLC has to have a business strategy. It needs to understand what its projected capital needs are, what its projected time horizon is, and what its anticipated rate of return is. If you’re saying that you just want to have it to invest in whatever good deal just comes along, I’m sorry. 

Sarah: I agree, it’s so important to make sure you do what you need to on the upfront so that you are covered on the back end.

Jeff: Exactly. So I don’t have to come fix their situation! Last thing I will leave you with. Remember: bad news travels quick! 

Sarah: You said it best, especially in the IRA world. Well, I hope that with this information more people will take the time to really stop and evaluate if a checkbook control IRA is right for them! Thank you for taking the time to share a bit more about what a checkbook control IRA is and some of the times when it may or may not make sense. When it comes to checkbook control IRAs, knowing what responsibilities will come with checkbook control power is necessary. Knowing that you have other options is also important. If you ever have questions about the safest ways to invest your self-directed IRA, call a Quest IRA Specialist at 855-382-4727 or check out our Youtube channel for educational videos! We are always happy to provide more education.  To learn more about how to get started investing with a self-directed IRA, schedule a 1-on-1 consultation with an IRA Specialist by clicking HERE.

Entity Investments in Your IRA – Swanson v. Commissioner and the “Checkbook Control” IRA-Owned LLC

Estimated reading time: 6 minutesOne of the most popular ideas in the self-directed IRA industry today is the “checkbook control” IRA.  You may have wondered what exactly it means to have “checkbook control” over your IRA’s funds.  In this article we will examine the celebrated case of Swanson v. Commissioner, on which the idea of “checkbook control” is based.  The entire text of the Swanson case is available on our website at www.QuestIRA.com.

The essential facts of Swanson are as follows:

1)         Mr. Swanson was the sole shareholder of H & S Swansons’ Tool Company (Swansons’ Tool).

2)         Mr. Swanson arranged for the organization of Swansons’ Worldwide, Inc. (Worldwide). Mr. Swanson was named as president and director of Worldwide.  Mr. Swanson also arranged for the formation of an individual retirement account (IRA #1).

3)         Mr. Swanson directed the custodian of his IRA to execute a subscription agreement for 2,500 shares of Worldwide original issue stock. The shares were subsequently issued to IRA #1, which became the sole shareholder of Worldwide.

4)         Swansons’ Tool paid commissions to Worldwide with respect to the sale by Swansons’ Tool of export property. Mr. Swanson, who had been named president of Worldwide, directed, with the IRA custodian’s consent, that Worldwide pay dividends to IRA #1.

5)         A similar arrangement was set up with regards to IRA #2 and a second corporation called Swansons’ Trading Company.

6)         Mr. Swanson received no compensation for his services as president and director of Swansons’ Worldwide, Inc. and Swansons’ Trading Company.

The IRS attacked Mr. Swanson’s setup on two fronts.  First, the IRS argued that the payment of dividends from Worldwide to IRA #1 was a prohibited transaction within the meaning of Internal Revenue Code (IRC) Section 4975(c)(1)(E) as an act of self-dealing, where a disqualified person who is a fiduciary deals with the assets of the plan in his own interest.  Mr. Swanson argued that he engaged in no activities on behalf of Worldwide which benefited him other than as a beneficiary of IRA #1.

The court agreed with Mr. Swanson, and found that the IRS was not substantially justified in its position.  The court said that section 4975(c)(1)(E) addresses itself only to acts of disqualified persons who, as fiduciaries, deal directly or indirectly with the income or assets of a plan for their own benefit or account.  In Mr. Swanson’s case the court found that there was no such direct or indirect dealing with the income or assets of the IRA.  The IRS never suggested that Mr. Swanson, acting as a “fiduciary” or otherwise, ever dealt with the corpus of IRA #1 for his own benefit.  According to the court, the only direct or indirect benefit that Mr. Swanson realized from the payments of dividends by Worldwide related solely to his status as a participant of IRA #1.  In this regard, Mr. Swanson benefited only insofar as IRA #1 accumulated assets for future distribution.

The second issue the IRS raises was that the sale of stock by Swansons’ Worldwide to Mr. Swanson’s IRA was a prohibited transaction within the meaning of section 4975(c)(1)(A) of the Code, which prohibits the direct or indirect sale or exchange, or leasing, of any property between an IRA and a disqualified person.  Mr. Swanson argued that at all pertinent times IRA #1 was the sole shareholder of Worldwide, and that since the 2,500 shares of Worldwide issued to IRA #1 were original issue, no sale or exchange of the stock occurred.

Once again, the court sided with Mr. Swanson.  The critical factor was that the stock acquired in that transaction was newly issued – prior to that point in time, Worldwide had no shares or shareholders.  The court found that a corporation without shares or shareholders does not fit within the definition of a disqualified person under section 4975(e)(2)(G).  It was only after Worldwide issued its stock to IRA #1 that petitioner held a beneficial interest in Worldwide’s stock, thereby causing Worldwide to become a disqualified person.  Accordingly, the issuance of stock to IRA #1 did not, within the plain meaning of section 4975(c)(1)(A), qualify as a “sale or exchange, or leasing, of any property between a plan and a disqualified person”.

On the surface it seems like the court endorsed the idea of an IRA holder being the sole director and officer of an entity owned by his IRA.  In other words, by having the IRA invested in an entity such as an LLC of which the IRA owner is the manager, the IRA owner gets to have “checkbook control” over his or her IRA’s funds.  This sounds like a great idea.  However, before jumping too fast into this area, there are some issues to consider.

One thing to remember is that the LLC does not insulate the IRA from the prohibited transaction rules.  Amazingly, the IRS and the court in Swanson v. Commissioner ignored completely the fact that Mr. Swanson’s non-IRA owned corporation, Swansons’ Tools, paid commissions to Worldwide, thereby reducing Swansons’ Tools’ taxable income and indirectly benefiting Mr. Swanson.  Especially after the recent case of Rollins v. Commissioner, it seems clear that this would be a prohibited transaction.  In the Rollins case, Mr. Rollins loaned money from his 401(k) plan to corporations in which he served as president but of which he owned only a minority interest.  The corporations were clearly not disqualified persons, but the court nonetheless held that there was an indirect benefit to Mr. Rollins, who was the largest shareholder and an officer of each corporation.

The IRS also might have argued that Mr. Swanson’s service as the president and sole director of Worldwide was a prohibited transaction as described in 4975(c)(1)(C), which prohibits the furnishing of goods, services or facilities between an IRA and a disqualified person.  Although Mr. Swanson stated that Worldwide had no “active” employees, one has to wonder at what point the services rendered to an IRA-owned entity become a problem.  Another question which was not raised in the Swanson case was whether or not an IRA owner having checkbook control over his IRA funds through a 100% IRA-owned entity violates IRC Section 408(a)(2), which requires that the custodian of an IRA be a bank or other qualified institution.  Why have that requirement at all if the IRA owner can get around it merely by having his or her IRA own 100% of an LLC managed by the IRA owner?

Although the Swanson case appears to be good case law, a great deal of care is merited when relying on this case.  Several questions which were not raised in the Swanson case remain unanswered.  As noted by the court, Mr. Swanson was “following the advice of experienced counsel.”  Even then, Mr. Swanson had to fight the IRS in tax court to win his case.  For most people, even getting into a battle with the IRS is a losing proposition.  Some people, perhaps through ignorance of the rules, appear to be abusing Swanson-type entities.  For example, in IRS Notice 2004-8 on abusive Roth transactions, the IRS states that it is aware of situations where taxpayers are using a Roth IRA-owned corporation which deals with a pre-existing business owned by the same taxpayer to shift otherwise taxable income into the Roth IRA.  If the IRS has become aware of the problem, there may come a day when they decide to go after these types of arrangements more actively.

When relying on the Swanson case to set up a checkbook control LLC or other entity, always use experienced legal counsel who is very familiar with how to set up this type of entity and who will be there to guide you on issues such as the prohibited transaction rules, the plan assets regulations, unrelated business income tax issues and the other rules and regulations which may apply.  What happens after the LLC is formed is just as important as the initial setup and can get you into just as much trouble.  To attempt a “checkbook control” entity without knowledge of all the rules and regulations or competent counsel to guide you is sort of like jumping out of an airplane without a parachute – it may be fun on the way down, but eventually you’re going to go SPLAT!