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!”

Frequently Asked Questions About Buying Debt Financed Real Estate in an IRA

Good news!  You can buy real estate in your traditional, Roth, SEP, or SIMPLE IRA, your 401(k), your Coverdell Education Savings Account for the kids, and even in your Health Savings Account.  Even better, your IRA can borrow the money for the purchase or even take over a property subject to existing financing.  What could be better than building your retirement wealth using OPM (Other People’s Money)?  However, there are some restrictions which you must be aware of when using your IRA to purchase debt financed real estate.  Below I answer a series of frequently asked questions regarding the purchase of debt financed real estate in an IRA.
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Q.        Is it really legal to buy real estate in an IRA?

A.        Yes.  Even the IRS agrees that real estate is a permitted investment.  In its answer to the question “Are there any restrictions on the things I can invest my IRA in?” the Internal Revenue Service states “IRA law does not prohibit investing in real estate but trustees are not required to offer real estate as an option.”

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Q.        Can my IRA buy real estate with a loan or take over a property subject to an existing loan?

A.        Yes.  An IRA may borrow money to acquire real estate or take over a property subject to an existing loan, provided that the loan is non-recourse to the IRA and to any “disqualified person.”  This means that typically the lender may only foreclose on the property in the event of a default.  Even if there is a deficiency, the lender cannot come after the rest of the IRA’s assets, nor can the lender come after the IRA owner or any other disqualified person.  Neither the IRA holder nor any other disqualified person is permitted to sign a personal guarantee of the debt.

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Q.        Where can I get a non-recourse loan for my IRA?

A.        There are at least four sources for financing which do not violate the non-recourse requirements for IRA’s.  First, there is seller financing.  Most sellers understand that if the loan goes into default they get the property back anyway, so asking for the loan to be non-recourse should not be too difficult to negotiate.  Second, there is private financing from financial friends.  If you cultivate a reputation as a professional real estate investor, there should be no reason that your financial friends would not loan your IRA money on a non-recourse basis, either from their own funds or from their own IRA’s.  I have seen

IRA’s borrow the money for both the purchase and the rehab on a non-recourse loan!  Third, there are banks and hard money lenders.  Non-recourse loans are not the norm, so many banks will turn you down.  However, there is at least one bank that lends in all 50 states, and in Houston I have had at least 3 local banks and 2 hard money lenders make non-recourse loans to IRA’s.  Finally, as mentioned above, you could take over a property subject to an existing loan, provided the originator of the loan is not you or another disqualified person.

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Q.        Is there any tax effect of having an IRA own debt financed real estate?

A.        Yes.  Income and gains from investments in an IRA, including real estate, are normally not taxed until the income is distributed (unless the distribution is a qualifying distribution from a Roth IRA, a Coverdell Education Savings Account, or a Health Savings Account, in which case the distribution is tax free).  However, if the IRA owns property subject to debt, either directly or indirectly through an LLC or a partnership, it may owe tax on the net income from the property or partnership.

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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 will cause the IRA to owe taxes.

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

A.        That is a good question.  To figure out if this makes sense, ask yourself the following key questions.  First, what would you pay in taxes if you made the same investment outside of the IRA?  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.  Second, 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!  Third, do you have plans 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.

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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 investments which will cause the IRA to pay taxes.  Keep in mind that companies which are publicly traded already have paid taxes before dividends are distributed, 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.”

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

A.        The IRA must pay the tax.

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

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

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Q.        What is the tax rate that IRA’s 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.

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Q.        Is there any way to get around paying this tax?

A.        Yes.  In some ways it may be considered a “voluntary” tax, since investments can often be structured in such a way as to avoid taxation.  Some ways to structure your IRA investment to avoid taxation include loaning money instead of acquiring the real estate directly or purchasing an option on the real estate, then assigning or canceling the option for a fee.  These techniques have a disadvantage in that they may not result in as much profit to the IRA, but will generally be free of tax.  There is also an exemption from this tax for 401(k)’s and other qualified plans in certain circumstances.

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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 inIRS

Publication 598, which is freely available on the IRSwebsite at www.irs.gov.  The actual statutes may be found in Internal Revenue Code §511-514.

There is one general truth that applies both inside and outside of an IRA – you can do more with debt than you can without it.  Despite the increased risk from debt and the taxes due on income from debt financed property, a careful analysis may lead to the conclusion that having your IRA pay taxes now may be the way to financial freedom in your retirement.  Be sure to have your IRA pay the tax if it owes it, though.  As I always say, “Don’t mess with the IRS, because they have what it takes to take what you have!”

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Entity Investments in Your IRA – Advantages, Cautions and Legal Considerations

This article is part of a series of articles discussing some issues arising when investing your IRA into an entity, such as a limited liability company, corporation, limited partnership, or trust.  Other articles in this series include prohibited transactions and disqualified person, unrelated business income (UBI) and unrelated debt-financed income (UDFI) as it relates to entity investments, the plan asset regulations and other regulations which may apply, and formation and management issues, including the “checkbook control” LLC which has become so popular in the self-directed IRA industry.

There are advantages, cautions, and legal considerations when investing in an entity within your IRA.  Advantages of having your IRA own an entity include:

1)         Your IRA’s funds may be held in the entity’s name at a local bank.  This can be an advantage when getting cashier’s checks for the foreclosure or tax lien auction, paying earnest money or option fees, or paying contractors who prefer local checks, among other things.

2)         Certain types of investments, such as real estate closings or investments at foreclosure auctions, may in some circumstances be easier to facilitate through an entity.

3)         Investing your IRA’s funds through an entity may give your IRA some asset protection.  Always check with local legal counsel!

4)         In certain limited circumstances, you may be able to act as a manager, director or officer of your IRA-owned entity without compensation.

5)         If the entity’s shares are all that the IRA owns, administration fees may be lower.

6)         If the director, officer or manager is a trusted friend, you may more easily control what happens with your IRA’s funds.

Cautions when investing your IRA through an entity include:

1)         Check with your CPA or tax advisor on the local, state and federal tax implications of the entity you want your IRA to invest in.

2)         Select competent legal counsel to guide you who is familiar with the restrictions imposed by the Internal Revenue Code, including the prohibited transaction rules of Section 4975, as well as the plan asset regulations.  Otherwise, you may inadvertently engage in a prohibited transaction.  Make sure that the investment in the entity is not prohibited in itself and also that the company is not structured in a way that the operations of the company will lead to a prohibited transaction.

3)         All fees for the formation of the entity and for the preparation of any necessary tax returns as well as any taxes due must be paid from funds belonging to the IRA.

4)         Unless the entity is taxable itself, to the extent it owns debt-financed property or operates as a business, unrelated business income tax (UBIT) may attach to the profits from the entity.  Remember, there is no distinction between general and limited partners.

5)         Your third party administrator generally does not review the formation document or the by-laws, operating agreement or partnership agreement.  The nature of a self-directed IRA is that the IRA holder is responsible for the contents of the agreement, and usually must read and approve the subscription agreement and operating or partnership agreement prior to the administrator signing.  Typically, the only review that is undertaken is to make sure that the ownership of the asset is correctly listed in the name of the IRA.  Also, bear in mind that the administrator does not review any investment for compliance with IRS guidelines, so the IRA holder and his or her advisers should be very familiar with any restrictions.

Other things for you and your legal counsel to consider include:

1)         You should review the entity agreements to make sure that an IRA or qualified plan is permitted to be a shareholder, member or partner.  The agreement should specify the voting procedure for shares held by an IRA or qualified plan.

2)         There should be no transfer or buy-sell restrictions that would restrict the shares if the IRA is distributed either because the IRA holder dies or because the shares are distributed as part of a Required Minimum Distribution (RMD), or if the IRA holder decides to move the shares to a different custodian or administrator.

3)         The IRA holder and other related disqualified persons generally cannot receive compensation from the company.

4)         Depending on the ownership percentage by the IRA and other disqualified persons, it may be a prohibited transaction to fund additional capital calls.  If so, only the amount of the initial commitment can be funded.  Many administrators or custodians have restrictions on future capital calls.  The concern is that if the IRA and other disqualified persons fund more than 50% of the entity the entity will become a disqualified person to the owning IRA and future capital contributions might be considered a “transfer to, or use by or for the benefit of, a disqualified person of the income or assets of the plan” in violation of Internal Revenue Code §4975(c)(1)(D).

5)         If the IRA holder is or may soon be subject to required minimum distributions, either the IRA holder must have sufficient resources left in the subscribing IRA or other traditional IRA’s to cover the RMD, unless there will be guaranteed sufficient distributions from the entity to fund the RMD.  Otherwise, shares of the entity may have to be distributed.  This would cause significant difficulties both for the IRA holder and for the entity.

6)         Because of the limited review by the custodian or administrator of the formation documents and the investment, the IRA holder and his or her advisor should do the normal due diligence on the company, including investigating all of the principals involved reviewing the financial strength of the company, verifying with the Secretary of State that the company is in good standing, and checking with the Securities and Exchange Commission , the Better Business Bureau and any other governmental or non-governmental agency to see if any complaints have been filed against the company.  The IRA holder is 100% responsible for evaluating the company and the investment.