The Blog
Seven Big Mistakes in Estate Planning
April 27, 2012
I came across an article in Forbes today that does a nice job of describing seven significant mistakes that are often made regarding estate planning. These mistakes include:
(1) Not having a plan (i.e. allowing state law to control);
(2) Using an online (or DIY) service to produce documents;
(3) Failure to review beneficiary designations (e.g. on retirement plans, life insurance, etc.) or titling of assets (e.g. joint tenancy, payable-on-death accounts, etc.);
(4) Failure to consider estate and gift tax consequences of life insurance;
(5) Ignoring the power of lifetime gifting (i.e. annual exclusion gifts – whether outright or “leveraged”);
(6) Failure to take advantange of the 2012 estate/gift tax exemption;
(7) Leaving assets outright to children.
For the complete article, click here: http://www.forbes.com/sites/robclarfeld/2012/04/25/7-major-errors-in-estate-planning/
Please do not hesitate to give me a call if you have questions regarding your current estate plan or if you would like to discuss unique opportunities that are set to expire at the end of 2012.
WARREN BAKER is a tax attorney in Seattle, WA, specializing in estate planning, self-directed IRA consulting, and business structuring. He can be reached at 206-624-9410.
New article in PSBJ – “Self-directed IRAs pose challenges in estate planning”
March 22, 2012
Dear readers,
Just a quick post to let you know that my article was recently published in the Puget Sound Business Journal (March 16-22, 2002 – Estate Planning Supplement – page 12A). The article is entitled “Self-directed IRAs pose challenges in estate planning” and discusses several potential estate planning complexities that self-directed IRA owners must consider, including: (1) required minimum distribution (“RMD”) issues when an IRA owns “illiquid assets” (e.g. real estate, LLC units); and (2) prohibited transaction problems when a self-directed IRA is inherited by a beneficiary that does not understand the legal and tax issues surrounding these structures.
If you don’t get a chance to read the hard copy version, the electronic version can be found here (requires subscription): http://www.bizjournals.com/seattle/print-edition/2012/03/16/estate-planning-self-directed-iras.html
ENJOY!
Could Mitt Romney’s IRA be disqualified?: An adventure into the muddy waters of the prohibited transaction rules.
February 5, 2012Copyright © 2012 by Warren L. Baker – Amicus Law Group, PC
While much of the scrutiny over Mitt Romney’s IRA has been centered on whether the IRA invested offshore in order to avoid current IRA tax consequences, very little focus has been on whether Mr. Romney’s IRA could be legally unsound at its core. Does Mr. Romney benefit, directly or indirectly, on a personal level from the investments made by his IRA? Was Mr. Romney’s IRA allowed to purchase assets on a preferred basis, which could constitute an invalid constructive contribution to his IRA? Admittedly, whether Mr. Romney’s IRA has committed a prohibited transaction will forever be between him, his advisors, and the federal government. However, I can tell you from experience that the prohibited transaction issues described in this article can cause significant problems regardless of whether you are an investor with $40,000 in your self-directed IRA or you are Mitt Romney and have multiple millions.
For my readers that might be wondering “why are you writing about Mitt Romney’s IRA”, let me provide some background. As the Republican Presidential nomination race heated up in January of 2012, Mr. Romney began receiving some criticism that he was not “relatable”, due in part to his vast wealth, which he accumulated as a result of his success at the private equity firm he helped co-found, Bain Capital. The heat was turned up even further by two events: (1) Mr. Romney stated on the campaign trail that his overall tax rate is “around 15-percent”; and (2) fellow Republican Presidential nominee candidate Newt Gingrich released his personal tax return showing that he pays around 35-percent. The end result of these politically-charged events is that Mr. Romney was pressured to disclose more detailed personal financial information, in the form of his 2010 federal tax return and estimated figures for 2011.
One piece of information that caught the attention of many news agencies and legal commentators was Mr. Romney’s very large IRA, reported to be worth anywhere between $20 million and $100 million. The media jumped on the idea that Mr. Romney’s IRA could not possibly be this large, based on the inherent contribution limits imposed on IRA accounts. However, several explanations exist that could help to justify the value of Mr. Romney’s IRA, including: (1) large annual contributions were made to a different type of retirement plan (e.g. a defined benefit plan and/or a 401(k) plan – which, depending on the plan, allow tens-to-hundreds of thousands of dollars of contributions per year) and later “rolled over” or transferred to the IRA; and (2) very successful investing on a tax-deferred basis within the IRA.
For purposes of illustration, assume Mr. Romney was able to accumulate $2 million in retirement savings by the time he was 44 years of age (which, given his almost instant success in the business world, is not out of the question). If we then assume that this $2 million was very successfully invested into mostly risky, yet lucrative private equity investments, which resulted in an average 20-percent annual return over the next 20 years, Mr. Romney’s IRA would be worth over $75 million today.
All of this is fine and good as long as Mr. Romney’s IRA investments were always handled in a legal manner. In my role as a tax attorney and advisor to hundreds of self-directed IRA investors, I always alert my clients to two major legal/tax problems that can arise within “self-directed IRAs” (side note: Because Mr. Romney’s IRA was likely invested into “non-traditional” types of investments, e.g. private equity funds that are not available on the public securities market, I would generically categorize Mr. Romney’s IRA as a self-directed IRA). First, the income resulting from the IRA’s investments can result in current tax consequences to the IRA itself. This generally occurs when the IRA either: (1) receives income from a trade or business “regularly carried on” by the IRA (or by a flow-through tax entity in which the IRA holds equity), which is not otherwise exempt from current tax under the unrelated business taxable income (UBTI) rules;1 or (2) receives income that would normally be exempt from tax under the UBTI rules, but the income results from “debt-financed property”.
Several articles have been written recently regarding the appropriateness of Mr. Romney’s IRA investing into offshore Cayman Islands companies (sometimes called “blocker corporations”), which could then be used to invest into private equity funds run by Bain Capital – all without triggering UBTI tax consequences to Mr. Romney’s IRA (the reason why this works is that dividends from corporations are exempt from UBTI; as opposed to certain “flow-through” income from LLCs and partnerships). Although this issue is significant due to the fact that UBTI is taxed at trust rates (35-percent), I will assume, for purposes of this article, that Mr. Romney’s IRA legitimately avoided UBTI, and thus, has always grown entirely tax-deferred.
The second major legal/tax problem that self-directed IRA investors must be aware of is avoiding the complete invalidation of the IRA’s tax-exempt status. The Internal Revenue Code (“IRC”) and the Employee Retirement Income Security Act (“ERISA”) both describe certain transactions that are not allowed within a retirement account.2 These so-called prohibited transactions include various types of financial interactions between a “disqualified person”3 and “a plan” (which includes an IRA), including:
(1) a sale or exchange, or leasing, of any property between a plan and a disqualified person;
(2) lending of money or other extension of credit between a plan and a disqualified person;
(3) furnishing of goods, services or facilities between a plan and a disqualified person;
(4) transfer to, or use by or for the benefit of a disqualified person, of any assets or income of a plan;
(5) a fiduciary dealing with the assets or income of a plan in the fiduciary’s own interest or for the fiduciary’s own account (i.e., self-dealing); or
(6) the receipt of consideration by a fiduciary for the fiduciary’s own account from any party dealing with a plan in connection with a transaction involving the assets or income of the plan (i.e., a kickback).
A “disqualified person” includes the IRA account owner4, his or her spouse, and certain other family members, business entities, and business partners.
Prohibited transactions occurring as a result of items (1) through (4) above are normally fairly easy to detect because they involved direct interactions between the IRA and a disqualified person (or entity). For example, if Mr. Romney’s IRA purchased a vacation home from (or was used by) Mr. Romney’s children, a prohibited transaction would definitely occur. For purposes of this article, I will assume that Mr. Romney’s IRA has not committed this type of blatant prohibited transaction. However, that assumption does not close the door on potential prohibited transaction problems.
One of the key characteristics of a self-directed IRA is that the IRA owner has discretionary authority over the IRA’s investments. This is important because it results in the IRA owner being characterized as a “fiduciary”, and thus, brings into play what is commonly referred to as “fiduciary prohibited transactions” (see items (5) and (6) above). Both the Department of Labor (DOL) and the Internal Revenue Services (IRS) have ruled that the fiduciary prohibited transaction rules are applicable regardless of whether there is a disqualified person on the other side of the transaction.5 For example, the DOL has reviewed scenarios in which the investments made by the IRA affected the IRA owner’s exercise of his “best judgment” as a fiduciary (despite the fact that no disqualified person was involved), and ruled that a prohibited transaction could occur as a result of a conflict of interest.6 In addition, Tax courts,7 the DOL,8 and the IRS9 have all stated that if a fiduciary or another disqualified person (e.g. the IRA owner) benefits, directly or indirectly, as a result of the use of tax-deferred retirement assets, a prohibited transaction could occur, regardless of whether the retirement plan directly interacted with a disqualified person.
In summary, a self-directed IRA owner cannot execute investments that result in a conflict between his/her loyalty to the IRA and his/her loyalty to another person (whether a disqualified person or not). Also, a disqualified person cannot receive a direct or indirect personal benefit from the IRA’s investments. This is where I believe Mr. Romney’s IRA could have a legal problem. According the Wall Street Journal10, Mr. Romney’s IRA is currently invested into numerous investment entities run by Bain Capital. Presumably, the IRA is a limited partner in these venture funds or is invested as a limited partner via an offshore corporation. Bain Capital, on the other hand, serves as a general partner, which likely results in management fees (currently) and “carried interest” payments (down the road).
In general, carried interest is earned by investment managers who actively work at a firm. Mr. Romney left Bain Capital in 1999, but as part of his departure agreement retained profit sharing rights as a retired partner. In fact, Mr. Romney has earned $13 million of carried interest income over the past two years alone. There lies the ultimate problem. If the on-going investments being made by Mr. Romney’s IRA are resulting in a direct or indirect benefit to him personally, a prohibited transaction argument exists. It is likely that Mr. Romney would argue that he is not a fiduciary because his investments are controlled by a “blind trust” or third-party fiduciary. However, if he is not in control of his IRA’s investments (either directly or indirectly), why is his IRA still invested into so many funds run by Bain Capital? Would an independent fiduciary continue investing into these funds? If Mr. Romney is not controlling the IRA, but is simply directing the IRA trustee, he still has a fiduciary prohibited transaction problem.11
Although the federal legal framework governing IRAs is in desperate need of clarification, I believe that both of the following scenarios, if they exist in Mr. Romney’s situation, either directly violate the IRA legal principles or, at the very least, are in conflict with the intent of the IRA rules:
(1) The IRA’s investment results in direct or indirect personal compensation or benefit to a disqualified person. Allowing a disqualified person to currently benefit from the IRA’s investments conflicts with the idea that tax-differed funds are not truly “owned” by the IRA account holder until they are withdrawn down the road and taxes are paid.
(2) The IRA is granted a special investment right that would not be available without a disqualified person’s interest in the underlying entity and/or investment structure. For example, if the IRA is allowed to purchase an asset at a discount and/or earns income at a preferred rate based on the fact that a disqualified person in involved, a prohibited transaction and/or invalid IRA contribution is possible.
If Mr. Romney’s IRA did indeed commit a prohibited transaction (perhaps many years ago), the IRA’s tax-exempt status could be revoked and the entire value of the IRA could be deemed to be distributed to Mr. Romney, effective January 1st of the year in which the prohibited transaction occurred. The result of this rather harsh rule can be absolutely disastrous. For purposes of illustration, assume the combined value of Mr. Romney’s retirement accounts was $20 million in 1999 (when he left Bain Capital). Assume further that Mr. Romney rolled all of his retirement plans into one IRA in 1999, an event that is not uncommon when someone changes careers. Finally, assume that Mr. Romney’s IRA committed a prohibited transaction in early 2000, which would automatically revoke his IRA’s tax-exempt status as of January 1, 2000. In simplified terms, the tax result would be:
(1) $20 million of additional income to Mr. Romney in 2000. Because this income is coming from an IRA, the income would be taxed at ordinary income rates (top rate was 39.6% in 2000). Tax due: $9.9 million.
(2) Because the prohibited transaction was not acknowledged at the time, this $9.9 million would be subject to interest and underpayment penalties from 2000 until 2012. Although the IRS will occasionally agree to reduce penalties (assuming no fraudulent transaction is found), interest cannot be waived. Additional amount due: $8.1 million (assuming interest only at a 5-percent average rate).
(3) Because the IRA would have lost its tax-exempt status in 2000, all earnings within the IRA after that time would be treated as being earned by Mr. Romney individually. Assuming the assets grew another $55 million since 2000 and Mr. Romney would be taxed on these earnings at 35% (assuming this income would be ordinary in nature), the additional tax due by Mr. Romney would be $19.25 million.
(4) Finally, because the earnings in #3 were not recognized by Mr. Romney, penalties and interest could apply to this tax liability as well, resulting in an additional amount due of $15.75 million (assuming interest only at a 5-percent average rate and no penalties).
(5) Total owed to IRS: $53 million (i.e., 70% of IRA’s value would be lost; if penalties were imposed under #2 or #4, almost the entire IRA could be wiped out)
As you can see from the discussion above, the rules that govern self-directed IRAs are not always crystal clear. However, the consequences of ignoring these legal and tax principles altogether can be extremely detrimental to any IRA investor, including, but certainly not limited to, Mr. Romney.
Citations:
1 Internal Revenue Code (“IRC”) Section 408(e)(1). The UBTI provisions are found at § § 511 through 514. Conforming amendments were not made to § § 511(a)(2)(A) and 501(a) to include IRAs when the IRA Code provisions were enacted, but IRC § 408(e)(1) clearly indicates the UBTI provisions apply to IRAs.
2 IRC § 4975(c)(1); ERISA § 406(a).
3 IRC § 4975(e)(2).
4 The language is not as clear as it should be, but the intent to include such persons is seen at IRC § 408(e)(2), describing IRA owners as the “creators” of the accounts. The House approach during the drafting of ERISA would have applied the Code’s prohibited transactions rules of IRC § 503 (applicable to “creators” of certain types of entities subject to those prohibited transaction rules). See H.R. Rep. No. 1280, 93d Cong., 2d Sess. 340 (1974). The definitions found in IRC § 4975(e)(2) were adopted instead, but the IRA provisions never were cleaned up before being enacted.
5 See also IRS Employee Plans Technical Guidance, Prohibited Transactions, IRM 4.72.11.3.5 (June 14, 2002).
6 See DOL Op. Ltr. 93-33A (IRA investment benefited IRA owner’s brother and sister).
7 See Rollins v. Commissioner, T.C. Memo 2004-260 (401(k) made loans to companies that were not automatically disqualified, but minority shares were owned by the disqualified parties. Tax Court held that a § 4975(c)(1)(D) prohibition did not require an actual transfer of money or property between the plan and the disqualified person. The fact that a disqualified person could have benefited as a result of the use of plan assets was sufficient).
8 While there is nothing per se wrong with the IRA owner and the IRA investing in the same investment, several DOL advisory opinion letters illustrate that not all investments may be proper. See DOL Adv. Op. 2000-10A (Although fiduciary prohibited transactions are very fact-specific, DOL listed examples in which certain actions, if they occurred, could trigger such a prohibited transaction, including: (1) A prohibited transaction would occur if an IRA transaction is part of an agreement, arrangement or understanding in which the fiduciary caused the IRA assets to be “used in a manner designed to benefit” the fiduciary (or any person in which the fiduciary had an interest); and (2) Employment of the fiduciary by the partnership, or payment of unreasonably large compensation, or compensation based on the IRA’s return on investment might trigger a prohibited transaction.
9 See IRS Employee Plans Technical Guidance, Prohibited Transactions, IRM 4.72.11.3.6 (June 14, 2002) (“If a fiduciary receives any consideration for his own personal account from any party dealing with the plan in connection with a transaction involving the income or assets of the plan, it is a prohibited transaction.”) (emphasis added).
10 Wall Street Journal online, “Romney’s Unorthodox IRA” (January 19, 2012) http://online.wsj.com/article/SB10001424052970204468004577168972507188592.html.
11 See Treas. Reg. § 54.4975-6(a)(5)(i) (The fiduciary prohibition transaction rules do not permit IRA owners to direct the IRA trustee to enter into any transaction in which the owner has an interest that may affect the “exercise of his judgment as a fiduciary”; the typical conflict of interest situation).
Warren L. Baker interviewed for Kiplinger’s Retirement Report article
December 13, 2011
Just a quick post to let our blog readers know about a new article that was recently published in the December 2011 edition of Kiplinger’s Retirement Report (subscribed to by nearly 90,000 retirees and preretirees) entitled, “Avoid the Pitfalls of Self-Directed IRAs”. The Editor of the publication, Susan B. Garland, interviewed me (Warren L. Baker) as an attorney resource for the article. The article describes the rapid growth in this area of investing (for example, one well-known custodian, Pensco Trust Co., has seen their assets under management increase from $1.6 billion to $3.6 billion in the last five years alone) but also describes some of the dangers. As I have discussed in other posts on this blog, there are definitely signficant legal and tax issues that all self-directed IRA (or IRA-owned LLC) investors should consider before moving forward with one of these structures.
Dangerous myths when choosing a guardian in a Will
November 2, 2011
For parents with minor children, one of the important provisions within a Will is the naming of a “guardian”. In most situations, this provision will only come into play if both parents pass away, and therefore, their minor children are left with no primary caretaker. Regardless of how unpleasent this topic may be, parents need to think about this issue carefully during the estate planning process.
I recently read an article by Jocoba Urist (an attorney and Huffington Post blogger) entitled “4 Dangerous Myths About Choosing a Guardian” which does a good job of flushing out some common misconceptions that parents have regarding naming a guardian. The complete article can be found here:
http://www.huffingtonpost.com/jacoba-urist/guardian-wills-children_b_1024505.html
SEC Investor Alert regarding self-directed IRAs and the risk of fraud
October 31, 2011
In September 2011, the Securities and Exchange Commission’s (SEC) Office of Investor Education and Advocacy released an “Investor Alert” addressing the risk of fraud assocated with self-directed IRAs. In short, the Investor Alert warns self-directed IRA investors that several characteristics inherit in self-directed IRAs can lead to an increased risk of fraudulent investment schemes. For example, it is possible for a self-directed IRA to invest into a privately-held business ventures (partnerships, LLCs, etc.) that lack the type of government oversight that is inherent in the public securities market. While most of my clients choose to invest using self-directed IRAs because they would like more control and oversight over their retirement account investments (e.g. direct real estate investment), the amout of money flowing into these structures is bringing out the scammers.
The SEC recommends the following ways to avoid fraud (I have also added some personal commentary):
(1) Avoid unsolicited investment offers.
(2) Ask questions.
(3) Be mindful of “guaranteed” returns.
(4) Ask a professional.
The complete pdf version of the Investor Alert can be found on the SEC’s website at: http://www.sec.gov/investor/alerts/sdira.pdf
Warren L. Baker to speak at East King County Estate Planning Council meeting on 9/23
September 21, 2011
Just an FYI to all you East King County Estate Planning Council members that I will be co-presenting with John G. McGlynn of Pacific Portfolio Consulting this Friday, September 23rd at 7:30am at the Bellevue Hyatt Regency. The topic is entitled: Retirement Plans: 401(k) Update and Non-traditional IRA Investing. I hope you can join us!
PSBJ article annoucement – You invested into WHAT with your retirement account?!?
September 16, 2011 
I am pleased to announce the official publication of my article, You invested into WHAT with your retirement account?!?, in the September 16-22 edition of the Puget Sound Business Journal (see p. 29). For subscribers, the complete article can be viewed online at http://www.bizjournals.com/seattle/print-edition/2011/09/16/banking-finance-alternative-iras.html
Please let me know if you, your collagues, or your clients would like to discuss the topic of “self-directed IRA” investing in more detail. I can be reach at 206-624-9410.
Estate Planning 101 for Real Estate Investors
August 16, 2011
When most of my clients hear the words “estate planning”, they first think about avoiding estate taxes. However, under current law, federal estate tax (maximum rate of 35%) does not kick in unless someone passes away with more than $5 million in assets, and the State of Washington death tax (maximum rate of 19%) does not get triggered unless the estate value is more than $2 million. I certainly have clients that will fall within this taxable range (especially when taking into account life insurance – which many people fail to consider), but even for those clients, estate planning is more about passing their assets to their children, grandchildren, other relatives, and/or charities in a responsible and organized manner. For clients that are real estate investors, estate planning is almost always intertwined with structuring their affairs to avoid current liability concerns and to allow for smooth management/ownership transition in the event of disability or death. In other words, avoiding taxes at death is normally a minor issue in comparison to other estate planning objectives.
In a general sense, there are two basic methods for passing assets at death: (1) a Last Will and Testament (“Will method”); and (2) a Revocable Living Trust (“Revocable Trust method”). Under the Will method, a deceased client’s “probate assets” will pass according to the terms of the Will. Probate assets include real estate, personal property (e.g. jewelry, cars, household items, etc.), bank accounts, business entity ownership (e.g. LLC membership units), and other property that does not pass according to a “beneficiary designation form” (e.g. retirement plans, life insurance, etc.). The wording of a Will can pass assets directly to heirs (e.g. “all of my assets to my spouse, and if he/she is deceased, to my children equally”) or can pass assets into a trust (e.g. “all my assets to my Family Trust to be administered as described in Section 8 of this Will”). The Will also names individuals that become very important at death, for example: the “Guardian” is the person who will care for the client’s minor children if both spouses have passed away; the “Personal Representative” is the person who will act out the wishes of the client based on the terms of the Will; and the “Trustee” is the person who will manage the trusts (on behalf of the beneficiaries of the trust) created under the Will, if any. In general, the first time a person should start thinking about creating a Will is when they own significant probate assets (e.g. first home) and/or have minor children. A Will can be amended at anytime, and clients often make changes as they age and their family situation and/or assets evolve.
One of the downsides of the Will method of estate planning is that some of a client’s assets will pass through “probate” at their death. Although this legal process is relatively painless under Washington law, there are several downsides, including: (1) the deceased person’s Will becomes public record, which has the potential to raise hostility within the family, particularly if some family members have been excluded from the Will; (2) the probate process can take a long time and can cost thousands of dollars to complete.
The Revocable Trust method involves creating a Revocable Trust and transferring assets into the trust. The potential benefits of this method include: (1) assets held within the trust at death will pass directly to the beneficiaries of the trust without going through probate; (2) although more expensive to set up initially, the Revocable Trust method can save probate costs at death (note: this benefit is the primary motivator for the widespread use of Revocable Trusts in states like California, where the probate costs are much higher than in Washington); (3) if the client holds real estate in several different states at death, multiple probate proceedings can be avoided (note: most states require a separate probate proceeding if real property is held within their jurisdiction – unless the property is legally owned by a trust).
In most instances, I do not recommend the use of the Revocable Trust method for clients that are relatively young (e.g. 30s or 40s) unless the client owns property in multiple states. The reason is that Revocable Trusts not only need to be drafted properly, but also need to be funded and maintained correctly. I have had many clients tell me that they have a Revocable Trust in place, only to find out that their former attorney did not assist them in legally funding the structure. A Revocable Trust that is never funded will not result in the benefits described above. Several other reasons why the Revocable Trust method is not always the best for some clients include: (1) if real estate held within the trust is sold and new property is acquired, the trust needs to remain appropriately funded (I have seen many situations where the new property is never legally placed into the trust); (2) the eventual probate cost savings do not outweigh the cost to create, fund, and maintain the trust structure. However, for clients in their 60s or 70s with relatively fixed assets, the Revocable Trust method can make a lot of sense.
Regardless of the estate planning method used, I always recommend that my clients also have a Healthcare Directive and a Power of Attorney in place. A Healthcare Directive allows a client to decide what they would like their doctors to do if they are ever in a “permanently vegetative state”. This document can help relieve the client’s family of the difficult decisions that can arise in this very specific situation. The Power of Attorney document allows the appointed “Attorney-in-Fact” (e.g. the client’s spouse) to make financial and healthcare decisions on behalf of the client if the client is ever incapacitated (whether temporarily or permanently) or otherwise unable to act. The Power of Attorney document can either be currently effective or it can “spring” into place if the client is ever diagnosed (by his or her doctors) as incapacitated. In either case, the client must be very careful not to name someone as Attorney-in-Fact that might abuse their power. For real estate investors, it is particularly important that bills are paid and properties are managed appropriately, regardless of the mental state of the property’s owner.
Special estate planning considerations are also necessary for clients who invest into real estate using “self-directed IRA” (or IRA-owned LLC) structures. More information on this topic can be found at: http://amicuslawgroup.com/the-self-directed-ira-part-4-estate-planning-challenges/
The Self-Directed IRA – Part 6: Sorting Out the Custodian vs. Facilitator Riddle
June 1, 2011
[In a continuing series of articles, tax attorney Warren L. Baker is writing on the topic of “self-directed” IRAs – from the basic formation process to the complex tax and legal ramifications involved when investing using these structures.]
The basic goal for most “self-directed IRA” owners is simple: invest retirement funds into assets outside the stock market (e.g. real estate). However, when it comes to actually accomplishing this task, investors often get confused due to the ever-growing maze of companies that claim to be experts in this very specific area of tax law. Part of the problem is that the primary education tool being used by interested consumers is an internet search, and although the internet is a reasonable place to start, it can lead to more questions than answers. For example, people often contact me with questions like: “what is a facilitator and how do they differ from a custodian?” What role does an attorney or an accountant play in this process? Do I need all of these companies/professionals, or just some? The purpose of this article is to describe the categories of companies and professionals that an investor will encounter in the self-directed IRA formation process and beyond. My hope is that this information will allow for better decision-making and fewer “I wish I had known that when I started this process” moments.
IRA Custodian: Every IRA must be held by a custodian. Custodians are generally structured as a bank or a trust company and these companies are highly regulated by the federal government. Whether a custodian allows for “self-directed” IRA investment into assets like real estate, hard money lending, private businesses, etc. depends on the internal policies of each custodian, and not necessarily the underlying law governing IRAs. For example, a company like Charles Schwab could (in theory) allow the IRAs that they hold to be invested directly into real estate, but they do not. The reason is not because it is illegal to invest an IRA into real estate, but rather they have chosen to avoid the complexities that these types of “non-traditional” investments can cause for the custodian. The result is that only specialized types of custodians operate in the self-directed IRA arena, and even these custodians have different internal policies and fees regarding self-directed IRA investment.
Further, because of the nature of the assets held by a self-directed IRA (e.g. real estate), holding these types of accounts brings with it certain complexities (e.g. reviewing real estate documents, paying the IRA’s property tax, etc.) and timing problems. In order to make up for the administrative hassle resulting from these complexities, self-directed IRA custodians often impose annual and transactional based fees. The timing problem occurs when an IRA account holder wants to purchase an asset but the custodian’s procedure results in the client missing out on the asset purchase. These fees and timing issues are the two primary reasons why IRA account holders have flocked to IRA-owned LLC structures (“IRA/LLC”).
IRA/LLC Facilitator: In simple terms, the explosion of IRA “facilitators” is the direct result of the real (or perceived) shortcomings of the self-directed IRA custodians and the real (or perceived) benefits of an IRA/LLC. As I have discussed in prior articles, the IRA/LLC structure involves a self-directed IRA investing its assets into a newly-formed LLC, and thereby allowing the IRA account holder to have “checkbook control” over the IRA/LLC’s investments (via a business checking account in the LLC’s name). Ideally, the result of this structure is less custodian oversight (i.e. fewer fees) and quicker transactions. The facilitators are companies who are in the business of selling (and facilitating the formation of – hence the term “facilitator”) the IRA/LLC structure. Over the past decade, the IRA/LLC structure has spread quickly due, in part, to the marketing efforts of facilitators. A “self directed IRA” search on Google will bring up numerous paid ads by IRA/LLC facilitators. These companies typically charge anywhere between $1500 and $4000 (which normally includes the state LLC filing fees and IRA formation cost) to assist a client in the IRA/LLC formation process.
Based on my discussions with hundreds of clients who have set up IRA/LLC structures, my belief is that most facilitators are doing their best to act in the client’s best interest. However, there are several inherent problems with the facilitator model. First, the driving force of most facilitators is a team of salespeople who speak directly with potential clients. This is a problem because oftentimes a client’s entire knowledge base relating to prohibited transactions [see my Part 3 article] and current IRA tax consequences [see my Part 5 article] is based on conversations with someone who is trying to “sell them” the structure. In my view, there is a very fine line between a salesperson talking directly with clients about the rules and regulations governing the IRA/LLC structure “for informational purposes only” and providing unauthorized “legal advice”. To try and solve this problem, some facilitators refer clients to “outside attorneys” (note: I have been referred many clients under this concept), which definitely results in the client being better prepared to operate the IRA/LLC. However, because clients frequently pay their fee to the facilitator prior to speaking with the attorney, the value of these discussions is diminished, and often viewed by clients as a simple formality.
The second problem with the facilitator model is the fact that facilitators cannot draft legal documents. Facilitators attempt to sidestep this problem by using only “form documents” when filing for the LLC formation under state law and creating the LLC’s governing documents (e.g. Operating Agreement, meeting forms, etc.). However, this one-size-fits-all model is problematic in any situation where the client needs something customized to their specific situation.
Based on the severe legal/tax problems that can arise when a client fails to use an IRA/LLC correctly, I believe strongly in a three step IRA/LLC model: (1) preliminary legal and tax education on every aspect of IRA/LLC, from formation to operation to termination, and discussion of whether the IRA/LLC structure even makes sense for the particular client; (2) formation of the IRA/LLC structure in a manner that is consistent with the client’s individual investment goals; and (3) on-going meetings with legal counsel (at least annually) to make sure the IRA/LLC is observing the applicable legal rules and tax compliance issues.
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