[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.]
When looking at the world of self-directed IRAs from the “10,000 foot level,” there are two categories of legal/tax issues that are the most critical when investing an IRA into “non-traditional” investments (e.g. real estate, privately-held businesses, hard-money lending, tax liens, etc.). The first and most important problem to avoid is triggering the automatic invalidation of the IRA, or IRA-owned LLC (“IRA/LLC”), by having the structure enter into a “prohibited transaction” (see Part 3 of my article series). If a prohibited transaction occurs, many of the other issues become irrelevant because the IRA loses its tax-exempt status (i.e. the assets in the IRA become the personal assets of the IRA holder, significant tax consequences are triggered, and the IRA ceases to exist). However, assuming no prohibited transaction has occurred, the second major issue is whether the IRA’s (or IRA/LLC’s) investments are triggering current taxes at the IRA level. Unfortunately, this issue is often ignored due to the IRA account holder’s false assumption that income to an IRA is always exempt from tax. This is definitely not true.
Active Business Income – UBTI:
Earnings within an IRA (or IRA/LLC) are generally exempt from tax. However, certain investments create taxable income called “unrelated business taxable income” (UBTI). UBTI is income from a trade or business regularly carried on by the IRA which is not substantially related to the exercise by the IRA of the IRA’s tax-exempt purpose. Interestingly, the tax code defines any active trade or business to be unrelated to the IRA’s purpose. However, there are statutory “modifications” that specifically exclude certain types of income out of UBTI. These include, but are not limited to:
–dividends (e.g. paid to the IRA as a result of the IRA owning C Corporation stock);
–interest (includes “points”);
–rent from real property;
–sales proceeds from real property (assuming the property is not held as inventory or held in the ordinary course of the IRA’s business, e.g. flipping or development activity).
The basic idea behind the UBTI rules is that Congress did not intend for IRAs to compete with active businesses. Rather, an IRA is designed to be a passive investor. In an ideal world, the tax on UBTI puts IRAs on an equal playing field with other active businesses. However, because an IRA is taxed on UBTI at trust rates (which are very “condensed” – i.e. it doesn’t take very much income to get into the top tax bracket), an IRA can actually owe more tax than a similarly- situated individual who is operating the exact same business.
1. IRA purchases a coffee shop and pays unrelated third-parties to operate the business (recall that no disqualified person can be financially involved). The income from the coffee shop will be treated as UBTI to the IRA.
2. IRA purchases 10% of a “Project LLC” (or partnership) that invests into a “fix and flip” real estate strategy. Because the real estate is being held as inventory, income “flow-through” to the IRA will be subject to UBTI. Further, because the IRA would be taxable on the UBTI whether the Project distributed profits back to the IRA or not, the IRA could run into a major liquidity problem (i.e. it could have a tax liability but no cash to pay the tax – note: the IRA account holder definitely cannot pay this tax on behalf of his or her IRA!).
3. IRA makes a “loan” to an operating business structured as an LLC or partnership. Rather than only interest being paid back to the IRA, the business agrees to pay a percentage of its profits. The income associated with the “disguised equity” will likely be subject to UBTI because it does not constitute “interest”.
Note: All of these examples apply equally regardless of whether the IRA invests directly or through an IRA/LLC structure.
Debt-Financed Income – UDFI:
Another way for an IRA’s income to be treated as UBTI and be currently taxable is under the “unrelated debt-financed income” (UDFI) rules. UDFI is triggered when the IRA receives (either directly or indirectly through a “flow-through” entity, like an LLC or a partnership) income from “debt-financed” property. For example, if an IRA purchases a piece of rental real estate using partial debt-financing (either seller financing or bank financing), UDFI will be triggered. However, because UDFI only applies to the percentage of income resulting from the debt-financed portion of the property, UDFI will generally result in less tax being owed than in the UBTI situation discuss above. This makes logical sense because the percentage of income resulting from the capital invested by the IRA (rather than the amount borrowed) should normally result in tax-exempt income.
IRA purchases a piece of real estate using a 40% down payment and 60% seller financing. The property is then rented out long term to unrelated third-parties. Although the rental income would be completely exempt from current tax if the IRA purchased the property outright, in this situation 60% of the rental income would be subject to the UDFI tax calculation. However, the tax impact will be reduced due to the fact that 60% of the expenses (e.g. depreciation) from the property can be used to offset the UDFI income.
Note: Because a disqualified person (e.g. the IRA account holder) cannot be personally liable for debts of the IRA (or IRA/LLC), any debt involved in these examples must be “non-recourse”. The practical result of this requirement is that the IRA will likely have to put down at least 40% of the purchase price and pay interest at a higher rate.
IRA Tax Filings:
If an IRA generates gross income subject to UBTI or UDFI of more than $1000 during the taxable year, the IRA must file Form 990-T (generally by April 15th) and pay a tax. This raises many potential issues/problems, including:
1. In order to file the 990-T, the IRA must be issued a federal tax ID number (“EIN”).
2. Self-directed IRA custodians often do not have the information necessary to file the 990-T because the IRA is invested into privately-held entities (e.g. LLC) and the investment paperwork related to those entities is sent directly to the IRA account holder. This problem is always present in situations where the IRA’s only investment is the 100% ownership of an LLC, which in turn makes all of the investments (facilitators like to advertise these structures as having “checkbook control”).
3. Despite the instructions for Form 990-T stating that the “fiduciary” is responsible for filing the tax return, many self-directed IRA custodians state in their custodial agreements that the IRA account holder is responsible for filing any applicable tax returns. Therefore, it is vital for the IRA account holder to be properly educated on the UBTI/UDFI rules. Unfortunately, most facilitators and custodians do not give specific guidance in this area because they do not want to be viewed as giving legal advice. The end result is a bit of a tax reporting “black hole” and the potential for large penalties and interest imposed by the IRS.
4. An IRA subject to UBTI/UDFI must file on-going quarterly estimated tax payments in the same manner as a corporation. In other words, after the first 990-T is filed, the IRA must make payments every three months.
- Many accountants / CPAs are not very familiar with Form 990-T, which can result in the IRA account holder (and Manager of the IRA/LLC) scrambling to find a tax professional that can sort out these issues.
Despite all of these potential UBTI/UDFI issues, with appropriate up-front advice and back-end tax compliance support, all of these issues can be readily addressed.April 25, 2011
Choosing a Guardian
Perhaps the most important benefit of a Will is that it allows the parents to determine who will step in and continue raising their children in the unlikely event of their deaths. If there is no Will nominating a guardian, the decision is left up to the courts even though they cannot possibly know the parenting style, values, moral beliefs and child-rearing philosophy of the parent(s). The court must make a decision based on state law and in the best interests of the children, which is often difficult to determine.
Whomever they name, the first problem most couples encounter is simply imagining leaving their kids behind. No one likes to think about someone else raising their children. No one is as good as they are. Even so, they still must choose someone. So how does one go about choosing?
Here are just a few of the considerations to think about when choosing a guardian:
- Who is most able to take on the responsibility of caring for a child – emotionally, financially, physically, etc.?
- Whose personality, parenting style, values, and religious beliefs most closely match your own?
- Will your child have to move out of the area, and will that pose any problems?
- Does the person you’re considering have children of their own? Will your child fit in or be lost in the shuffle?
- Does the person have enough time and energy to devote to your child?
There are many circumstances that might warrant making changes to your guardian nomination: your guardian could move across the country or abroad; they could develop health issues that may affect their ability to care for your children; they could get divorced, or marry someone you don’t like; or you could decide that there is someone that is currently better suited for the job.
Whatever choice you make, be sure to review it frequently. After all, people do pop in and out of our busy lives. Parents should review this issue once a year, just as they would their insurance policies and investments.
Don’t Surprise Anyone
Most importantly, parents should discuss their plans with the person being nominated. You do not want your guardian to learn about their designation for the first time in the unlikely event of your death. Parents should have a discussion with the guardian and get their approval first.
As I have described in prior articles, the use of so-called “self-directed IRA” structures has exploded in popularity in recent years. The basic purpose of these structures is to invest some (or all) of an IRA account holder’s retirement assets into “alternative” investments, i.e. almost anything other than stock market-based investments. By far the most popular self-directed IRA investment category is real estate. These structures are also used to invest into: loans, privately-held businesses, precious metals, etc. In order to facilitate a real estate investment, the IRA account holder must establish a self-directed IRA and then choose one of two methods of investing the IRA’s funds. The first method involves instructing the IRA custodian to purchase the real estate directly using the IRA’s assets. The second method requires the IRA to purchase 100% ownership in a newly-formed Limited Liability Company (LLC) and subsequently have the LLC purchase the real estate. In either case, these structures present specific estate planning challenges (in addition to other tax/legal issues discussed in other articles in this series).
IRA Beneficiary Designation Forms / Required Minimum Distributions: When establishing a new IRA, whether self-directed or not, the IRA custodian will require the IRA account holder to list his or her primary and secondary beneficiaries. Often, the account holder will list his or her spouse, if applicable, as the primary beneficiary and his or her children as secondary beneficiaries. One benefit of this strategy is that the account holder’s spouse can “roll” the IRA into his or her own name upon the account holder’s death, which is generally the best tax result. However, there can be compelling estate planning reasons for listing a specific trust as the beneficiary of an IRA, but very careful planning must occur in order to ensure that the Required Minimum Distribution (RMD) rules apply in a tax-advantageous manner.
The basic idea behind the RMD rules is that the federal government forces an IRA holder (or his or her beneficiary) to gradually withdraw the funds out of their retirement account beginning at a certain point in time in the future. For pre-tax IRAs (e.g. a traditional, SEP), the RMDs must start by the year following the year in which the IRA account holder turns 70 ½ years old. For Roth IRAs, the RMDs are not triggered at age 70 ½, but rather they generally start when the IRA is inherited by anyone other than the original IRA account holder’s spouse. Particular RMD problems occur if one (or more) of the beneficiaries of an IRA (whether pre-tax or Roth) are the account holder’s estate or another entity that does not have a measurable life expectancy (e.g. a charity). For example, if a trust is named as the beneficiary of the IRA, but the trust is not structured in a way that eliminates “non-individual” beneficiaries, the IRA will be required to distribute all of its assets over the 5-year period following the account holder’s death. This result greatly reduces the time available for the IRA to grow tax-free, so the application of “the 5-year rule” should almost always be avoided.
In a self-directed IRA context, the RMD rules can cause particular difficulties. Assuming the IRA consists of pre-tax funds, the account holder must begin taking RMDs on a yearly basis starting at age 70 ½. In other words, the RMD rules apply to self-directed IRAs the same way as any other IRA. If the IRA’s assets consist of real estate, privately-held business interests, or other “illiquid” assets, it is possible for the account holder to be required to take a distribution, but the IRA to have no cash. In these situations, the IRA account holder is left with the following options: (1) take his or her RMD from a different IRA of the same tax character (assuming the distribution is sufficient to cover the RMD for all of the account holder’s IRAs); (2) have the self-directed IRA distribute an illiquid asset directly to the account holder, which will likely result in a large income tax bill but no cash [e.g. a $200,000 piece of real estate being distributed out of a pre-tax IRA will result in a $56,000 tax bill (assuming 28% tax bracket), but no cash to actually pay the tax]; or (3) face the daunting 50% excise tax for failing to take the RMD. This same “lack of liquidity” problem can occur if the account holder of the self-directed IRA passes away and the beneficiaries are forced to take an RMD, particularly if the “5-year rule” is triggered. Fortunately, the RMD amount is determined based on the value of the account holder’s IRA (or IRAs) on December 31 of the year prior to when the RMD must be distributed. Thus, even if the IRA holds “illiquid” assets, an account holder will have an entire calendar year to sell some (or all) of the IRA’s assets to comply with the RMD rules.
Often, the account holder who sets up the self-directed IRA is very familiar with the legal framework within which he or she must operate. However, when the account holder passes away, the risk of a prohibited transaction often increases due to the beneficiary’s lack of understanding of the self-directed IRA structure. For example, imagine a self-directed IRA that owns 100% of a LLC. The LLC has several assets, including a checking account, savings account, and real estate holdings. Upon the account holder’s death, if a disqualified person (e.g. the surviving spouse) does not understand the IRA legal restrictions and financially interacts with the LLC (e.g. borrows money from the checking account), a prohibited transaction could occur. At first blush, assets held by a self-directed IRA (or IRA-owned LLC) might be difficult to distinguish from other assets held by the deceased IRA account holder. For example, the decedent might own several pieces of real estate and/or LLCs personally. Thus, special care must be taken to avoid prohibited transactions following the account holder’s death.
Disclaimer: The foregoing is not intended to be given as legal, financial or tax advice, but intended as general information only. If you require legal, financial, or tax advice you should seek the assistance of a qualified professional.March 8, 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.]
For those readers who may have missed my first two articles, let me start with some background. Although most Americans invest their retirement funds into publicly-traded assets (e.g. stocks, bonds, mutual funds), the laws governing IRAs allow almost unlimited investment flexibility. I have worked with hundreds and hundreds of clients who have invested their “self-directed” retirement funds in “alternative” IRA assets, e.g. real estate, privately-held businesses, precious metals, loans, and almost every other investment you could ever imagine.
As a starting point, many of my clients use their self-directed IRA to purchase a newly-formed Limited Liability Company (“LLC”), which can greatly reduce the involvement of the IRA custodian (i.e. decreased transaction costs). The reason for this is that the LLC operates almost entirely out of a business checking account, with the “Manager” of the LLC (i.e. the account holder of the IRA) being the authorized signer on the account. However, as I will discuss below, these self-directed IRA (and IRA-owned LLC) structures have the potential to create major tax and legal problems if the IRA account holder is not extremely careful.
If you conduct a “self-directed IRA” Google search, you will find numerous websites that discuss “prohibited transactions”, but very few do a decent job of providing real life examples of the rules in action. In my opinion, the reason for this is that very few attorneys, accountants, or other professionals (let alone the people actually creating these websites) have real-world experience in this area. Dispensing these complicated tax laws without further explanation is like handing someone the 3,000+ page Internal Revenue Code and telling them to calculate their taxes.
The starting point when discussing prohibited transactions is Internal Revenue Code (“IRC”) Section 4975(c)(1). In an IRA context, this tax code provision disallows certain interactions between an IRA and people that are “related” to the IRA account holder. Under the code, the “related” people are called disqualified people. The term “disqualified person” is defined in Section 4975(e)(2) and includes (but is not limited to): the IRA account holder; the account holder’s spouse, lineal descendents (e.g. children, grandchildren), lineal ascendants (e.g. parents, grandparents), and spouses of those people; business entities owned 50% or more by these people, and certain business partners, directors, and employees in these businesses.
I have listed all of the subsections of 4975(c)(1) below and provided several real-world examples to demonstrate the basic intent of each rule. Keep in mind that if a prohibited transaction occurs, the tax-exempt status of the IRA is lost and the IRA’s entire value is treated as taxable to the IRA account holder (plus possible interest and penalties). Note: all of these rules apply equally regardless of whether the IRA investment is being made directly out of the IRA or out of an IRA-owned LLC structure.
IRC Section 4975(c)(1). Prohibited Transaction.
(1) General rule. For purposes of this section, the term “prohibited transaction” means any direct or indirect–
(A) sale or exchange, or leasing, of any property between a plan and a disqualified person;
Example 1: The IRA purchases a piece of real estate from the IRA account holder or any other disqualified person. This sale is prohibited regardless of whether the IRA purchased the property in an otherwise “commercially reasonable” manner – i.e. a qualified appraisal justifying the purchase price is not going to help avoid the prohibited transaction.
Example 2: The IRA pays the IRA account holder’s son twenty dollars to mow the lawn on the IRA’s property. Because the son is a disqualified person, any financial exchange with him (regardless of the amount of the transaction) is prohibited. This is an example of how a very “minor” transaction can result in the complete invalidation of the IRA.
Example 3: The IRA purchases a piece of commercial real estate from a unrelated third party, but later rents a portion (or all) of the property to a business that is 50% owned by the IRA account holder. Because a business entity that is 50% or more owned by a disqualified person becomes a disqualified person itself, this transaction would be prohibited. Again, this is the case regardless of whether “fair market terms” were used when executing the lease agreement.
Example 4: The IRA owns a piece of rental real estate that requires repairs to a bathroom. The IRA hires Mark (a contractor) to make the repairs. All materials and labor expenses are paid directly out of the IRA. Mark is a “friend” of the IRA account holder and owns 15% of a completely separate legal entity that is 25% owned by the account holder and 25% by the account holder’s wife. Because the IRA account holder and his wife own 50% or more of the entity, the entity becomes disqualified. Further, because the entity is disqualified, any 10% or greater owners also are disqualified. Thus, Mark is a disqualified person.
(B) lending of money or other extension of credit between a plan and a disqualified person;
Example 5: The IRA loans money to the IRA account holder or another disqualified person. This is automatically prohibited. A loan from the disqualified person to the IRA (or IRA/LLC) would also be prohibited. Thus, IRAs do not operate under the same general rules as 401(k) plans, which often do allow loans to account holders.
Example 6: The IRA account holder wants the IRA to purchase a piece of rental real estate but the IRA does not have enough cash to support an outright purchase. The IRA account holder seeks out a bank to make a loan to the IRA (or IRA/LLC) to make up the difference. The IRA account holder is asked to “personally guarantee” the debt, which he or she does. Because signing a personal guarantee is considered by the IRS to be an “extension of credit”, a prohibited transaction has occurred. This example is particularly problematic in IRA/LLC situations because the bank involved might not realize that an IRA owns the LLC, and even if they do, the banker is probably not aware of this rule.
Example 7: The IRA account holder is listed as a “co-signer / joint-guarantor” on the IRA/LLC’s credit card and/or margin brokerage account application. Either situation results in the same problem as Example 6 above.
(C) furnishing of goods, services, or facilities between a plan and a disqualified person;
Example 8: Similar to Example 3, the IRA purchases a piece of commercial real estate from a unrelated third party. The IRA then allows the IRA account holder (or the account holder’s business) to use the property for free. This furnishing of facilities is prohibited. This transaction is also likely to be a violation under Sections (D) and (E) below.
(D) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;
Example 9: The IRA purchases a piece of rental real estate on Lake Dreamy. Although the IRA rents out the property for most of the year, the IRA account holder (or another disqualified person) uses the property for one week every July. Regardless, of whether the disqualified person pays the IRA fair market value rent or stays at the property for free, this is a prohibited transaction.
Example 10: Assume the same situation as Example 9 except that the property is rented to the IRA account holder’s brother or friend. Although a brother or friend are not normally going to be considered automatic disqualified people (assuming they do not have co-ownership with the IRA account holder in another business structure), there is a potential “conflict of interest” problem here. This is not an automatic prohibited transaction, but could be scrutinized by the IRS.
(E) act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account;
Assuming the disqualified person involved in the particular transaction is considered a “fiduciary” of the IRA, many of the above examples also implicate this section of the code. It could certainly be argued that an IRA account holder that is also acting as the “Manager” of an IRA-owned LLC structure would be characterized by the IRS as a “fiduciary”.
(F) receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.
Example 11: The IRA purchased a piece of real estate. The IRA account holder (or another disqualified person) is a licensed real estate agent and collects a commission on the purchase. This is a prohibited transaction regardless of whether the commission was reasonable under the circumstances.
As you can see from the discussion above, there are many fact patterns that can cause prohibited transaction concerns. For this reason, the first thing that I advise my clients to think about when considering any IRA (or IRA/LLC) investment is whether a potential prohibited transaction exists. If so, further analysis is required.
To be continued…February 8, 2011
[In a continuing series of articles, 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.]
In my last article, The “Self-Directed” IRA – Part 1: Formation, I began to discuss a method of investing retirement assets into “alternative” types of investments (e.g. real estate, promissory notes, mortgages, tax liens, privately-held businesses, precious metals, etc.) using a specialized type of IRA custodian. Many of these self-directed IRAs are used to purchase 100% ownership of a newly-formed Limited Liability Company (“LLC”), which can greatly reduce the involvement of the IRA custodian (read: decreased transaction costs). The reason for this is that the LLC operates almost entirely out of a business checking account, with the “Manager” of the LLC (i.e. the account holder of the IRA) being the authorized signer on the account. However, as I will discuss in my Part 3 article, “prohibited transactions” are a big concern because the account holder has a lot of power over the IRA/LLC’s assets.
One question that people ask me on a regular basis is WHY a client would invest in this manner. Based on hundreds of conversations I have had with individuals and groups of investors, these “self-directed” IRA structures seem to be growing in popularity due to many different factors, including:
(1) Many people have a general distaste for “traditional” stock market investments. Many clients start our first conversation with a statement like, “I hate the stock market.” Amazingly, my experience is that clients have this same preconceived notion regardless of whether the stock market is going up (e.g. 2009, 2010) or down (e.g. 2008). Personally, I don’t take a position on whether a client should be invested into the stock market – that is a job for the client’s financial advisor.
(2) Stock market volatility drives many people crazy. I was speaking with a financial advisor colleague recently that told me a story that fits well with this idea. The advisor was investing $1,000,000 for a client in the late-90s. The particular year in question, the advisor achieved a 35% return despite the market appreciating by 25%. Despite this result, the client removed all of his funds. When the advisor asked why the client was removing his funds, the client said that he “drove himself nuts watching the daily ups and downs of the market” despite a very good yearly return. The ability to go online and see the value of your retirement assets on a minute-by-minute basis is a stomach-churning experience for many people – and the increased volatility of the market over the past few years has made the problem worse.
(3) Diversification. Many clients will use only a portion of their current retirement assets to fund a new self-directed IRA and/or fund the new IRA with only their Traditional or Roth assets. As I will discuss in more detail in future articles, I believe the plan of not having “all your eggs in one basket” is particularly important in these structures. For example, if the client needs to take regular personal distributions from his or her retirement assets, self-directed IRA structures can result in liquidity problems (e.g. only illiquid assets like real estate are held within the structure). Also, in general, the more a client needs to filter money through the self-directed IRA custodian, the more transaction fees are involved. Finally, if the client triggers a “prohibited transaction” and his or her IRA becomes invalidated, the pain will be much worse if the client has all of their retirement funds within the self-directed IRA. This is because the entire IRA (not just the amount involved in the transaction) is treated as distributed to the client if a prohibited transaction occurs.
(4) Clients want to base their retirement future on assets they can “see and touch”. Clients tell me on a daily basis that they feel more comfortable having some (or all) of their retirement assets invested in something “tangible”. This idea is normally interrelated to the “stock market fears” described above. However, many of my clients have been very successful investing their personal funds into “hard assets” (e.g. real estate), so there is a natural tendency for these clients to lean forwards these types of investments within their IRA as well.
(5) Many clients, particularly individuals who have been involved in real estate investment personally, feel that there are a lot of real estate opportunities right now. This is particularly the case because self-directed IRA structures often purchase properties using all cash – meaning that a tight credit market can actually be helpful (i.e. less competition). Clients often tell me that they know a lot of people that “need cash right now”, which results in various real estate and lending opportunities.
The second question that people ask me about self-directed IRAs is: WHAT are my clients investing into using self-directed IRAs. Of course, because of attorney-client confidentiality, I cannot disclose names or specifics. However, as a general matter, the following are the most common categories of investment strategies that my clients employ:
(1) Real estate. Within the general category of “real estate”, the most common investment is all-cash purchases of residential rental properties, which are then held “long-term” as passive investments. As I will describe in a future article, using debt-financing in these types of transactions is possible, but can be tricky (for example, the debt must be “non-recourse”). Also, purchasing real estate with the intension of developing or “flipping” it can lead to current taxes to the IRA. I have also had clients invest into all of the following types of real estate: commercial property, raw/vacant land, condominiums, trailer parks, and vacation rentals.
(2) Loans / Promissory Notes. These investments generally involved the self-directed IRA loaning money to an individual or business entity in exchange for points and interest. One positive aspect of loans is that the income is tax-deferred to the IRA (however, situations where the loan is actually for “disguised equity” in an active business can lead to a current tax to the IRA). Of course, the biggest downside of loans is that borrower occasionally defaults, which can leave the IRA witl little or no recourse (depending the client’s ability to secure the IRA’s loan at the outset).
(3) Privately-held businesses. A self-directed IRA can invest into privately-held businesses, but clients need to be aware of numerous potential issues. The type of business entity involved (e.g. Limited Partnership, LLC, Corporation, etc.) can impact the tax consequences to the IRA. Also, the client’s (or their family’s) personal involvement in the business needs to be examined closely. Because an IRA (or IRA-owned LLC) is not an allowable “S” corporation shareholder, investments of S Corps are not an option.
(4) Precious metals. One of the general limitations on IRAs is that they are not allowed to invest into “collectibles” (e.g. artwork, rugs, wine, rare coins, etc.). However, certain types of coins and bullion are excluded from the definition of collectibles. Thus, it is possible for an IRA to own precious metals, but the manner in which these metals are held must be considered. An IRA (or IRA-owned LLC) can also own commodities through a traditional securities account.
(5) Publicly-traded securities. The idea of investing an IRA into publicly-traded securities is certainly nothing new – and it might seem counter to some of the reasons why clients form self-directed IRA structures in the first place (see above). However, many clients I speak with form IRA-owned LLC structures where the LLC subsequently forms a brokerage account. From there, the Manager of the LLC invests into a wide variety of publicly-traded investments on behalf of the LLC. Clients often complain that their “old” retirement account (e.g. a former employer’s 401(k) plan) did not allow a diverse array of investment options and the self-directed IRA/LLC structure provides them the additional benefit of more “traditional” investment possibilities.
Next up: Part 3 – Prohibited Transactions…
DISCLAIMER: The above information is for educational purposes only and does not constitute legal advice. Under no circumstances shall this correspondence create an attorney-client relationship.January 27, 2011
On December 17, 2010 President Obama signed into law a multi-billion dollar tax cut package – the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the “2010 TRA”). The 2010 TRA extends the Bush-era individual and capital gains/dividend tax cuts for all taxpayers for two years. The bill also provides for an AMT “patch,” a one-year payroll tax cut, 100 percent bonus depreciation through 2011 and 50 percent bonus depreciation for 2012, and extends various energy credits, among other provisions.
The new law gives taxpayers some certainty in tax planning for the next two years, especially concerning the individual income tax rates, capital gains/dividend tax rates, and the estate tax. However, the provisions are temporary and the ultimate fate of the Bush-era tax cuts is deferred until after 2012, a presidential election year. For most individuals, the most immediate impact of the new law will be the payroll tax cut and the extension of the reduced personal income tax rates.
Individual Tax Rates
The 2010 TRA extends through December 31, 2012 all individual rates. An estimate of the 2011 tax brackets:
Tax Rate Single Persons Taxable Income Married Filing Joint Taxable Income
10% Under $8,500 Under $17,000
15% $8,501 to $34,500 $17,001 to $69,000
25% $34,501 to $83,600 $69,001 to $139,350
28% $83,601 to $174,400 $139,351 to $212,300
33% $174,401 to $379,150 $212,301 to $379,150
35% Over $379,150 Over $379,150
Combined with the payroll tax cut discussed below, the extension of the individual rate cuts will give many individuals a significant increase in immediate dollars available to them in 2011 over what would have resulted without a tax bill.
Qualified capital gains and qualified dividends are taxed at a maximum rate of 15%, with a 0% rate for taxpayers in the 10 and 15% income tax brackets for 2010. The 2010 TRA continues this treatment for two years through December 31, 2012. Without the 2010 TRA, the maximum rate on net capital gains had been scheduled to rise to 20% in 2011, and the rate on qualified dividends also would have risen from 15% to the tax rates on regular income that threatened to reach as high as 39.6%. The 2010 TRA also extends the 100% exclusion of gain realized from qualified small business stock held for more than five years.
Qualified dividends, which continue to be eligible for the reduced tax rates, are dividends received from a domestic corporation or a qualified foreign corporation, on which the underlying stock is held for at least 61 days within a specified 121 day period.
Itemized Deduction Limitation
The “Pease” limitation (named after the member of Congress who sponsored the bill enacting it) has in recent years caused a “phase-out” of itemized deductions for higher-income individuals on expenses like property taxes, home mortgage interest and charitable contributions. The Pease limitation was repealed during 2010, but was scheduled to reappear in 2011. The 2010 TRA extends full repeal of the Pease limitation for two more years, through December 31, 2012.
Personal Exemption Phaseout
Before 2010, taxpayers with incomes over certain thresholds were subject to the personal exemption phaseout (PEP). The PEP reduced the total amount of exemptions that may be claimed where the taxpayer’s adjusted gross income exceeded certain limits, projected for 2011 to start at $169,550 for singles and $254,350 for joint filers. The 2010 TRA extends repeal of the PEP for two years, through December 31, 2012.
The Joint Committee on Taxation estimates that higher-income taxpayers will save over $20 billion from the combined itemized deduction and personal exemption provisions in the new law.
Alternative Minimum Tax
The 2010 TRA provides an AMT “patch” intended to prevent the AMT from encroaching on middle income taxpayers by providing higher exemption amounts and other targeted relief for 2010 and 2011. Without this patch, which had expired at the end of 2009, an estimated 21 million additional households would be subject to the AMT.
Payroll Tax Cut
The 2010 TRA reduces the employee-share of the FICA portion of Social Security taxes from 6.2% to 4.2% for wages earned during the payroll tax holiday period (calendar year 2011) up to the taxable wage base of $106,800.
Self-employed individuals will pay 10.4% on self-employment income up to the threshold. The new payroll tax holiday period is estimated to inject over $110 billion into the economy in 2011. The 2% FICA reduction is available to all wage earners, with no phase out limit irrespective of income level. Thus, individuals earning at or above the FICA cap of $106,800 will receive a $2,136 tax benefit in 2011.
Self-employed individuals under the Tax Relief Act would calculate the deduction for employment taxes without regard to the temporary rate reduction (that is, one-half of 15.3 % of self-employment income). However, the 2010 TRA provides an enhanced percentage representing the employer portion of the deduction.January 27, 2011
100 Percent Bonus Depreciation
The 2010 TRA (Tax Relief Act) boosts 50% bonus depreciation to 100% for qualified investments made after September 8, 2010 and before January 1, 2012. The 2010 TRA also makes 50% bonus depreciation available for qualified property placed in service after December 31, 2011 and before January 1, 2013. Certain long-lived property and transportation property is eligible for 100% depreciation if placed in service before January 1, 2013. This provision is one of the most expansive for businesses. Unlike Code Sec. 179 expensing, it is not limited to use by smaller businesses or capped at a certain dollar level.
The 2010 Small Business Jobs Act also increased the Code Sec. 179 dollar and investment limits to $500,000 and $2 million respectively, for tax years 2010 and 2011. The new law provides for Code Sec. 179 expensing at a level of $125,000 for 2012. Bonus depreciation is not limited by the size of a taxpayer’s investment in qualified property and it can generate net operating losses. Bonus depreciation, however, applies only to new property and is not exempt from certain uniform capitalization rules as is small business expensing.
Small Business Stock
The 2010 Small Business Job Act enhanced the exclusion of gain from qualified small business stock to non-corporate taxpayers. For stock acquired after September 27, 2010 and before January 1, 2011, and held for at least five years, the 2010 Small Business Jobs Act provided an exclusion of 100%. The 2010 TRA extends the 100% exclusion for one more year, for stock acquired before January 1, 2012. With the 100% exclusion, none of the gain on qualifying sales or exchanges of small business stock is subject to federal income tax. In addition, the excluded gain is not treated as a tax preference item for AMT purposes, so none of the gain will be subject to AMT. Investors, however, must be patient to realize this benefit because they must hold the qualified shares for at least five years (or rollover proceeds to other qualified shares).
Certain baseline requirements for the exclusions continue to apply:
- To qualify as small business stock, the stock must be issued by a C corporation that invests 80% of its assets in the active conduct of a trade or business and that has assets of $50 million or less when the stock is issued.
- Qualified stock must be held for more than five years (rollovers into other qualified stock are allowed).
- The amount taken into account under the exclusion is limited to the greater of $10 million or ten times the taxpayer’s basis in the stock.
- Any taxpayer, other than a C corporation, can take advantage of the exclusion.
The 2010 TRA temporarily extends for one or two years a number of energy tax incentives, including credits for biodiesel and renewable diesel, new energy-efficient home credit for qualified builders, and extends the credit, but reduces the benefit thereof to pre-2009 levels, for individuals making energy-efficient home improvements.January 27, 2011
Federal Estate Taxes
Some of the biggest news in the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the “2010 TRA”) involves estate taxes. The federal estate tax changed significantly over the past 10 years, with gradually increasing exemptions from imposition of estate tax rising to $3.5 million dollars per person in 2009. In 2010 the federal estate tax went away for one year, but was poised to return in 2011 at the old rates and exemption amounts (55% and $1 million per person) if no legislation had been passed last December.
The 2010 TRA revives the estate tax for decedents dying after December 31, 2009, but at a significantly higher applicable exclusion amount and lower tax rate than had been scheduled under the old law. The maximum estate tax rate is 35 percent with an applicable exclusion amount of $5 million per person. This new estate tax regime, however, is itself temporary and is scheduled to sunset on December 31, 2012.
Together with the revival of the estate tax, 2010 TRA eliminates the modified carryover basis rules that applied in the absence of an estate tax. Property inherited after 2010 TRA receives a stepped-up basis equal to the property’s fair market value on the date of the decedent’s death (or on an alternate valuation date).
Option for 2010
The 2010 TRA gives estates of decedents dying after December 31, 2009 and before January 1, 2011, the option to elect not to come under the revived estate tax. The new law gives those estates the option to elect to apply (1) the estate tax based on the new 35 percent top rate and $5 million applicable exclusion amount, with stepped-up basis or (2) no estate tax and modified carryover basis rules. Any election would be changeable only with IRS consent.
The 2010 Tax Relief Act provides for “portability” between spouses of the estate tax applicable exclusion amount. Generally, portability would allow a surviving spouse to elect to take advantage of the unused portion of the estate tax applicable exclusion amount of his or her predeceased spouse, thereby providing the surviving spouse with a larger exclusion amount. A “deceased spousal unused exclusion amount” would be available to the surviving spouse only if an election is made on a timely filed estate tax return. Portability would be available to the estates of decedents dying after December 31, 2010. Under the Tax Relief Act of 2010, the portability election will sunset on January 1, 2013.
With the election and careful estate planning, married couples can effectively shield up to $10 million from the estate tax by providing that each spouse maximize his or her $5 million applicable exclusion. Because this provision is scheduled to sunset after 2012, the utility of the portability election is limited to situations where both spouses die with the two-year term (that is, 2011-2012), or if this provision is extended, after 2012.
For gifts made in 2010, the 2010 TRA provides that gift tax is computed using a rate schedule having a top rate of 35 percent and an applicable exclusion amount of $1 million. For gifts made after 2010, the gift tax is reunified with the estate tax with a top gift tax rate of 35 percent and an applicable exclusion amount of $5 million. This “reunification” of estate and gift tax exemption amounts presents tremendous lifetime planning opportunities to preserve family wealth.
Donors of lifetime gifts also continue to be able to use their annual gift tax exclusion before having to use part of their applicable lifetime exclusion exemption. For 2010 and 2011, that inflation-adjusted annual exclusion amount is $13,000 per recipient (married couples may continue to “split” their gift and may make combined gifts of $26,000 to each recipient), to an unlimited number of individual recipients.
The 2010 TRA provides a $5 million exemption amount for 2010 (equal to the applicable exclusion amount for estate tax purposes) with a Generation Skipping Tax (GST) rate of zero percent for 2010. For transfers made after 2010, the GST tax rate would be equal to the highest estate and gift tax rate in effect for the year (35 percent for 2011 and 2012).
State of Washington Estate Taxes
The State of Washington continues to have its own parallel estate tax system to the Federal Estate Tax. The State of Washington will impose an estate tax on the estates of persons resident to Washington with a net worth in excess of $2 million dollars per person. Estate taxes paid to Washington State are deductible for Federal estate tax purposes, but with the higher Federal exemption amounts there will be very few estates that benefit from this deduction. Estate tax rates in Washington range from 15% to 19% of the value of the taxable estate.
Washington residents with the ability to make gifts to family or friends may realize a significant tax savings benefit by making lifetime gifts rather than gifts under a Will or Trust. Gifts made during the gift-maker’s lifetime remove the gift from the gift-maker’s estate for Washington State estate tax purposes, thereby saving the State of Washington estate taxes that may otherwise apply if the gift were transferred at death. With the recent increase to $5 million per person in lifetime giving that can be done without incurring Federal gift tax, there is significant incentive to consider lifetime gifts that result in reduced State of Washington estate taxes in the future.
Charitable Giving and the 2010 Tax Relief Act
In 2011, taxpayers age 70 & ½ or older may make charitable transfers of otherwise taxable distributions from their traditional IRAs and Roth IRAs up to a total of $100,000 per taxpayer, per taxable year. So, rather than adding your required distributions to your taxable income, you can choose to donate those distributions to charity up to $100,000 per year.
Taxpayers were not able to make these tax-free transfers to charity in the 2010 tax year because the relevant tax code provisions expired at the end of 2009. As part of the recent tax law changes, charitable transfers can once again be made directly from an IRA to a charitable organization. While no income tax deduction results from this type of transfer, neither does this transfer cause income recognition to the donor from the IRA distribution.January 8, 2011
To start with, what is a “self-directed” IRA? The vast majority of people that have a retirement plan, whether it’s in the form of an IRA, 401(k), 403(b), etc. have their money invested in “traditional” types of investments, e.g. stocks, bonds, mutual funds. However, the general rules governing an IRA allow for any type of investment except for investments into “life insurance contracts” and “collectibles” (e.g. rare coins, antiques, wine, etc.). The most common investments for self-directed IRAs include: real estate; loans; tax liens; and privately-held companies. That sounds great in theory, but in order for you to actually invest retirement funds into assets outside of the stock market you will need to your retirement plan custodian to allow this type of investment. In other words, the financial institution that holds your retirement account must be able to facilitate the investment or you are out of luck. The reality is that most large investment institutions (e.g. Charles Schwab, Fidelity, etc.) have traditionally not allowed investments outside of publicly-traded securities. Thus, one of the first steps in the process of forming a self-directed IRA is generally to “roll” or “transfer” some (or all) of the retirement account to a new IRA custodian. But before we get to that issue, a few other steps will need to occur.
Step #1 – Can the funds be moved?: Prior to selecting a new IRA custodian (discussed more in Step #2), the retirement account owner needs to determine whether his or her retirement account is even eligible to be moved out of its current location. For example, many 401(k) plans significantly restrict the movement of money while the retirement account owner is still working for the company that sponsors the plan. In other words, if the 401(k)’s underlying “plan documents” will not allow the account owner to move their money, transferring funds into a self-directed IRA might not be possible. This is an issue that the IRA owner needs to resolve with their current plan administrator. In general, if the retirement account that is owned by the client is structured as an IRA (or a 401(k) from a previous employer), it can be moved (in whole or in part) to a new custodian without incurring current tax consequences.
Step #2 – The new custodian: Once the retirement plan holder determines that they are eligible to move some (or all) of their retirement funds, they need to select a self-directed IRA custodian. Often times, an experienced attorney will help in this selection process. Although there are an increasing number of IRA custodians that are willing to hold “alternative” IRA assets, there are dramatic differences between these custodians. Some custodians offer very minimal customer service, but have lower fees. Other custodians claim to offer the opposite. Another issue to consider is whether the custodian will allow the IRA to purchase a Limited Liability Company, which is important if the client wishes to have maximum control over the structure (see Step #4).
Step #3 – Rollover or transfer?: After setting up a new self-directed IRA, it needs to be funded, which can be done in one of two ways. (1) The client can request a “rollover” – meaning that the old retirement plan administrator sends a check to the client that is made out to the new IRA custodian. The client then must deposit the check into the new IRA within 60 days. If the client fails to deposit the check in time, the entire amount will generally be treated as a taxable distribution. (2) The client requests a “trustee-to-trustee” transfer – in which the funds move from the old custodian to the new custodian without the client coming into physical possession of the funds. When possible, the latter method is preferable.
Step #4 – IRA or IRA/LLC: Let’s assume for a moment that the client’s goal is to invest into a piece of residential rental real estate. Once the new self-directed IRA is funded, the client needs to decide whether he or she is going to invest the money directly out of the IRA (i.e. the IRA custodian buys the property on behalf of the IRA) or whether the IRA is going to purchase a Limited Liability Company (“LLC”) and invest using the LLC. With the client serving as the “Manager” of the LLC, the latter option allows the purchase of property using a check from the LLC’s checking account, which depending on the custodian’s ability to move quickly, will likely speed up the property purchase. Also, the IRA/LLC model will reduce the future costs due to reduced custodian involvement (i.e. lower fees). For tax purposes, because the LLC is a “flow-through” tax entity, investments made using either method are normally tax-deferred (note: there are major exceptions which I will discuss in future articles). However, the control / flexibility allowed by the IRA/LLC creates problems if the client does not operate the structure is a legal fashion (again, these issues will also be discussed extensively in future articles).
To be continued…
DISCLAIMER: The above information is for educational purposes only and does not constitute legal advice. Under no circumstances shall this correspondence create an attorney-client relationship.December 20, 2010
Investing your retirement funds into “alternative” investments, such as real estate, privately-held businesses, private loans, tax liens, etc. can be liberating for many people, but beware of tax/legal landmines. Continue reading →Newer posts →