Client Alert - The Tax Court and the IRS confirm the validity of the Self Directed IRA LLC Structure
The Tax Court and the IRS confirm the validity of the Self Directed IRA LLC Structure
In general, an Individual Retirement Account ("IRA") is exempt from taxation, subject to certain exemptions, pursuant to Internal Revenue Code Section 408. The Internal Revenue Service ("IRS") further provided that IRAs are permitted to own a broad selection of investment assets in Field Service Advisory 200128011 (April 6, 2001) where the IRS states the following about an IRA owned Foreign Sales Corporation (FSC):
There is no specific Code provision or regulation prohibiting an IRA from owning the stock of a FSC. The type of investment that may be held in an IRA is limited only with respect to insurance contracts, under section 408(a)(3), and with respect to certain collectibles, under section 408(m)(1).
With a Self Directed IRA, the IRA holder keeps most of this power. He or she directs the investment, instead of a broker. Whereas, a Self Directed IRA LLC offers one the ability to use a limited liability company ("LLC") to make almost any type of investment using IRA funds on their own without requiring the consent of any custodian or person. The IRA, through the participation of the Registered Trust Company or Self-Directed IRA Custodian, will typically be the sole member of the LLC. The IRA owner will be appointed as the Manager of the LLC by the members (the IRA accounts held care of the Custodian) pursuant to the special terms of LLC's Operating Agreement.
One major area of uncertainty with this structure was whether the use of entity to self direct IRA assets caused a prohibited transaction under Internal Revenue Code Section 4975. Prohibited transactions are any direct or indirect:
- sale or exchange, or leasing, of any property between a plan and a disqualified person;
- lending of money or other extension of credit between a plan and a disqualified person;
- furnishing of goods, services, or facilities between a plan and a disqualified person;
- transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;
- act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interests or for his own account; or
- 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.
Fiduciary prohibited transactions appear to be the most common type of prohibited transaction in the self-directed IRA context. The IRA owner is a fiduciary to the self-directed IRA and cannot use the IRA funds to directly or indirectly benefit himself. The fiduciary prohibited transaction rules under Code Section 4975(c)(1)(D) and (E) are applicable, regardless of whether there is a disqualified person on the other side of the transaction.
The definition of a Disqualified Person (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the IRS holder, any ancestors or lineal descendants of the IRS holder, and entities in which the IRS holder holds a controlling equity or management interest.
The question then becomes whether the Self Directed IRA LLC is a disqualified person prior to formation or capitalization of the LLC. Prior to the formation and capitalization, the LLC is not in existence. The LLC has no members, capital or outstanding membership interests. Before its legal formation, the LLC seemingly does not fit the definition of a "disqualified person" pursuant to Internal Revenue Code Section 4975. Hence, the initial capital contribution to the LLC by the IRA and otherwise disqualified persons, is not a prohibited transaction. This specific issue was addressed in Swanson v. Commissioner, 106 T.C. 76 (1996). The Tax Court, in ruling against the IRS that the funding of a new entity by an IRA for self directing assets was not a prohibited transaction, stated the following:
"We find that it was unreasonable for [the IRS] to maintain that a prohibited transaction occurred when Worldwide's stock was acquired by IRA #1. The stock acquired in that transaction was newly issued -- prior to that point in time, Worldwide had no shares or shareholders. A corporation without shares or shareholders does not fit within the definition of a disqualified person under section 4975(e)(2)(G). It was only after Worldwide issued its stock to IRA #1 that petitioner held a beneficial interest in Worldwide's stock, thereby causing Worldwide to become a disqualified person under section 4975(e)(2)(G)."
This conclusion was also acknowledged by the IRS in Field Service Advisory (FSA) 200128011 (April 6, 2001). In that FSA, the IRS stated:
"In light of Swanson, we conclude that a prohibited transaction did not occur under section 4975(c)(1)(A) in the original issuance of the stock of FSC A to the IRAs in this case. Similarly, we conclude that payment of dividends by FSC A to the IRAs in this case is not a prohibited transaction under section 4975(c)(1)(D). We further conclude, considering Swanson, that we should not maintain that the ownership of FSC A stock by the IRAs, together with the payment of dividends by FSC A to the IRAs, constitutes a prohibited transaction under section 4975(c)(1)(E)."
The choice of entity (LLC) should seemingly not affect the holding of the Swanson case or FSA 200128011. Rather, it is the fact of the newly issued equity interest in the newly formed entity that is pertinent. The IRS is cognizant of the hazards of litigation presented by pursuing this course as a mode of challenge. In Swanson, the Tax Court required the IRS to pay Swanson's costs and attorney fees.
In light of Swanson and FSA 200128011, the formation and capitalization of a new LLC for purposes of self-directing IRA investments in itself should not be considered a prohibited transaction under Internal Revenue Code Section 4975. We note, however, that just like with a custodian IRA, transactions involving IRA funds and a disqualified person or that directly or indirectly benefit a disqualified person may be prohibited under Internal Revenue Code Section 4975.
For more information, please contact your Bergman Law Group relationship partner, or one of the following:
This memorandum is intended only as a general discussion of these issues. It is not considered to be legal advice. We would be pleased to provide additional details or advice about specific situations. For additional information on this important topic, please feel free to call upon your Bergman Law Group, LLC relationship partner. No part of this publication may be reproduced, in whole or in part, in any form, without our prior written consent. For further information on the Bergman Law Group, LLC, please visit www.bergmanlawgroup.com.