Question: What are the consequences of participating in a prohibited transaction?
A disqualified person who takes part in a prohibited transaction must correct the transaction and must pay an excise tax based on the amount involved in the transaction. The initial tax on a prohibited transaction is 15% of the amount involved for each year (or part of a year) in the taxable period. If the transaction is not corrected within the taxable period, an additional tax of 100% of the amount involved is imposed. Both taxes are payable by any disqualified person who participated in the transaction (other than a fiduciary acting only as such). If more than one person takes part in the transaction, each person can be jointly and severally liable for the entire tax.
The amount involved in a prohibited transaction is the greater of the following amounts:
the money and fair market value of any property given; and
the money and fair market value of any property received.
If services are performed, the amount involved is any excess compensation given or received.
The taxable period starts on the transaction date and ends on the earliest of the following days:
the day the IRS mails a notice of deficiency for the tax;
the day the IRS assesses the tax; and
the day the correction of the transaction is completed.
The tax is paid with Form 5330.
For additional information, see Publication 560, Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans).
In May of 2013, the U.S. Tax Court ruled that two IRAs engaged in prohibited transactions under Internal Revenue Code Section 4975(c)(1)(B) and were disqualified because the IRA owners guaranteed a debt of a corporation owned by the two IRAs. See Peek vs. Commissioner, 140 T.C. No. 12, (2013). Why did the IRA owners guaranty the debt of the corporation owned by their IRAs? The rule against IRA owners guarantying loans to the LLC or corporation owned by the IRA is well know, at least among advisers who understand IRA LLCs.
The taxpayers in Peek apparently did everything wrong that they possibly could have done. Even if the IRA owners had not guaranteed the corporation’s debt the IRS could have disqualified the two IRAs for several other prohibited transactions. The Tax Court said:
“Because we hold that the loan guaranties were prohibited transactions, we need not and do not reach the additional questions of whether prohibited transactions occurred (i) when FP Company made payments of wages to Mr. Fleck and Mr. Peek (which the IRS contends were prohibited transactions under section4975(c)(1)(D)), or (ii) when FP Company made payments of rent to an entity owned by Mrs. Fleck and Mrs. Peek (which the IRS contends were prohibited transactions under section 4975(c)(1)(E)).”
How to Invest Self Directed IRA Funds in a Limited Liability Company & Make Nontraditional Investments
Question: Neither I nor my IRA custodian is a resident of or is located in Arizona. Can I form an IRA LLC in Arizona that will own and operate a business or own real estate in another state? If so, are there additional costs?
Answer: Yes. An entity (LLC, corporation or limited partnership) formed in one state can register to do business in any other state in the United States. Doing business includes owning real estate in a state other than the state in which the entity was formed. For example, if you are a resident of New York, your custodian is located in Ohio and your IRA LLC will own real estate in California, your IRA could form an Arizona limited liability company and then register it to do business in California. If hired, we will prepare the papers for an additional $200 (plus state filing fees) for each foreign state and file it with any state in which your IRA LLC will own real estate or own and operate a business.
To register an Arizona LLC to do business in California involves preparing and filing a registration form an paying a $70 filing fee. It’s a relatively simple procedure. The problem, however, with doing business in money-starved California is that it has an annual $800 minimum gross receipts tax on LLCs, regardless of where the LLC is formed. An entity formed outside California that does business in California is subject to a $100/day fine for failing to register to do business in the state.
Possible Additional Costs for an Arizona LLC that Does Business in Another State
If your IRA forms an Arizona IRA LLC and then qualifies to do business in another state, the IRA LLC probably will be required by the other state to pay an annual fee and file an annual report. Unlike Arizona, which does not require Arizona LLC’s to file an annual report or pay an annual fee after it is formed, most states do impose an annual fee tax on companies formed in the state and companies formed outside the state that do business in the state. Bottom line is that even if your IRA LLC were to be formed in the state in which it will do business, it would still be subject to the annual fee and report requirements of the state.
USA Today: “A self-directed IRA allows you to invest in things other than securities registered with state or federal authorities. For example, you can use the assets in a self-directed IRA to buy a rental property, or even as the down payment for a mortgage on a rental property. There are restrictions, however, on self-dealing: You can’t rent the place to yourself, for example. And you must have a qualified third-party custodian for the IRA. Self-dealing restrictions on investing in small businesses — especially sole proprietorships — are also complex, and you should see a tax lawyer before you put IRA money into a small business. ‘Self-directed IRAs have helped fund thousands of small businesses that otherwise wouldn’t be there, says Tom Anderson, president of the Retirement Industry Trust Association, a trade group.”