Question 1: Can I form a limited liability company in which my IRA is a member and use all or a portion of my IRA funds to make self directed investments through the LLC in various assets, including, but not limited to, real estate?
Answer: Yes, but there are some types of assets that cannot be acquired.
Question 2: Does it take a ton of money and a rocket scientist to form an LLC owned by an IRA (“IRA LLC”)?
Answer: No: I form Arizona IRA LLCs for $997. I’m not a rocket scientist, but I am an Arizona LLC and business attorney who has a masters degree in income tax law from New York University School of Law. I understand how to form IRA LLCs and have formed 8,300+ LLCs, including many IRA LLCs. See our 279 five star Google & Birdeye reviews.
Why I Form IRA LLCs
Because I have formed 8,300+ limited liability companies, people frequently contact me and ask if I can create an Arizona LLC owned by one or more IRAs. The answer is yes. For the purpose of this article, when I use the term “IRA” it also includes Roth IRAs, 401(k) plans and traditional retirement plans such as money purchase pension plans and defined benefit pension plans. I have formed many LLCs that have one or more IRAs as a member (aka owner).
In 2005 I attended a three hour seminar presented by the Personal Real Estate Investor Magazine at which nationally known “real estate guru” explained how self-directed IRA funds could be used to invest in real estate purchased through an LLC. One of the speakers was an attorney not licensed in Arizona who created IRA LLCs for a “mere” $4,000.” Since I was only charging $599 to form an Arizona LLC I was shocked to hear that the out of state attorney was able to charge so much. I asked him what he did to justify $4,000 for an IRA LLC. When he was unable to justify such a high price, I decided that I would research the law concerning IRAs, LLCs and self-directed investments so that I could create high-quality IRA LLCs for a lot less than $4,000.
Why Form an IRA LLC?
There are several reasons to make self directed investments through an IRA LLC.
To Purchase Non-traditional Assets – The primary reason people form IRA LLCs is to use their IRA funds to make self directed investments in “non-traditional” assets selected by the IRA owner. Most IRA custodians limit the types of assets in which the IRA can invest to stocks, bonds, mutual funds, annuities, CDs and similar “traditional” investments. Traditional investments are numerous, but consist of only a fraction of the possible assets that people desire to purchase and hold for investment.
“Checkbook control” – The IRA owner can be the manager of a manager managed IRA LLC, but the IRA owner cannot be compensated for services or use his or her funds to pay any of the IRA LLC’s expenses.
Asset Protection for the IRA Owner – The general rule of Arizona law is that the manager of an Arizona LLC is not liable for the debts or obligations of the LLC.
Asset Protection for Non-IRA Owners – The general rule of Arizona law is that the members (owners) of an Arizona LLC are not liable for the debts or obligations of the LLC. This is an especially important factor when the IRA LLC has members who are not IRAs.
To Pool Assets with Other Investors – When the cost to acquire an asset exceeds the funds available to a single investor, multiple investors may pool their funds to purchase the asset. The best way for multiple investors to pool assets is through an IRA limited liability company. The IRA and other investors contribute money to the IRA LLC that uses the funds to purchase the asset. An IRA LLC can have multiple members including more than one IRA, people and entities as long as the prohibited transaction rules are not violated.
To Create an Organizational & Management Structure When There are Multiple Members – Whenever there are multiple owners of a valuable asset, they need a set of rules and policies that will govern their common investment. The IRA LLC provides the governing structure, rules and policies applicable to how the joint owners will operate the company and deal with its assets. When you are a co-investor with others in a valuable asset, you should never rely on oral statements or agreements. You must have a written document that governs your arrangement. The Operating Agreement signed by all of the members is the foundational governing document.
When the Asset is “Complex” – If the asset to be purchased is “complex” then an IRA LLC is needed. For example, if you want to use self-directed IRA funds to purchase a ten unit apartment complex, you should form an IRA LLC to own and operate the apartments. Neither you nor your IRA custodian will want the IRA custodian to be involved in the day to day operations of the business such as paying utilities, depositing rent checks, signing leases, evicting tenants or any of the other common management tasks that arise from owning an apartment complex.
What Assets Cannot Be Purchased by an IRA?
Self directed IRA LLCs may purchase virtually any type of asset (tangible and intangible), except an IRA LLC may not purchase any of the following three types of assets:
Life insurance contracts such as a policy of life insurance policy on the life of the owner of the IRA;
Stock in an entity taxed under subchapter S of the Internal Revenue Code. This includes membership interests in an LLC taxed as a S corporation; and
Items classified as a collectible such as cars, furniture, stamps and antique rugs.
If an IRA purchased a prohibited asset, the IRS could disqualify the IRA, which would cause the IRA owner to have taxable income in the year of the purchase plus be subject to penalties.
Real estate is probably the asset most people purchase with self directed IRA funds. IRA funds can be used to purchase residential homes, condos, duplexes, tri-plexes, four-plexes, multi-tenant housing projects, raw land, commercial land of all types (office buildings, mini-storage units, shopping centers, industrial property, etc.) mobile home parks and other types of real estate.
What are the Consequences if an IRA LLC Engages in a Prohibited Transaction?
An IRA LLC must never engage in a transaction that is a prohibited transaction as defined in the Internal Revenue Code. If the IRA LLC ever engages in a prohibited transaction the IRA will be disqualified and all of the assets in the IRA account will be deemed to have been distributed to the IRA owner in the year of the disqualification and if the IRA is a traditional IRA (not a Roth IRA) the full fair market value of the assets are included in the taxable income of the IRA owner for the year of the disqualification.
What are the Prohibited Transaction Rules?
Every IRA must be aware of and take care not to violate the prohibited transaction rules. The Internal Revenue Code and the Department of Labor have rules and regulations commonly called the “prohibited transaction rules” that if violated by an IRA LLC will disqualify the the IRA, which results in taxes and penalties in the year of the prohibited transaction.
The prohibited transactions are set forth in Internal Revenue Code Section 4975(c)(1), which states that a “prohibited transaction” includes 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 interest 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.
Section 4975(c)(1) prohibits transactions between the IRA and a disqualified person. Transactions between an IRA and a person or entity that is not a disqualified person are not prohibited by Section 4975(c)(1).
Who are Disqualified Persons?
Internal Revenue Code Section 4975(e)(2) states “the term ‘disqualified person‘ means a person who is—
(A) a fiduciary;
(B) a person providing services to the plan;
(C) an employer any of whose employees are covered by the plan;
(D) an employee organization any of whose members are covered by the plan;
(E) an owner, direct or indirect, of 50 percent or more of—
(i) the combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of a corporation,
(ii) the capital interest or the profits interest of a partnership, or
(iii) the beneficial interest of a trust or unincorporated enterprise, which is an employer or an employee organization described in subparagraph (C) or (D);
(F) a member of the family [Definition of family member: “the family of any individual shall include his spouse, ancestor, lineal descendant, and any spouse of a lineal descendant.”] of any individual described in subparagraph (A), (B), (C), or (E);
(G) a corporation, partnership, or trust or estate of which (or in which) 50 percent or more of—
(i) the combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of such corporation,
(ii) the capital interest or profits interest of such partnership, or
(iii) the beneficial interest of such trust or estate,
is owned directly or indirectly, or held by persons described in subparagraph (A), (B), (C), (D), or (E);
(H) an officer, director (or an individual having powers or responsibilities similar to those of officers or directors), a 10 percent or more shareholder, or a highly compensated employee (earning 10 percent or more of the yearly wages of an employer) of a person described in subparagraph (C), (D), (E), or (G); or
(I) a 10 percent or more (in capital or profits) partner or joint venturer of a person described in subparagraph (C), (D), (E), or (G).
The above definitions also make a disqualified person any entity in which equity interests of fifty percent or more are owned by the IRA owner or a member of the IRA owner’s family. The definition of family member in Section 4975(e)(6) does not include does not include sisters, brothers, uncles, aunts, or any other non-lineal descendant.
General Rules to Avoid Having Your IRA LLC Engage in a Prohibited Transaction
The prohibited transaction rules can be very complex, but here are some simple rules of thumb all IRA LLCs should follow to avoid engaging in a prohibited transaction:
The IRA LLC should never pay money to the IRA owner or any member of the IRA owner’s family, including a spouse of a lineal descendant.
The IRA LLC should never distribute/give property to the IRA owner or any member of the IRA owner’s family, including a spouse of a lineal descendant.
The IRA LLC should never allow the IRA owner or any member of the IRA owner’s family, including a spouse of a lineal descendant, to use any property that belongs to or is leased or possessed by the IRA LLC. For example, if the IRA LLC owns a home, neither the IRA owner, nor the IRA owner’s spouse, parents, children or grandchildren can ever (NOT EVEN ONE DAY) stay in the home. If the IRA LLC owns a riding lawn mower, the IRA owner cannot borrow the lawn mower to mow the IRA owner’s home lawn. If the IRA LLC owns an airplane hanger, the IRA owner may not store the IRA owner’s airplane in the hanger for a night. If the IRA LLC owns land, the IRA owner may not take a group of people to the land for a picnic.
The IRA owner and all members of the IRA owner’s family, including a spouse of a lineal descendant, may not provide substantial services, including uncompensated services, to or for the benefit of the IRA LLC. If the IRA LLC owns a rental home that needs the interior painted at a reasonable cost of $2,000, the IRA owner may not paint the interior of the home to save the $2,000 that would otherwise be paid to a painter. This is considered a disguised contribution of money by the IRA owner to the IRA LLC. If the IRA LLC had paid the painter the $2,000, the net value of the IRA LLC would have decreased by $2,000. The IRS would say that the IRA owner’s painting is the equivalent of the IRA LLC paying a third party $2,000 for the paint job and then having the IRA owner contribute $2,000 of the IRA owner’s funds to the IRA LLC with the result that the IRA LLC’s net value is unchanged.
The IRA owner and all members of the IRA owner’s family, including a spouse of a lineal descendant, may not pay any expenses or the IRA LLC, including the cost to form the IRA LLC. We will not accept payment of an IRA LLC in advance of forming the LLC. We require payment after we form the IRA LLC and the IRA account funds the IRA LLC’s bank account. When the IRA owner pays expenses of the IRA LLC, it is a disguised contribution to the IRA just like in the preceding rule.
The IRA owner and all members of the IRA owner’s family, including a spouse of a lineal descendant, may not engage with the IRA LLC in any transaction that is a sale, purchase or lease of property. The IRA LLC cannot purchase the IRA owner’s real property or a home owned by the IRA owner’s child.
The IRA LLC may not use any property owned by the IRA owner or any member of the IRA owner’s family, including a spouse of a lineal descendant, as collateral for a loan.
The IRA LLC may not engage in any of the above transactions with a fiduciary, a person who provides services to the IRA or an entity of which the IRA owner owns 50% or more.
To summarize, the IRA owner and all members of the IRA owner’s family must never engage in any activity with the IRA LLC. There are many other situations in which an IRA LLC may engage that can be prohibited transactions. The above list is not all-inclusive. An IRA LLC should take any action that is not clearly an authorized transaction without first consulting with an experienced prohibited transaction advisor.
How to Hire IRA LLC Attorney Richard Keyt to Form an IRA LLC for $997