Can My IRA Invest More Money into an LLC Partially Owned by My IRA?

Question:  Two years ago my spouse and I caused our IRAs to make self-directed investments into an LLC that purchased a rental home.  Each IRA is a 50% member of the LLC.  The property needs repairs that will cost more money than the LLC has available.  Can we cause our IRAs to make additional capital contributions to the LLC to fund the repairs?

Answer:  No.  If either IRA were to make an additional capital contribution to the LLC, it would create a prohibited transaction under Internal Revenue Code Section 4975(c), which provides that a:

“prohibited transaction” means any direct or indirect— . . . transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan”

Because the two IRAs each own 50% of the LLC, the LLC is a disqualified person under Section 4975(e)(2)(G).  This provision says that a disqualified person is an entity 50% or more of which is owned by a fiduciary.  Each IRA custodian is a fiduciary with respect to its IRA account and because the custodian owns 50% of the LLC, the LLC is a disqualified person.  Therefor a transfer of money from the custodian to the disqualified person (the LLC) to fund the repairs is a prohibited transaction.

Can My IRA Invest More Money into an LLC Partially Owned by My IRA?2018-05-13T13:58:53-07:00

Can My Grandchild Borrow Money from My IRA LLC?

Question:  My IRA is the sole member of my IRA LLC.  Can my IRA LLC loan money to my grandchild?

Answer:  Legally yes, but the loan would be a transaction between the IRA LLC and a disqualified person, which is a prohibited transaction under Section 4975(c) of the Internal Revenue Code.  A disqualified person includes ascendants (parents and grandparents) and descendants (children, grandchildren, etc.) of the owner of the IRA and spouses of descendants.

Consequences of a Prohibited Transaction

An IRA LLC that engages in a prohibited transaction will cause the IRA to lose its tax-exempt status as of the first day of the tax year in which the prohibited transaction occurs.  This means that the IRA is deemed to have distributed to the IRA owner all of the assets in the IRA and the IRA owner must include in income for the year the fair market value of the assets as of the first day of the year unless the IRA is a Roth IRA.  If the IRA owner is under 59 1/2, the distribution will also cause a ten percent penalty.

Can My Grandchild Borrow Money from My IRA LLC?2018-05-13T13:58:53-07:00

IRS Publication 590 on Prohibited Transactions

IRS Publication 590 is entitled “Individual Retirement Arrangements.”  The following text is from page 43 of Publication 590:

What Acts Result in Penalties or Additional Taxes?

The tax advantages of using traditional lRAs for retirement savings can be offset by additional taxes and penalties if you do not follow the rules.  There are additions to the regular tax for using your IRA funds in prohibited transactions.  There are also additional taxes for the following activities.

  • Investing in collectibles.
  • Making excess contributions.
  • Taking early distributions.
  • Allowing excess amounts to accumulate (failing to take required distributions).

There are penalties for overstating the amount of nondeductible contributions and for failure to file Form 8606, if required.

This chapter discusses those acts that you should avoid and the additional taxes and other costs, including loss of IRA status, that apply if you do not avoid those acts.

Prohibited Transactions

Generally, a prohibited transaction is any improper use of your traditional IRA account or annuity by you, your beneficiary, or any disqualified person.

Disqualified persons include your fiduciary and members of your family (spouse, ancestor, lineal descendant, and any spouse of a lineal descendant).

The following are examples of prohibited transactions with a traditional IRA.

  • Borrowing money from it.
  • Selling property to it.
  • Receiving unreasonable compensation for managing it.
  • Using it as security for a loan.
  • Buying property for personal use (present or future) with IRA funds.

Fiduciary.  For these purposes, a fiduciary includes anyone who does any of the following.

  • Exercises any discretionary authority or discretionary control in managing your IRA or exercises any authority or control in managing or disposing of its assets.
  • Provides investment advice to your IRA for a fee, or has any authority or responsibility to do so.
  • Has any discretionary authority or discretionary responsibility in administering your IRA.

Effect on an IRA account.

Generally, if you or your beneficiary engages in a prohibited transaction in connection with your traditional IRA account at any time during the year, the account stops being an IRA as of the first day of that year.

Effect on you or your beneficiary.

If your account stops being an IRA because you or your beneficiary engaged in a prohibited transaction, the account is treated as distributing all its assets to you at their fair market values on the first day of the year. If the total of those values is more than your basis in the IRA, you will have a taxable gain that is includible in your income. For information on figuring your gain and reporting it in income, see Are Distributions Taxable, earlier. The distribution may be subject to additional taxes or penalties.

IRS Publication 590 on Prohibited Transactions2018-05-13T13:58:54-07:00

Caution: An IRA LLC Transaction that Indirectly Benefits the IRA Owner Is a Prohibited Transaction

If your IRA is a member of an IRA LLC, you must know and follow the prohibited transaction rules set forth in Internal Revenue Code Section 4975.  Many prohibited transaction rules are obvious such as the IRA LLC cannot loan money to the IRA owner or buy, sell or lease property with the IRA owner.

The prohibited transaction rules also contain a general, but nebulous rule some times referred to as the “indirect benefits” rule.  If the IRA LLC engages in a transaction that creates an “indirect benefit” for the IRA owner, it is also a prohibited transaction that will disqualify the IRA, cause the IRA to lose its tax-exempt status and result in a deemed distribution of the all the assets to the IRA owner as of the first day of the tax year in which the prohibited transaction occurred.

The indirect benefit rule is codified in Internal Revenue Code Section 4975(c)(1) (E), which states that a:

prohibited transaction means any direct or indirect . . . 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;”

Before an IRA LLC engages in a transaction, its members and managers must be able to answer the following question with a clear NO!

If the IRA LLC engages in the proposed transaction, will the IRA owner receive an indirect benefit?

This rule does not apply if the only indirect benefit is that the IRA LLC will make a profit some or of all of which will ultimately be distributed to the IRA and then to the IRA owner.

Here are some examples of common situations that involve violations of the indirect benefit rule and that will result in the disqualification of the IRA from its tax-exempt status.  The IRA owner or a member of his or her family (defined in Internal Revenue Code Section 4975(e)(6) as a spouse, ancestor, lineal descendant, and any spouse of a lineal descendant) or any other disqualified person:

  1. lives in a home owned by the IRA LLC.
  2. uses a ski boat owned by the IRA LLC.
  3. is an employee of the IRA LLC and is paid a salary.
Caution: An IRA LLC Transaction that Indirectly Benefits the IRA Owner Is a Prohibited Transaction2018-05-13T13:58:54-07:00

What is the Plan Asset Rule?

All IRA owners who have made self-directed investments into an IRA LLC and anybody considering do so should read Jeff Nabers’ article called “What is the Plan Asset Rule?”  This rule turns assets owned by an entity into assets that are deemed to be assets of the IRA with the consequence that any transaction between a disqualified person and the entity is a prohibited transaction.

“The plan asset rule, among other things, is used to determine whether or not a retirement plan is involved in a prohibited transaction.”

See my post called “Department of Labor Regulation 29 CFR 2510.3-101 – the Plan Asset Rules.”

What is the Plan Asset Rule?2018-05-13T13:58:56-07:00

Department of Labor Advisory Opinion 2006-09A

[RK Summary:  The Department of Labor ruled that an IRA owner could not cause the IRA to invest in promissory notes issued by an entity that was controlled by the IRA owner’s son in law because it would be a prohibited transaction under Internal Revenue Code Section 4975.]

The text of  Department of Labor Advisory Opinion 2006-09A is below.

December 19, 2006
Edward A. Appelt
24 Winslow Drive
Pittsburg, PA 15229

Department of Labor Advisory Opinion 2006-09A
IRC Section 4975 (c)(1)(A) & (B)

Dear Mr. Appelt:

This is in response to your request for an advisory opinion under section 4975 of the Internal Revenue Code (Code). Specifically, you ask whether allowing the owner of an individual retirement account (IRA) to direct the IRA to invest in notes being offered by a corporation, in which a relative of the IRA owner is the majority owner and stockholder, would give rise to a prohibited transaction under Code section 4975.(1)

You represent that as the owner of an IRA for which you have retained investment discretion, you would like to direct the investment of these IRA funds into notes (Notes) that are being offered by STARR Life Sciences Corporation (STARR). STARR is currently owned by the founders of the Company who are: Eric (your son-in-law) – 87.5%; Erika (an unrelated party) – 7.5%; and Dr. Strolh (an unrelated party) – 5.0%. (more…)

Department of Labor Advisory Opinion 2006-09A2019-03-17T14:14:14-07:00

Department of Labor Advisory Opinion 2006-01A

RK Summary:  The Department of Labor ruled that an IRA owner could not cause the IRA to invest in a new limited liability company that would purchase real estate and lease it to an entity 68%  of which is owned by the IRA owner because it would be a prohibited transaction under Internal Revenue Code Section 4975.  The opinion contains a statement that IRA owners should always keep in mind before an IRA LLC makes an investment”  “the Department considers “a fiduciary who makes or retains an investment in a corporation or partnership for the purpose of avoiding the application of the fiduciary responsibility provisions of the Act to be in contravention of the provisions of section 404(a) of the Act.”

The text of Department of Labor Advisory Opinion 2006-01A is below.

January 6, 2006
Debra C. Buchanan, Esq.
Guidant Legal Group, PLLC
225 Commerce Street, Suite 450
Tacoma, WA 98402

Department of Labor Advisory Opinion 2006-01A
ERISA Sec. 29 CFR 2509.75-2

Dear Ms. Buchanan,

This is in response to your request for an advisory opinion as to whether the following proposed transaction would be prohibited under section 4975 of the Internal Revenue Code (the “Code”), 26 U.S.C. § 4975.(1)

You represent that Salon Services and Supplies, Inc. is a Washington state “S” Corporation (“S Company”) which is 68% owned by Miles and Sydney Berry, a marital community (M). The other 32% is owned by a third-party, George Learned (“G”). Miles Berry (Berry) proposes to create a limited liability corporation (“LLC”) that will purchase land, build a warehouse and lease the property to S Company. The investors in the LLC would be Berry’s individual retirement account (“IRA”) (49%), Robert Payne’s (“R”) IRA (31%) and G (20%). R is the comptroller of S Company. R and G will manage the LLC. You represent that S Company is a disqualified person with respect to Berry’s IRA under section 4975(e)(2) of the Code. You represent that R and G are independent of Berry. You also represent that the LLC does not contain plan assets because it is a “real estate operating company” (REOC) as defined by 29 C.F.R. § 2510.3-101(e). (more…)

Department of Labor Advisory Opinion 2006-01A2019-03-17T14:14:14-07:00

When Can an IRA Invest in a Business Partly Owned the IRA Owner the IRA Owner’s Family?

Texas attorney Noel C. Ice wrote a very detailed law review type article called “Under What Circumstances Can an IRA Invest in a Business Owned in Part by the IRA Owner and Members of The IRA Owner’s Family?”  If you want to get into the nuts and bolts of the law, this article is for you.  Here’s some text from the introduction:

“Can an IRA form or invest in a partnership (or other entity) in which the IRA and other disqualified persons have more than a 50% interest in capital or profits without violating the prohibited transaction rules? Maybe, if Swanson

[1] is followed.”

“Can an IRA form or invest in a partnership (or other entity) in which the IRA and other disqualified persons have less than a 50% interest in capital or profits prior to formation, but who have more than a 50% interest in capital or profits after formation, without violating the prohibited transaction rules? Theoretically yes, according to PWBOpL 2000-10A and FSA 200128011.”

“Can an IRA form or invest in a partnership (or other entity) in which the IRA and other disqualified persons have less than a 50% interest in capital or profits without violating the prohibited transaction rules? Probably, but great caution is called for.”

“Is a partnership (or other entity) that is controlled by family members of the IRA owner a disqualified person? Yes, if the IRA is self-directed.”

“Is an IRA trustee or custodian always a fiduciary? Yes”

“Is an IRA owner always a disqualified person? Probably. However, if there is no power to self-direct investments, it is arguable that the IRA owner is not a fiduciary with respect to the IRA, and hence, is not a disqualified person.”

When Can an IRA Invest in a Business Partly Owned the IRA Owner the IRA Owner’s Family?2018-09-28T09:54:59-07:00

Department of Labor Advisory Opinion 1993-33A

[RK Summary:  The Department of Labor ruled that an IRA owner could not cause the IRA to purchase land at fair market value from a tax-exempt entity of which the IRA owner’s daughter and son-in-law were the officers and directors and then lease the land back to the entity at fair-market rent or below market rent, depending on the entity’s ability to pay because it would be a prohibited transaction with a disqualified person under Internal Revenue Code Section 4975.]

December 16, 1993

Mr. Roberto Faith
1101 S.W. 102 Court
Miami, Florida 33174

Department of Labor Advisory Opinion 2006-09A
IRC Section 4975 (c)(1)

Dear Mr. Faith:

Your letter to the Internal Revenue Service (the Service) has been forwarded to this Office for our consideration and response with respect to the first of the two rulings you requested. You request guidance concerning the application of the prohibited transaction provisions of the Internal Revenue Code (the Code) to a proposed purchase and lease-back of a tax-exempt school’s land and building by a self-directed Individual Retirement Account (the IRA). Specifically, you ask whether the purchase and lease-back of the school would result in a prohibited transaction under section 4975 of the Code, and if so, whether the prohibited transaction would result in a deemed distribution from the IRA under section 408(e)(2) of the Code.

You represent that you have discretionary control over the IRA’s assets. You propose to cause the IRA to purchase the land and building of Harkness Road High School Ltd. (the School), a high school founded by your daughter and son-in-law, who are the sole directors and officers of the School. The purchase would be made at fair market value. Subsequently, the IRA would lease the land and building to the School at a fair-market rent or below market rent, depending on the School’s ability to pay.

Pursuant to regulations promulgated by the Department of Labor (the Department), at 29 C.F.R. §2510.3-2(d), an IRA as described in the regulation is not an employee pension benefit plan. The Department does not have jurisdiction under Title I of the Employee Retirement Security Act of 1974 (ERISA) over IRAs that are not employee pension plans.1

Nevertheless, under Presidential Reorganization Plan No. 4 of 1978, effective December 31, 1978, the authority of the Secretary of the Treasury to issue interpretations regarding section 4975 of the Code has been transferred, with certain exceptions such as section 4975(c)(3) of the Code, to the Secretary of Labor.

The Department’s authority to issue interpretations involving certain prohibited transaction provisions of section 4975 of the Code extends to transactions involving individual retirement accounts which are not plans and over which the Department would not normally have any jurisdiction. The Department, therefore, can address your first inquiry concerning the purchase and lease-back regardless of whether your IRA is a plan under ERISA. While your second inquiry, which asks whether the purchase and lease-back would result in a deemed distribution, turns on the resolution of the prohibited transaction inquiry, it involves a section of the Code over which the Department has no jurisdiction. Accordingly, we are referring this part of your request back to the Service for their response.

The Code prohibits certain transactions between a plan and a disqualified person with respect to the plan. Code section 4975(e)(1) defines a plan to include an IRA described in Code section 408(a). Code section 4975(a) imposes a tax on each prohibited transaction as that term is defined in section 4975(c). Specifically, section 4975(c)(1) prohibits any direct or indirect sale or exchange, or leasing, of any property between a plan and a disqualified person (4975(c)(1)(A)); any lending of money or other extension of credit between a plan and a disqualified person (4975(c)(1)(B)); any transfer to, or use by or for the benefit, of a disqualified person of the income or assets of a plan (4975(c)(1)(D)); and any act by a disqualified person who is a fiduciary whereby he or she deals with the income or assets of a plan in the fiduciary’s own interest or for his or her own account (4975(c)(1)(E)).

Section 4975(e)(2)(A) defines the term “disqualified person” to include a plan fiduciary. Section 4975(e)(3)(A) of the Code defines the term “fiduciary,” in part, to include any person who exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control regarding management or disposition of its assets. As a person with investment discretion over the assets in the IRA, you are a fiduciary with respect to the IRA, and, therefore, a disqualified person under section 4975(e)(2) of the Code.

Section 4975(e)(2)(F) of the Code defines a “disqualified person” to include a family member of a plan fiduciary. Section 4975(e)(6) defines a family member to include a lineal descendant and any spouse of a lineal descendant. Therefore, your daughter and son-in-law would be disqualified persons with respect to the plan. Accordingly, the sale and lease-back arrangement, described above, between the plan and the School would constitute a use of plan assets for the benefit of disqualified persons in violation of section 4975(c)(1)(D) of the Code.2

Moreover, it is the view of the Department that violations of sections 4975(c)(1)(D) and (E) would occur if a transaction were part of an agreement, arrangement or understanding in which the fiduciary caused plan assets to be used in a manner designed to benefit any person in whom such fiduciary had an interest that would affect the exercise of his or her best judgement as a fiduciary. For example, Treasury Regulation § 54.4975-6(a)(6), Example (6), illustrates that where F, a fiduciary of plan P with discretionary authority respecting the management of P, retains S, the son of F, to provide services necessary to the operation of the plan for a fee, F has engaged in an act described in section 4975(c)(1)(E), because S is a person in whom F has an interest that may affect the exercise of F’s best judgment as a fiduciary. Therefore, if you, as fiduciary of the IRA, were to purchase the School property at fair-market value pursuant to an arrangement to lease it back to the School at a rent that is dependent on the School’s ability to pay in order to benefit your daughter and son-in-law, the transaction would violate Code section 4975(c)(1)(D) and (E).

The Department notes that section 4975(c)(3) of the Code, over which the Secretary of the Treasury retains jurisdiction to issue interpretations, provides, in part, for an exemption from the excise tax on prohibited transactions that would otherwise be imposed if the account ceases to be an individual retirement account by reason of the application of section 408(e)(2)(A) of the Code and is treated as distributing all its assets. However, because the Service retains jurisdiction to issue interpretations concerning section 4975(c)(3) of the Code, we are referring this portion of your inquiry back to the Service.

Finally, to the extent that the IRA is an employee pension benefit plan covered by Title I of ERISA, it should be noted that the Department has consistently taken the position that, to act prudently under ERISA, a plan fiduciary must consider, among other factors, the availability, risk, and potential return of alternative investments for the plan. Because the purchase of the School would be an investment selected in preference to alternative investments, the purchase would not be prudent if it provided the IRA with less return, in comparison to risk, than comparable investments available to the plan, or if it involved a greater risk to the security of plan assets than other investments offering a similar return. Similarly, the Department construes the requirements that a fiduciary act solely in the interest, and for the exclusive purpose, of providing benefits to participants and beneficiaries as prohibiting a fiduciary from subordinating the interests of participants and beneficiaries in their retirement income to unrelated objectives. In this regard, a decision to cause an IRA to purchase a property at fair-market value pursuant to an arrangement to lease the property to the seller at a rent that is dependent on the seller’s ability to pay would be difficult to reconcile with the prudent person rule under ERISA.

This letter constitutes an advisory opinion under ERISA Procedure 76-1 (41 Fed. Reg. 36281, Aug. 27, 1976). Section 10 of the Procedure explains the effect of advisory opinions.

Sincerely,

ROBERT J. DOYLE
Director of Regulations
and Interpretations

ORI/DFI/TLT/BAW/12/14/93/F-5137A/A00066

1 You have not indicated whether the IRA is an “employee pension benefit plan” within the meaning of section 3(2) of Title I of the Employee Retirement Income Security Act of 1974 (ERISA). To the extent there is also Title I jurisdiction over the IRA, the fiduciary provisions of Title I would apply and references to the Code in this letter should be deemed to also refer to the corresponding sections of ERISA.

2 You have not provided facts in your submission concerning ownership interests in the School. In consequence, this opinion does not address how Code section 4975 would apply if your daughter or son-in-law had any ownership interest in the School.

Department of Labor Advisory Opinion 1993-33A2019-03-17T14:14:13-07:00
Go to Top