Category Archives: Self-Directed Traditional IRAs

Another Blow to Checkbook Control IRA Owned Entities

            In the latest United States Tax Court case involving an IRA owned entity managed by the IRA owners, the taxpayers have once again lost.  In 2001 taxpayers Lawrence F. Peek and Darrell G. Fleck established traditional IRAs.  Each IRA then purchased 50% of a newly formed corporation, FP Company, Inc. (FP Company) for $309,000.  Mr. Peek and Mr. Fleck were appointed as corporate officers and directors of FP Company.  FP Company then acquired the assets of Abbot Fire & Safety, Inc. (“AFS”) for $1,100,000, which included a $200,000 promissory note from FP Company to the sellers of AFS, with personal guaranties by Mr. Peek and Mr. Fleck.  The $200,000 note to the sellers was secured by deeds of trust on Mr. Peek’s and Mr. Fleck’s personal residences.  In 2003 and 2004, Mr. Peek and Mr. Fleck both converted their IRAs to Roth IRAs, paying the taxes on the fair market value of the shares at that time.  In 2006 the Roth IRAs sold FP Company to Xpect First Aid Co., eventually receiving $1,668,192 for their stock.

             The Tax Court ruled that 1) each of the personal guaranties of the FP Company loan is an indirect extension of credit to the IRAs, which is a prohibited transaction under Internal Revenue Code (“IRC”) §4975(c)(1)(B); 2) because the prohibited transaction terminated the IRAs under IRC §408(e), the gains realized on the sale of FP Company are included in the taxpayers’ personal income, and 3) the taxpayers are liable for the accuracy-related penalties under IRC §6662.

             The IRS argued that Mr. Peek’s and Mr. Fleck’s personal guaranties of the $200,000 promissory note from FP Company to the sellers of AFS in 2001 were prohibited transactions under IRS §4975(c)(1)(B), which prohibits any direct or indirect lending of money or other extension of credit between a plan (including an IRA) and a disqualified person.  Mr. Peek and Mr. Fleck were disqualified persons as to their IRAs as fiduciaries. Mr. Peek and Mr. Fleck countered that the guaranties were not prohibited transactions because they did not involve their IRAs directly – the personal guaranties were for debts of FP Company, not their IRAs.  The Tax Court ruled, however, that to read the statute as Mr. Peek and Mr. Fleck would have liked “would rob it of its intended breadth.”  The Supreme Court has observed that “when Congress used the phrase ‘any direct or indirect’ in section 4975(c)(1), it thereby employed ‘broad language’ and showed an obvious intention to ‘prohibit something more’ than would be reached without it.”  As the IRS Commissioner pointed out, if the statute prohibited only a loan or loan guaranty between a disqualified person and the IRA itself, then the prohibition could be easily and abusively avoided simply by having the IRA create a shell subsidiary to which the disqualified person could then make a loan.

             As far as the tax consequences of the prohibited transactions in this case, the Tax Court ruled that 1) the accounts that held the FP Company stock were not IRAs in 2006 when the stock was sold, 2) the accounts ceased to be IRAs in 2001 and therefore were not exempt from income tax, and 3) the tax consequence of their non-exemption was that Mr. Peek and Mr. Fleck were liable for tax on the capital gains realized in 2006 and 2007 from the sale of the FP Company stock.  Because the guaranties remained in place and constituted a continuing prohibited transaction, the accounts that held the FP Company stock could not be IRAs in subsequent years, including the subsequently established Roth IRAs.

             The Tax Court also ruled that Mr. Peek and Mr. Fleck were liable for a 20% accuracy related penalty because their tax underpayments were “substantial understatements” of income tax under §6662(b).  Mr. Peek and Mr. Fleck relied upon a CPA, Mr. Christian Blees, to set up a strategy which Mr. Blees identified as the “IACC” plan.  The IACC plan called for the participant to establish a self-directed IRA, transfer funds from an existing IRA or 401(k) plan into the self-directed IRA, set up a new corporation, sell shares in the new corporation to the self-directed IRA, and finally to use the funds from the sale of shares to purchase a business.  In addition to describing the plan, the IACC documents included a discussion of prohibited transactions which would be detrimental to the IACC plan’s tax objectives, including a warning that all actions must be taken by the participant as an agent for the corporation and not by the participant personally.  Given that Mr. Peek and Mr. Fleck had been given advice about the hazards of prohibited transactions and their personal involvement with the FP Company transactions, the Tax Court held that they were negligent and liable for the 20% accuracy-related penalty.  Mr. Peek and Mr. Fleck were unable to convince the court that they acted with reasonable cause and in good faith because of their reliance on advice provided by Mr. Blees, the CPA, because Mr. Blees was a promoter and not a disinterested professional.  A “promoter” is “an advisor who participated in structuring the transaction or is otherwise related to, has an interest in, or profits from the transaction.”  Additionally, there is no indication that Mr. Peek and Mr. Fleck ever asked for advice from Mr. Blees about whether or not the personal guaranties would be prohibited transactions.

             This case shows the danger of checkbook control IRA owned entities.  Some people use this setup in an attempt to get around the prohibited transaction rules, which clearly does not work.  In fact, arguably it could increase the likelihood of a prohibited transaction occurring within your IRA.  Remember that the phrase “direct or indirect” is meant to be very broad, and simply interposing an entity in between your IRA and the transaction will not provide any insulation against the prohibited transaction rules. Relying on a promoter for advice as opposed to a disinterested professional will not help you avoid penalties, either.

 Self-directed IRAs are indeed a very powerful tool for building your retirement wealth, but if you violate the prohibited transaction rules your IRA will be deemed distributed to you as of January 1 of the year in which the prohibited transaction occurs. As I always have said, use the law, but do not abuse the law.

Can an Inherited IRA be converted to a Self-Directed IRA?

Question: I have an inherited IRA that I received this year and would like to convert into a self directed Roth IRA. I have not taken any distributions at this point. Is this doable? Thanks in advance.

Answer: Thank you for your inquiry.  You can indeed change an inherited IRA into a self-directed IRA with which you can invest in real estate, notes, options, oil and gas, private company stock, and a whole lot more.  What you cannot do is convert an inherited traditional IRA into an inherited Roth IRA.  The only way you could convert the IRA is if you inherited it from a spouse and you elect to treat it as your own, then convert it to a Roth IRA.  Also, please remember that you cannot add to an inherited IRA, so you will need to take that into account when deciding on your investment strategy.

You must also take Required Minimum Distributions (RMDs) from the account regardless of your age, but fortunately there is no penalty for taking the distributions, only taxes if it is a pre-tax account such as a traditional IRA.  If you fail to take an RMD you will be penalized 50% of what you should have taken from the account.  I only mention this because you mentioned that you have not taken any distributions from the account yet.  You generally must begin taking distributions in the year following the date of death of the original account owner.  In some cases you may elect to take no distributions until the 5th year after the date of death, at which point all of the money in the IRA must be removed.

Please let me know if we can assist you with a self-directed IRA.  Our company website is, and our toll free number is 800-320-5950.  Have a wonderful holiday season, and a happy, healthy, and prosperous 2013!

The Balancing Act

I traveled to Pompano Beach, FL last week to record a financial segment for “The Balancing Act”, a Lifetime Television show.  A lot of hard work went into this and it went off without a hitch! It was such an honor for me to be on their show, the topic was my personal favorite (and area of expertise), Self-Directed IRAs. I finally got to wear my awesome suit that I have been tweeting about but I wasn’t ready for my lesson on wearing make up and eating spicy food- ha ha!!

See below for the pics And click HERE for the Press Release!

The recording will air on February 19th- Make sure you record your DVRs to watch me appear on National Television!!

How Can My Minor Child Have a Roth IRA?

Article Written by H. Quincy Long in 2012

“How can my minor child have a Roth IRA?” If I only had a million dollars for every time I have been asked this question, I would be a very rich person!  When entrepreneurial people learn of the myriad of possibilities for non-traditional investments within a self-directed IRA, they usually immediately see the benefit of starting on their child’s retirement now in addition to utilizing their own IRAs.  In this article I will discuss the benefits of starting an IRA early, how a minor can qualify for a Roth IRA, the tax filing requirements for a minor with earned income, and what can be done with the IRA once the money is deposited in the account.

First, let me briefly discuss the benefits of starting early on retirement savings.  Assume your 15 year old daughter starts off her Roth IRA with $1,000 from her earnings and adds $1,000 per year until she retires at age 67.  If she can earn an average return of just 10% per year, her tax free Roth IRA will be worth $1,552,472 at retirement – not bad for only investing a total of $52,000 over 52 years.  Contrast this with an individual who starts saving at age 35 and puts $5,000 in for 32 years with the same annual return of 10%.  His Roth IRA will be worth approximately $1,111,253 when he retires at age 67, and  is contributions will total $160,000.  No matter what your age and annual return assumptions are, one thing is very clear – the earlier you start saving the better!

Before you get too excited and start writing your IRA custodian or administrator checks to open Roth IRAs for your minor children, you must make sure that they qualify to make a contribution.  In order to contribute to a Roth IRA, a single individual must have earned income (compensation) at least in the amount of the contribution and Adjusted Gross Income of no more than $122,000 (for 2011).  For example, if your daughter earns $1,000 babysitting in 2011, she can contribute a maximum of only $1,000 to her Roth IRA, even though the contribution limit for individuals under age 50 is $5,000.

How can a minor earn money so they qualify to contribute to a Roth IRA?  The younger your child is, the more difficult it will be to justify compensation if the IRS questions the contribution.  I have heard of parents hiring their minor children as a model for advertising purposes in the parents’ trade or business, but if you intend to do this make sure that you actually use of the photos in your advertising.  Keep track of how and when you used the photos, and have adequate documentation in your file as to what reasonable compensation would be for a model doing an advertising shoot with unlimited use of the photos.  By the age of 8 or 9 children can be of some use to their parents’ businesses by doing things like cleaning up trash in the yard of rent houses, collating materials if the parent teaches classes, stuffing and stamping envelopes, or other menial tasks.  At age 7 my daughter helped me with artwork to put on t-shirts by carefully writing in crayon “Do you have a self-directed IRA?  I do!”  I then had her wonderful artwork turned into a silk screen for the back of t-shirts with my company logo on the front.  I gave away hundreds of the shirts to my clients.  With the unusual writing on the back of the shirts, people asked a lot of questions and it turned out to be one of my most effective advertising campaigns!  Other ways for minors to earn money include cutting grass, babysitting, or working at restaurants and offices when they are a little older.  If you are hiring them in your own business, be sure that you always document the time spent working and pay them a reasonable wage.

The next questions I get asked when discussing Roth IRAs for minors are “What is the tax effect of my child earning compensation?” and “Does my child have to file a tax return?”  I will briefly summarize the rules here, but always check with your CPA or tax professional.  More information may also be found in IRS Publication 929, Tax Rules for Children and Dependents.  A minor child who is a dependent on someone else’s tax return cannot claim a dependency exemption, but can still claim the standard deduction on their tax return if they are required to file.  The standard deduction for a single dependent minor varies between $950 and $5,700 for 2010, depending on the type and amount of income.  In general, for 2010 a dependent minor must file a tax return if 1) unearned income, such as interest and dividends, was over $950, 2) earned income was over $5,700, or 3) if the minor has both earned income and unearned income, the adjusted gross income was more than the larger of $950 or the earned income (up to $5,400) plus $300.  If the dependent minor worked at an employer who withheld income taxes from their paycheck, in most cases they will want to file a return to collect a refund of this amount, even if there was no filing requirement.

There are situations where a dependent minor has to file a tax return regardless of the above filing requirements.  One of the more common circumstances is when the dependent minor has self-employment income (such as from babysitting or cutting grass) of more than $400.  In this case they will owe Social Security and Medicare tax on that income and will have to file a tax return to pay the tax.  For example, a recent tax client of mine who was 18 years old and still a dependent on her mother’s tax return earned $3,183 doing clerical work, for which she received a 1099-MISC.  She was not treated as an employee by the person who hired her, so she was required to file a dependent tax return to report this income.  Because her Adjusted Gross Income was below $5,700 she owed no federal income tax.  Unfortunately, she still owed $487 in Social Security and Medicare taxes.  If she had been treated as an employee, the employer would have paid its portion and withheld her portion of the Social Security and Medicare tax from her paycheck.  In that case she would not have had to file a federal tax return, unless she wanted to claim a refund for any federal income taxes withheld.

There is an interesting exception to the requirement that a dependent minor pay Social Security and Medicare tax on their earned income.  If a child under age 18 works in their parents’ trade or business and their parents’ business is either a sole proprietorship or a partnership in which the parents are the only partners, the income is exempt from Social Security and Medicare taxes.  This exception does not apply if the business is incorporated or if the partnership includes persons other than parents.  The exemption is extended to those under age 21 for work other than in a trade or business, such as domestic work in the parent’s private home.  So if a minor earns compensation of less than $5,700 working in their parents’ trade or business or for domestic work in their private home and they have no other income, no federal income tax or Social Security and Medicare taxes would be due.  This means that no tax return would have to be filed, but they would still qualify to contribute to a Roth IRA up to the amount of their earned income, subject to the $5,000 maximum contribution!  However, just to be safe it may be advisable to go ahead and file a zero tax due return for documentation purposes.  Always check with your CPA or tax advisor to find out if your child will owe state or local income taxes on this income.  More information on the family employee exception to Social Security and Medicare taxes may be found in IRS Publication 15, Circular E, Employer’s Tax Guide, Chapter 3.

What you can do with the money once in a Roth IRA?  The beauty of a self-directed IRA is that even small amounts can be invested in non-traditional investments.  There are at least four ways a small Roth IRA can be invested.  The Roth IRA may be combined with IRAs of other people to make a single investment.  The most IRAs I have seen participate in a single note investment was 10 different accounts, with the smallest IRA investor being only $2,000.  That note had a yield of 12% per year!  Another investment which is common in small IRA accounts is an option to buy real estate.  Once you have an option, you may let it lapse, exercise the option and close on the property, sell the option to a third party for a fee if the option agreement allows this, or even release the option for a cancellation fee from the property owner.  Another variation on this idea is for the Roth IRA to enter into a sales contract, then assign that contract to a third party for a fee.  Finally, the IRA could buy a property with a loan, either from taking over the property subject to the seller’s existing financing, negotiating non-recourse seller financing, or obtaining a non-recourse loan from a private party or another non-disqualified IRA.  However, if the IRA either owns debt-financed property or operates a business of any type (including a real estate dealer business), it may be required to file IRS Form 990T and pay Unrelated Business Income Tax (UBIT).

If your child qualifies, there is no doubt that one of the best things you can do for them is to open a Roth IRA.  Perhaps the best part of this strategy is the time you will spend with your child teaching them the benefits of saving early and the methods of investing their money wisely. This is truly a win-win situation for both you and your child.  Happy investing!

If I convert my regular IRA to a self-directed IRA do I have to pay the taxes?

Question: I have found your website to be particularly helpful, and am considering making the jump to Quest and self-directed. Here’s my concern:

If I convert the IRA to self-directed, I must pay the taxes. Do the taxes need to be paid out of the account or can I pay them independently? Also, when do I need to pay them? Do I pay them when I file my regular taxes?

Answer: On the contrary, you will not have to pay taxes if you move your IRA into a self-directed IRA here unless you convert the funds from a traditional, pre-tax IRA into a Roth IRA.  We are able to hold traditional IRAs, Roth IRAs, SEP IRAs, SIMPLE IRAs, Individual 401(k)s, Coverdell Education Savings Accounts (ESAs), and Health Savings Accounts (HSAs).  Every one of these accounts can be self-directed and can buy real estate, notes, private company shares, and a whole lot more!

If you do a Roth conversion, then the obligation to pay the taxes is yours personally.  Some people pull money out of their IRAs to pay taxes, of course, but depending on your age this may cause you to owe taxes and penalties on the amount withdrawn.  My suggestion is that you call one of our offices to discuss your individual situation.