Question: I have an investment property, but I owe 100% on it. Can I use that self directed IRA to pay the mortgage? and then keep the property and the income in the IRA?

Answer: Unfortunately, the answer to your question is no, your IRA cannot be used to assist you in paying your mortgage on this property.  Other than a rollover from one IRA to another, only cash may be contributed to your IRA.  Additionally, it is a prohibited transaction to have a sale, lease or exchange of property between an IRA and a disqualified person (and you are a disqualified person as to your IRA) (See Internal Revenue Code, or IRC, Section 4975(c)(1)(A)).  So you cannot convey the property to your IRA.  Another prohibited transaction is that there can be no extension of credit between an IRA and a disqualified person (IRC Section 4975(c)(1)(B)), nor can there be a transfer to, or use by or for the benefit of, a disqualified person of the income or assets of an IRA. (IRC Section 4975(c)(1)(D).

The bottom line is that you may not use your IRA, either directly or indirectly, to benefit yourself right now, unless you simply take a distribution from the IRA and possibly pay taxes and penalties, depending on the type of account and your age.

I am sorry I wasn’t able to give you better news, but if you do need the services of a self-directed IRA Administrator or Custodian please do not hesitate to contact us.

Question: I have recently started a registered Investment Advisory firm, a fee-based advisor, no commissions. I’m trying to determine if I can manage the IRA’s of my parents, spouse, grandparents, etc, in my business, but not charge them a fee. So I would receive no compensation for managing their IRA’s. From what I’ve read, this should be okay, as long as I receive no form of compensation. Is that correct?

Second question, I also have set up a LP in which I will raise money from investors for. The LP would make business acquisition loans to one of my companies, in order to finance the purchase of a business. And the LP would receive a good interest rate on the investment. I’m trying to figure out for sure if it would be a prohibited transaction for my parents IRA that I am managing, to invest in the LP. I think that would be a prohibited transaction, is that correct?

Answer: You ask a couple of good questions.  With respect to your first question, it is certain that you would not be permitted to take any compensation if you performed those services for your family’s IRAs. However, I would be somewhat cautious in using your firm to manage their IRAs, because you are, as you know, a disqualified person as to each IRA that you listed.  The potential problem you run into is Internal Revenue Code (IRC) Section 4975(c)(1)(C), which defines a prohibited transaction to include the direct or indirect “furnishing of goods, services, or facilities between a plan and a disqualified person.”  Another potential argument is that such a transaction might fall within IRC 4975(c)(1)(D), in which a prohibited transaction is defined to include the “transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan.”  Admittedly, I take a fairly conservative approach to such issues.  I am not aware of any case which actually was decided solely on the basis of the provision of “services” by a disqualified person to an IRA, but I think it’s fair to say that the conservative approach would be to not manage your family’s IRA assets at your firm, unless you are aware of a class prohibited transaction exemption or a specific ruling allowing you to do so.  If you are aware of such a ruling, I would love to hear about it. I am smart enough to know how dumb I am, and I am always looking for more knowledge.

You are correct in your assumption that the second scenario would definitely be a prohibited transaction, for several reasons.  Depending on your ownership percentage, the LP may or may not be a disqualified person to your parents’ IRAs. Even if the LP was not a disqualified person, you personally are a disqualified person and would likely benefit either directly or indirectly from your parents’ IRA investments (see Rollins v. Commissioner, in which case loans were made from Mr. Rollins 401(k) plan to non-disqualified entities of which Mr. Rollins was the largest (although a minority) shareholder and of which he was an officer – in that case the court held that Mr. Rollins had the burden of proving that he didn’t receive a direct or indirect benefit, which he failed to do).  Depending on the circumstances even if the LP is not a disqualified person the plan asset regulations of 29 C.F.R. § 2510.3-101 may come into play, in which case the LP would be ignored for purposes of the prohibited transaction rules of IRC 4975, and it would be like the IRAs made the loan directly to your company, which would be prohibited.  Even if you could somehow get around the plan asset regulations, if your parents made the IRA investment with the understanding that the LP would turn around and enter into a transaction with your company this would be considered a prohibited arrangement (see Advisory Opinion Letter 2006-01A, for example, and the regulations contained in 29 C.F.R. § 2509.75-2).  The bottom line on this question is no, you cannot do it in the manner you describe it.

The problem with answering something complicated in a quick email is that it may raise more questions than it gives answers.  This can be a complex area of the law, and before undertaking any of the acts you had questions about I would definitely suggest that you sit down with a lawyer who is very familiar with the prohibited transaction rules to discuss the situation in detail and get some actual advice.  I cannot give you tax, legal or investment advice in this case, but I hope I at least gave you some information to review with your legal counsel.  Good luck, and have a great day!

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.

Question: Hello, I am in Austin and hoping to set up my own online business through my IRA.  I will be the sole owner.  Is this possible?  Do I need to form an LLC?  And lastly, if the business becomes profitable, would I be able to pay back the IRA and then run it as a regular business from which I can make personal use of the profits?

Answer: Thank you for your inquiry.  First let me start by reiterating what it says below, which is that we do not provide tax, legal, accounting, investment or other professional advice.  Anything I say is merely educational in nature and you should absolutely consult your own advisors.

I have been asked similar questions many times.  First, let me answer your last question.  No, if your IRA owns the business, you would not be able to pay back the IRA and then run it as a regular business from which you can make personal use of the profits, unless of course you took the LLC as a distribution from your IRA and paid taxes and, if you’re under age 59 1/2, penalties on it.  To the extent your IRA has money in it you can always take a distribution of cash, provided you are willing to pay taxes and/or penalties.

Do you need an LLC to own a business in your IRA? It depends on the business, but under most circumstances an LLC would be a good idea, simply because of all the issues that an active business has to deal with, especially if you have any employees.

Is it possible to set up an online business through your IRA where your IRA (not you) would be the sole owner?  Well, that’s the $64,000 question, as they say, isn’t it?  There are several issues with doing this.  First of all, unless the business is set up to be owned by a taxable entity such as a C corporation or an LLC which elects to be treated as a C corporation, the profits from the business would be considered Unrelated Business Income (UBI) to the IRA and as a result the IRA would owe Unrelated Business Income Tax (UBIT) on its profits.  This may take away some of the advantages you hoped to achieve by starting the business in your IRA.  You may want to review IRS Publication 598, which describes UBI in more detail.  Note that if the business pays its own income taxes (because it is a C corporation or other taxable entity), then the UBI would not pass through to the IRA.  The fact that a particular investment may cause your IRA to owe UBIT does not necessarily mean that you should not make that investment, but it certainly is a factor you will want to be very familiar with prior to entering into such an investment.

Another issue with your plan is that the IRS may consider your services to the IRA owned business to be an excess contribution to your IRA under Internal Revenue Code Section 4973, or worse, a prohibited transaction under Internal Revenue Code Section 4975.  Your question reminds me of the facts of Chief Counsel Advice No.  200917030, which may be summarized as follows:

Chief Counsel Advice (CCA) 200917030 involved a couple who formed a Roth IRA owned corporation into which they directed payments for consulting, accounting and bookkeeping services they provided to other individuals and businesses.  This was found to be a listed transaction similar to the one described in Notice 2008-4, which should have been reported by the taxpayers on Form 8886, Reportable Transaction Disclosure Statement.  The CCA said in this case, like the transaction in Notice 2004-8, the structure of the transaction purportedly allows a taxpayer or multiple related taxpayers to create a Roth IRA investment that avoids the contribution limits by transferring value to the Roth IRA Corporation comparable to a contribution to the Roth IRA, thereby yielding tax benefits that are not contemplated by a reasonable interpretation of the language and purpose of Code Sec. 408A (the Code section authorizing Roth IRAs). In this case, the value of the services provided was shifted from Taxpayers or their business to the Roth IRA Corporation when the Taxpayers provided services through the Roth IRA Corporation as employees of the Roth IRA Corporation. Furthermore, the total value of services provided by Taxpayers to clients of the Roth IRA Corporation was not received by Taxpayers in the form of salary or other compensation from the Roth IRA Corporation. As in the Notice 2004-8 transaction, Taxpayers shifted the value of income or property from Taxpayers or a business of Taxpayers to the Roth IRA Corporation, thereby purportedly avoiding the contribution limitations applicable to Roth IRAs. Taxpayers or their business engaged in transactions with the Roth IRA Corporation by providing services to clients through the Roth IRA Corporation. Value was transferred from Taxpayers or their business to the Roth IRA Corporation comparable to a contribution to the Roth IRA whenever the Roth IRA Corporation received payment from clients as a result of the services provided by Taxpayers.

The bottom line is that the IRS naturally wants to collect taxes on services you provide.  And an IRA is intended to be used for arms-length investments, not to derive a current benefit.  To the extent you change either of those basic premises you may get into trouble with the IRS if they review the transaction.

Having said this, does it mean that you cannot own a business in your IRA?  No, it does not mean that at all.  It means that you cannot provide personal services to that IRA-owned business.  In other words, the business must be an investment only.  You may of course invest in a business which you know someone else is starting, assuming the person starting the business is not otherwise a disqualified person.  Also, as mentioned above, you will want to investigate the tax structure of the business to see if it will subject your IRA to UBIT, and if it does, whether the after-tax profits you expect your IRA to receive are higher than other investments your IRA might make.

If your need is for current income, some people consider doing what the IRS refers to as a ROBS arrangement (Rollover for Business Startups).  The IRS has concerns about this set up, and you may find tons of information on the internet about these types of arrangements.  This typically involves 1) setting up a brand new C corporation, 2) appointing yourself as director and President of that corporation, 3) adopting a 401(k) plan for the corporation with you as trustee of the plan, 4) rolling your IRA into the 401(k) plan, and 5) as trustee of the 401(k) plan investing in all the shares of the corporate as employer securities.  The set up is fairly expensive, but there are many firms who offer to set up a ROBS arrangement on your behalf who swear by its legitimacy.  If you decide to go that route then by all means make sure whoever you go to for the plan is aware of the IRS’ concern and satisfy yourself that they have met those concerns.

I am aware that this information probably conflicts with a lot of the information out there on the world wide web, where anything is possible and you can avoid all these pesky prohibited transaction rules by simply starting an IRA-owned LLC, or what is sometimes referred to as a “checkbook control IRA.”  Unfortunately, the prohibited transaction rules still apply in almost all cases, and so if you cannot do it directly in your IRA then you cannot do it simply by imposing an LLC in between the IRA and the transaction.

I hope that somewhat answers your question, although I realize that such a response often creates more questions than it does give answers.  Good luck with your investments, and if you need assistance with a self-directed IRA (emphasis on the self-directed part) please feel free to let us know.

Follow Up Question: Thanks so much for your informative and thorough reply.  After researching some more, and since I don’t need that much capital, I think the best option for me is to take an annuity distribution from my IRA which apparently is not subject to the 10% penalty.

Follow Up Answer: Correct. As long as you maintain the payments for the LONGER of 5 years or until you are 59 1/2 there is no 10% premature distribution penalty. Note
that there are 3 different methods of calculating the amount of the distributions, but it’s fairly easy to find calculators online.  The key thing to know is that you cannot vary the annuity plan during the 5 years or you will have to go back and pick up the 10% penalty amount. If you can live with these restrictions, an annuity payment, or series of Substantially Equal Periodic Payments as it’s more formally known, is a great alternative.  Best of luck with your business venture.

Testimonial: Thanks again.  Your generosity in sharing your expertise amounts to altruism!

Question: Thank you for your article on IRA myths: http://www.eldr.com/blogs/its-your-ira/top-10-self-directed-ira-myths-debunked

I have a 300k self directed IRA at Schwab, but I am intrigued by a non-stock market investment alternative.

I’m aware of a 300 acre orchard for sale in Belize for 400k.  Your article mentioned that debt can be used in the IRA and then tax must be paid on the portion of the investment funded by debt.  I presume it would be prudent to borrow around 200k to fund the business with working capital.  Do you have a suggestion on the legal entity best suited for this scenario, the order in which transactions should occur, etc.  Is there a book that spells out doing this?

Answer: Thank you for your question.  I do not know of a book spelling out how to do a debt-financed transaction in a foreign country, though there are certainly books on international investing.  Typically what we see at Quest IRA is a local corporation or other entity formed to hold the investment, and the IRA owns the shares of the entity.  Of course this implies that you have someone down in Belize to manage the entity for you.

I am not sure what the banking situation is down there and whether or not you could borrow money with a 50% down payment, so that is one thing you would need to investigate.  The tax situation is another factor.  You will want to understand the local tax implications of any investment.  As far as the IRA being taxable, that does apply when either the IRA owns a business which is  non-taxed at the business owner level (i.e. either it is directly owned by the IRA or the IRA invests in a non-taxed entity such as a partnership or an LLC), or when the IRA rents personal property (rents from real property are exempt), or when the IRA owns debt-financed property either directly or through a non-taxed entity.  Depending on how you structured the transaction, it may be possible to avoid the Unrelated Business Income Tax (UBIT) if the IRA invests in a taxable entity.  More information on this topic may be found in IRS Publication 598, which is freely available at www.irs.gov, or by reviewing Internal Revenue Code Sections 511-514.  I have also attached some information for you to this email.  Of particular interest to you may be the following paragraph in the AICPA Planning article attached: (Found on www.QuestIRA.com)

Exempt organizations can also avoid the debt-financed property rules by investing in such property through a foreign corporation. In PLR 9952086, an exempt organization held 100% of the stock in a foreign corporation that invested in a foreign corporation that invested in a U.S. partnership holding debt- finance securities. The Service held that the dividends paid by the foreign corporation to the exempt organization were excluded from UBTI as dividends under Section 512(b)(2) and were not debt-financed income because the exempt organization had not incurred debt to acquire its interest in the foreign corporation.

In a series of three recent private letter rulings, the Service has again concluded that dividends received from a foreign corporation is tax-free dividend income even if the foreign corporation borrows to invest in securities. See, e.g., PLR 200251016 (Sept. 23, 2002); PLR 200251017 (Sept. 23, 2002); PLR 200251018 (Sept. 23, 2002); PLR 199952086 (Sept. 30, 1999).

Good luck with your investments, and have a great day!

Here is the replay of the Teleconference on this debated topic: http://instantteleseminar.com/?eventid=32541861

Question: I am trying to use my Roth IRA to start a llc that will purchase shares of an income producing business. This is a great investment that I currently hold in a taxable account. My plan is to sell the shares back to the business and repurchase them through the llc that my IRA owns. The returns historically average between 30-45% per year. My problem is that I only have $34,000 in the Roth and I can shift from $33,000 to $250,000 worth of shares to the Roth owned llc. I’m just wondering what is the best way to finance this and if you have any recommendations on lenders. My brother is willing to lend a non recourse loan but that seems a little risky although my interpretation is that he is not a disqualified person. I appreciate any input that you have.

Answer: Unfortunately, there are a number of problems with what you propose.  First of all, it is a violation of the prohibited transaction rules to, either directly or indirectly, sell or exchange the shares that you own in a taxable account to your Roth IRA.  Just based on the brief description in your email, it seems almost certain that your plan would violate Internal Revenue Code Section 4975(c)(1)(A), which prohibits the direct or indirect “sale or exchange, or leasing, of any property between a plan and a disqualified person.”  You will certainly want to get competent legal assistance from an attorney who is intimately familiar with the prohibited transaction rules to guide you.

As far as lenders go, the ones that I am familiar with loan against real estate assets, not shares of an LLC, so unfortunately I don’t have any lender recommendation for you.  As you know, all loans must be non-recourse to any disqualified person and to the IRA itself as well.  You are correct that your brother is not a disqualified person solely because of his status as your brother, but you are also correct in assuming that having your brother loan your IRA or your IRA owned LLC money is risky.  The problem is that all IRA transactions are supposed to be on an arms-length basis.  If the person you are dealing with is someone in whom you have an interest in which would affect your best judgment as a fiduciary for your IRA, then the transaction may still be considered to be prohibited because a benefit to that person may be deemed to be an indirect benefit to you.  This area of the law is a bit tricky, so hopefully your legal counsel will be knowledgeable enough to guide you on this issue as well.

Finally, I assume that your goal is to avoid taxes on this wonderful investment you have found.  Unfortunately, the method you have selected will not accomplish this goal, although it certainly may have other benefits.  There are 3 circumstances when an IRA, which normally enjoys tax free treatment of its gains, must pay taxes.  First of all, if the IRA owns or operates a business, either directly or through a non-taxed entity (the tax is avoided if the entity invested in is taxable).  Second, if the IRA receives rents from personal property.  And third, if the IRA owns debt-financed property.  Your proposed solution may cause taxes to be due under the first and third scenarios, depending on how you structure the transaction.  You may find out more about the topic of Unrelated Business Taxable Income (UBTI) in IRS Publication 598, or by referring directly to the Internal Revenue Code Sections 511-514.  Also, I have written a few articles on the topic which may be found on our website at www.QuestIRA.com.  If the profit from the venture is as high as you say it is, then the after tax returns should still make for a fantastic return for your Roth IRA, assuming you can overcome the other obstacles to the investment.  Good luck!

Concerned Investor: Just would like your opinion on the WSJ article about Lawsuits over Self Directed IRA’s: (Read WSJ Article Here)

Is the article of immediate concern?  Is this just scam artists at work?

Also, read the article from the Securities Exchange Commission (SEC) on fraud within self-directed IRAs (Read SEC Article Here)

Question: Thoughts on question Above?  This lawsuit has scared some people for sure. Notice this article is directed at SDIRA’s and not specifically to Equity and Entrust, that could be a perception to people who do not understand. I think I should tell him to go to Quest and not worry about it, but would I love to give a little substance to relieve his concern.  Thoughts?

Answer: Regarding the article and the lawsuit, it basically is a fundamental misunderstanding of what roles the custodian and administrator play versus what role the client plays in making their own decisions.  There is no doubt that scam artists use self-directed IRAs as tools to get money.  But the question is whose role is it to police the investments that the clients choose, the client or the custodian?  The correct answer is that it is the client’s responsibility to do their due diligence on the investment and the people they are investing with.  This is very clearly spelled out in numerous places in the documents signed by every client.  And that’s why the product is called a ‘SELF-DIRECTED IRA.’

Having said this, the industry as a whole is doing as much as we can to help educate our clients and potential clients on how to avoid fraud, and of course we are setting up our own internal auditing processes as well to assess whether it is administratively feasible to handle certain investments.  However, we do not do due diligence for the clients and we do not recommend any investment or service provider.  Clearly a self-directed IRA is not for everyone, and here at Quest at least we do not pretend that it is.  We merely educate people as to what the possibilities are and then it is up to the client to decide if they want to pursue a self-directed IRA, and if they do open an account to find their own investments and do their own due diligence.

The Texas State Securities Board has come out with an explanation of self-directed IRAs which we agree with completely (the SEC issued a similar statement as well).  I have attached a copy.  At first blush you might read it to be against the use of self-directed IRAs, but really what it is saying is that you have to be careful of investment providers who may use self-directed IRAs to take your money.

Let me know if you have any further questions.  Have  a great day!