What Not To Do With Your Checkbook IRA

The “Checkbook Control” IRA, also known as a Self-Directed IRA LLC, has grown in popularity over the last several years especially with real estate investors.  Using an IRA to invest in a special purpose entity wholly owned by the IRA has been affirmed by several court cases as well as an IRS Advisory opinion letter.

The Checkbook Control IRA involves the establishment of a special purpose limited liability company (LLC) that is owned by the IRA (care of the IRA custodian) and managed by the IRA holder or any third-party. As manager of the IRA LLC, the IRA holder will have the ability to invest the assets through a local bank account.

How the Checkbook IRA Works?

The Self-Directed IRA LLC with “checkbook control” has quickly become the most popular vehicle for investors looking to make alternative assets investments, such as rental real estate, that require a high frequency of transactions. As we mentioned, the LLC is created, funded and owned by the IRA, and managed by the IRA holder.

The “checkbook control” Self-Directed IRA allows one to eliminate certain costs and delays often associated with using a full-service IRA custodian.  The structure allows the investor to act quickly when the right investment opportunity presents itself cost effectively and without delay.

What Investments can I Make with a Checkbook IRA?

When it comes to making investments with a Checkbook IRA, the IRS generally does not tell you what you can invest in, only what you cannot invest in.  The types of investments that are not permitted to be made using retirement funds is outlined in Internal Revenue Code Sections 408 and 4975.  These rules are generally known as the “Prohibited Transaction” rules.  Other than life insurance, collectibles, and transactions that involve or directly or indirectly benefit the IRA holder or a “disqualified person,” one can use his or her IRA to make the investments.

A “disqualified person” is generally defined as the IRA holder and any of his or her lineal descendants or ascendants, and/or any entities controlled by such persons.  Note – siblings are not considered “disqualified persons.” Some of the most popular Self-Directed IRA investments are, but are not limited to, real estate, stocks, loans, notes, tax liens/deeds, investment funds, and even cryptocurrency.

Be Aware of the UBTI Rules

In general, the majority of income and gains associated with a Checkbook IRA will flow back to the IRA without tax. This is known as tax deferral or tax-free returns in the case of a Roth IRA. However, in a number of instances, a tax known as Unrelated Business Taxable Income tax (UBTI or UBIT), could be triggered when a retirement account invests in certain types of transactions. This can turn a potential tax-free investment into a very tax-inefficient one.

The UBTI tax is triggered in three circumstances:

Related: What is the UBTI Tax Rate?

What Not to do with a Checkbook IRA

The rules surrounding the Checkbook IRA are actually quite simple, although, there are a number of small pitfalls to be aware of.  In general, so long as you do not invest your Self-Directed IRA LLC in life insurance, collectibles, or any prohibited transaction outlined in 4975, you can do it. 

Below are a number of the most popular “not to do” activities with a Checkbook IRA:

• Do not use the IRA LLC as your personal entity or bank account. The case Neimann v. Comm – T.C. Memo. 2016-11 is a great example of what not to do with a Checkbook IRA. Neimann transferred an asset in his IRA LC to himself personally directly violating the IRS prohibited transaction rules.
• Do not use a credit card.  Only debit cards are permitted as you are not allowed to personally guaranty an obligation of your IRA.
• Only use a nonrecourse loan when purchasing real estate.  You are not permitted to use a traditional mortgage with a retirement account as you may not personally guarantee an obligation of your IRA
• Do not charge the IRA a management fee for serving as manager of the IRA LLC.
• When managing the IRA LLC, less is more. Try to hire third parties to perform all active services on behalf of the LLC.
• It is common to form the IRA LLC in the state where the LLC activity will be conducted. This is especially true for real estate as most state will deem the LLC engaged in a business by owning real estate in the state. Hence, you should form the IRA LLC where the real estate is located.  If you are not purchasing real estate, then you can essentially establish the LLC in any state
• If your IRA LLC will be engaged in real estate activities in multiple states, then be sure to register the LLC in all states where the LLC will own real estate.  If the IRA LLC is more passive, such as cryptos, gold, or private business investments, then the IRA LLC can generally be established in any state.
• For residents of California, be aware that the state imposes a $800 minimum franchise fee on any LLC established in the state.  California has the highest annual franchise fee of any state.  In addition, California is very aggressive when it comes to imposing their franchise fee on LLCs that are managed by a resident of California, even if the LLC has no connection to the state.
• If your IRA LLC is owned by two or more parties, the LLC must file IRS Form 1065 (due April 15).  A state partnership return must also be filed.  An LLC does not pay entity-level tax, so no federal income tax is due, however, the multiple-member LLC still must file a federal and state partnership return. Note – a single member LLC (LLC owned by one IRA) is treated as a disregarded entity and no federal income tax return is required to be filed
• As manager of the IRA LLC, most states will require you to file an annual LLC report.  The fee should be paid using IRA LLC funds.
• Investing in a business that is operated through a pass-through entity, such as an LLC, could trigger UBTI. The maximum UBTI tax rate is 37%, so it is important to be aware of those rules.

Conclusion

We literally write the book on the Checkbook IRA.  Accordingly, IRA Financial offers the industry-leading annual consulting service that allows its clients to gain access to our in-house tax professional to help them navigate the relevant IRS rules on operating a Checkbook IRA.  More importantly, we will continue to be able to serve as your transaction reviewer, which the IRA custodian requires and will help you stay in full IRA compliance.

Establishing a Self-Directed IRA is now easier and more cost effective than ever.  Gaining the ability to take control of your retirement funds and make the investments you want when you want them is priceless.  There are just a small number of transactions or actions that should not be done with your Checkbook IRA.  Establishing your Checkbook IRA with IRA Financial will give you, as manager of the LLC, the peace of mind that your IRA LLC will remain in full IRS compliance.