The Risks of Using Self-Directed IRAs
Self-directed IRAs (SDIRAs) are becoming more and more popular as IRA holders look to enter alternative investments. While SDIRAs can open up a world of investment options, the rules around them are complicated and compliance can be tricky. Below, we’ll look at a couple of relevant court cases that illustrate some of the potential pitfalls.
Self-Directed Equals Higher Fees
An SDIRA can own an investment in pretty much any type of asset except life insurance or collectibles. The downside to accessing investments beyond stocks, mutual funds, ETFs, and bonds is that it is more expensive.
The SDIRA custodian usually charges an annual fee as well as transaction fees. The assets also need to be valued at the end of every year for reporting purposes so there is usually a custodial appraisal or valuation fee. These fees and structures often lead to SDIRA owners taking shortcuts to save money or ease administration.
Side-Stepping Rules is Looking for Trouble
One recent case that went before the tax court involved a taxpayer whose SEP-IRA owned an LLC where he was the only owner and manager, with a national bank as the custodian. The taxpayer opened a checking account for the LLC at the same bank.
The taxpayer took distributions from his SEP-IRA and put the money into the LLC account. He then used the money to fund loans on real estate to third parties. The loans were paid back over time and the repayments, including interest, were deposited back into the IRA.
The bank issued a Form 1099-R reporting the distributions as taxable events; however, the taxpayer excluded this income from his tax return. The IRS taxed distributions, plus the 10 percent penalty because he was under 59½. The case went to tax court with the taxpayer claiming he never actually took distributions because the money went from the IRA custodian to the LLC checking account.
The tax court found in favor of the IRS for several reasons. Most importantly, the taxpayer held full control of the funds that were distributed. Another mistake was that he owned the LLC, which held his checking account and not the IRA. As a result, the bank as an IRA custodian no longer held legal control over the money.
In the end, the taxpayer didn’t want to change custodians from the national bank, which held his SEP-IRA, because he didn’t want to pay the fees associated with setting up a proper SDIRA. If he had, then he could have structured the investments to be made via the LLC, with the IRA as the owner of the LLC, and avoided the taxable distributions completely. In the end, it cost him far more than the fees ever would have.
Collectibles Versus Property and Possession
In another case that went before the tax courts, the taxpayer opened an LLC owned by her IRA where she was the sole managing member. The IRA then purchased American Eagle gold coins, which she took physical delivery of and held in her possession.
IRAs are not allowed to own collectibles, with gold bullion and coins generally considered collectibles. There are exceptions, however, with gold American Eagles being one of them – so no issue here.
The problem centered on whether the taxpayer took physical possession of the coins. The tax code says that exempt precious metals can be held in physical possession by an IRA custodian. As a result, the taxpayer taking physical possession of the gold was deemed a distribution.
These two cases show that LLCs created to invest through an SDIRA must follow all the IRA rules. This is because the IRA is the entity considered to be engaged in all transactions executed by the LLC. Further, the IRA owner shouldn’t be the managing member of the LLC or take physical possession of the assets. It should always be the IRA custodian who holds the assets and maintains control.