I CAN'T AFFORD IT BUT MY IRA CAN! USING IRA ASSETS TO START A BUSINESS J Scott Dillon Carruthers R Roth, P A 235 N Street Edgeworth NC 27401 Greensboro, 336 478 1119 Jsdgcrlaw corn IRA cannot invest in: Life insurance contracts on IRA owner Collectibles (coins, artwork, stamps, classic cars, antiques, etc.) alcoholic beverages, ' stock corporation — S stock is not prohibited under IRA rules, but IRA is not permissible S corp stockholder
IRA can invest in: Real estate (sole ownership or tenancy in common) ~ Privately-held C corp stock LLC membership interests ~ ~ Limited partnership interests But my IRA company tells me they can' in business assets 7? invest not set up to deal with Most IRA sponsors assets IRA investments in business 'eed to find IRA custodian specializing in "self-directed IRAs" — in place to deal with purchase and Systems of alternative assets administration Pensco Trust Company, American IRA LLC, many others
Reasons Nl hy Investors Choose to use IRA Assets to start a Business Frustration with low returns and volatility ~ of traditional securities investments Ability to flip investments or compound or tax-free basis on tax-deferred returns ~ That's where the money is! Reasons not to use IRA Assets to start a Business For traditional (non-Roth} IRA — Eventual tax on capital appreciation at ordinary income tax rates — Income in respect of decedent — loss of step-up in basis — Problems distnbutions with required minimum Compliance with special tax laws. ~ — Prohibited transaction rules — Unrelated business taxable income Greater potential for problems ~ — Lack of awareness of limitations — Temptation to overlook limitations
Two Ways to Buy/Start Business with IRA that we'l cover ~ "Checkbook control" IRA-owned LLC ~ "ROBS" — Rollovers as Business Start-Ups ~ First we need to understand: — Prohibit transaction rules — Unrelated business taxable income consequences I. PROHIBITED TRANSACTION RULES ~ Section 4975 of IRC prohibits certain transactions between IRA and udiscIua lified person" (DQP) use of IRAs for Purpose: To encourage accumulation of retirement and prohibit savings of those in control of IRAs from taking advantage tax benefits for their current benefit personal
PROHIBITED TRANSACTION RULES PT rules, it ceases to be IRA (IRC If IRA violates ~ 4OH(e)(2)) — IRA is deemed distributed, resulting in taxable in year of transaction income — 10% penalty if not age 59-1/2 Person" Means IRC 4975, "Disqualified Under ~ The account owner — YOU ~ Your spouse 'our parents and grandparents ~ Your children and grandchildren 'pouses of your children and grandchildren (but not parents-in-law) Your IRA trustee or custodian
Person" Means IRC 4975, "Disqualified Under An entity more than 50% owned by any combination ~ of foregoing A 10% owner, officer, director, or highly compensated of such entity employee A trust if 50% or more of beneficial interests are ~ owned by DQPs services to IRA (i.e., CPA ~ Any person providing IRA tax return) preparing Brothers, sisters, aunts, uncles, and cousins are NOT ~ persons disqualified Types of Prohibited TransactIOAs IRC 4975 under There are 2 unofficial categories: ~ Oirect PTs ~ Personal benefit/conflict of interest PTs
Direct Prohibited Transactions IRC section 4975 prohibits'. ~ Sale, exchange, or leasing of property between IRA and DQP Lending of money or other extension of credit between IRA and DQP ~ Furnishing of goods, services, or facilities between IRA and DQP ~ Transfer to or use by DQP of income or assets of IRA {other than regular taxable distributions) Examples: ~ — in real estate owned by her IRA to son Sue sells interest — Steve's spouse personally guarantees loan to his IRA by bank — by his IRA to LLC John sells or leases real estate owned owned 25% by John, 24% by his wife, and 10% by his father — Paul causes his IRA to buy beach rental house and uses it two weeks a year personally — IRA owns 100% of LLC and sells 10% interest to unrelated of LLC manager — in her IRA. House goes vacant for 2 Jill owns rental house and, since IRA doesn't have cash to pay expenses, months is vacant. She intends to Jill pays expenses while house IRA once tenant is located. reimburse herself from
Personal Benefit Prohibited Transactions IRC section 4975 also prohibits: Indirect use of IRA income or assets for personal ~ benefit of DQP Receipt of any consideration by DQP who is a fiduciary for his own account from any party IRA in connection with transaction dealing with income or assets of IRA involving Examples: Purchase of LLC interest requires $ 100,000 minimum ~ Steve can't afford to invest with non-IRA investment. and $ 75,000 assets, so invests $ 25,000 individually from I RA. and wants to use his IRA to Ben manages restaurants ~ buy 10% interest in new restaurant LLC, with restaurant for a fee understanding he will manage
— Plan Assets Rules Prohibited Transactions 29 CFR 2510 3-101 Plan Asset Regulations; ~ — Plan asset rules apply to IRAs — Ltrs. 2000-10A, ERISA Op 2006-01A — If 100% of "operating company" is owned by one or more IRAs and DQPs, assets of company are deemed IRA assets — If 25% or more of "investment company" by one is owned or more IRAs and DQPs, assets of company are deemed IRA assets — In determining thresholds are met, all IRAs are whether considered, even if owned by unrelated individuals "Operating company" is entity engaged in or sale of product or service other production than investment of capital. a "real estate operating » Includes company", where at least 50% of assets are invested in real estate or developed; has right which is managed company to substantially participate in management directly or development activities; and company in ordinary course of its business engages directly in such activities » Includes "venture capital operating company" at least 50% of its assets in venture capital investing or derivative investments investments and rights with respect to one exercising management or more operating companies it invests. in which
of being under plan asset Consequence rules 'll assets of entity deemed owned by IRA Transaction between entity and DQP can be PT Examples: Laura's IRA owns 100% of Alpha, LLC. Alpha makes loan to Laura's son. Loan is direct PT, since loan is deemed made by IRA. Ben's IRA owns 100% of Delta, Jerry is general LLC manager of Delta. Ben and Jerry are unrelated. Ben's IRA is deemed to own assets of Delta, and Jerry is deemed to be fiduciary of Ben's IRA Loan or sale of asset by Delta to Jerry is direct PT. Business or Debt II. Unrelated Financed Income In addition to PTs, self-directed IRAs have another minefield to navigate: — income tax (UBIT} Unrelated business — debt financed Unrelated income (UDFI)
Business Income Tax Unrelated IRAs and plans (as well as charities and other non- profit entities} are subject to UBIT rules is that exempt organizations should not Rationale ~ activities not receive tax break for business related to performance of exempt substantially purpose Net unrelated business income generated ~ by IRA is subject to current taxation generally under IRC Section 511 at trust income tax rates IRA owner must report on Form 990-T. ~ UBIT is taxed twice — when earned and when (no tax basis for previously taxed UBIT} distributed Examples: — of restaurant Net income from operation owned by I RA — Net income from sale of products by company owned by IRA in form of pass- To apply, business must be operated ~ entity such as LLC or limited partnership through owned by IRA Doesn't apply to IRA-owned C corporation
~ Exceptions to U BIT: — First $ 1,000 of net income — and interest Dividends — Royalties — Rents from real estate {unless based on percentage of tenant's profits) — Gains from sale or exchange of property (except inventory) +++Due to exceptions for rents and sale proceeds, in IRA real estate UBIT often is not a problem transactions 598 on UBIT +:+See IRS Publication Unrelated Debt Financed Income (UDFI) ~ Net income generated from debt financed is subject to UDFI even if it would property not be subject to UBIT — Applies to dividends, interest, royalties, rents — Applies to gain from sale or exchange of property
to current UDFI is calculated on pro rata basis, in proportion incurred to purchase balance of acquisition indebtedness the property: Net Income from property during tax year (determined using straight-line depreciation) TIMES Average acquisition indebtedness during tax year Average adjusted basis during tax year UDFI is calculated at trust tax rates, except for capital gains rates on sale of property III. "Checkbook Control" I RA-owned LLC ~ Compare traditional self-directed IRA investment: Ben Smith opens self-directed IRA account at Pensco Trust IRA funds to new self-directed Ben rolls over traditional IRA Ben directs Pensco to purchase apartment building Pensco receives deed in name of Pensco Trust fbo Ben Smith IRA price paid by Ben's IRA Purchase All rent checks sent to Ben's IRA All on-going expenses paid by Ben's IRA
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