Checkbook IRA LLC Pros and Cons with Quincy Long Hosted by Cash Flow Depot (Teleconference)

A very popular idea in the self-directed IRA industry is to have what some have termed a “checkbook control” IRA. These have been under attack by the IRS. Click the link below to listen to Quest IRA President H. Quincy Long talk about the dangers of Checkbook Control IRA LLCs
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Checkbook Control IRA-Owned Entities Under Attack

By: H. Quincy Long

 A very popular idea in the self-directed IRA industry is to have what some have termed a “checkbook control” IRA.  Basically this involves the following steps:  1) an IRA is formed with a self-directed IRA provider; 2) a brand new LLC or other entity is formed with the IRA owner as the manager or a director and officer; and 3) the IRA custodian is directed to invest the IRA funds in the newly formed entity.  Voila! The IRA owner has checkbook control over his or her IRA funds and can do deals quickly without anyone looking over their shoulder to see that the rules are being followed.  Admittedly, this sounds like a wonderful idea from the IRA owner’s perspective, but it is fraught with danger and traps for the unwary, as some taxpayers are now discovering.  The IRS has been attacking this type of setup, especially when they involve Roth IRAs.

             The genesis for the idea is largely attributable to the case of Swanson v. Commissioner, a Tax Court case which was decided in 1996.  In that case, Mr. Swanson set up a self-directed IRA at a bank and formed a corporation of which he was appointed the director and president.  He then directed the bank to subscribe to the original issue shares of the corporation so that his IRA became the sole shareholder.  Subsequently Mr. Swanson transacted business between his IRA owned corporation and his privately owned corporation.  These transactions were prohibited transactions, but the IRS’ litigation position was limited to arguing that the purchase by the IRA of the original issue shares and the payment of dividends from the IRA owned corporation back to the IRA were prohibited.  Mr. Swanson had very good lawyers, and the IRS eventually conceded the case as it related to the alleged prohibited transactions.

The Swanson case certainly generated a lot of excitement, but a careful examination of the case reveals that the Tax Court ruling is limited.  Far from approving the entire concept of a “checkbook control” IRA owned entity, as some people allege, Swanson v. Commissioner can only be relied on for two concepts:  first, that the purchase of the original issue stock of the corporation was not a prohibited transaction because prior to the IRA purchasing the stock there were, by definition, no owners, which meant that there could not have been a transaction between the IRA and a disqualified person (the court ruled that the corporation did not become a disqualified person until it was funded, which raises other interesting issues); and second, that the payment of dividends from the IRA owned corporation back to the IRA was not a prohibited transaction as a direct or indirect benefit to Mr. Swanson, since the only benefit of the dividend payments accrued to his IRA and not to Mr. Swanson personally.  As the Tax Court noted in Repetto v. Commissioner, discussed below, in the Swanson case “the central issue was whether the IRS was substantially justified in its litigation position for the purpose of determining whether the taxpayer was entitled to an award of reasonable litigation costs.” Mr. Swanson recovered from the IRS litigation costs in the amount of $15,780.  Significantly, what was not at issue in the Swanson case was the fact that Mr. Swanson did benefit personally from the business transactions between his privately owned corporation and the corporation owned by his IRA, since these transactions were not addressed by the IRS in their litigation position.

On December 31, 2003, the IRS released IRS Notice 2004-8, entitled Abusive Roth IRA Transactions.  The notice generally covers a situation which is very similar to Mr. Swanson’s, in that it typically involves the following parties:  (1) an individual who owns a pre-existing business such as a corporation or a sole proprietorship, (2) a Roth IRA that is maintained for the taxpayer, and (3) a corporation or other entity, substantially all the shares of which are owned or acquired by the Roth IRA.  The privately owned business and the Roth IRA owned entity enter into transactions which are not fairly valued and thus have the effect of shifting value into the Roth IRA in an attempt to avoid the statutory limits on contributions to a Roth IRA.  Also covered by Notice 2004-8 is any transaction in which the Roth IRA corporation receives contributions of property, including intangible property, by a person other than the Roth IRA without a commensurate receipt of stock ownership, or any other arrangement between the Roth IRA corporation and the taxpayer or a related party that has the effect of transferring value to the Roth IRA corporation comparable to a contribution to the Roth IRA.  Under these circumstances the setup is deemed to be a listed transaction, which means that the taxpayers must disclose the transaction to the IRS or face significant penalties.  These transactions may be attacked in a number of ways, including as an excess contribution under Internal Revenue Code (IRC) Section 4973, or in appropriate cases a prohibited transaction under IRC Section 4975.

On April 24, 2009, the Office of Chief Counsel for the Internal Revenue Service released Chief Counsel Advice (CCA) #200917030.  Like Advisory Opinion Letters from the Department of Labor, a CCA does not set legal precedent, but nonetheless they are instructive on how the IRS views the topic and can be influential in the way a case is handled by the IRS and in Tax Court.  This CCA covered a situation in which the taxpayers, a husband and wife, set up a corporation owned by their Roth IRAs into which they would direct payments for consulting, accounting, and bookkeeping services they provided to other individuals and businesses.  The taxpayers provided services to various clients, including the company for which the husband worked but did not own, through the Roth IRA corporation, purportedly as employees of the corporation, but without compensation.  When the Roth corporation filed its corporate income tax return it properly disclosed the listed transaction.  However, the taxpayers did not disclose the listed transaction on their individual tax return.  Instead, they only disclosed an excess contribution to their Roth IRAs on IRS Form 5329, which they said had been removed so as to avoid the 6% excess contribution penalty.  The CCA indicated that in this case, like the transaction described in IRS Notice 2004-8, the structure of the transaction purportedly allowed the taxpayers to create a Roth IRA investment that avoids the contribution limit 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 Section 408A (the Internal Revenue Code section pertaining to Roth IRAs).  Effectively, the taxpayers in this case were transferring the value of their services to the Roth IRA corporation, which in turn paid dividends back to their Roth IRAs.

In the recently released Tax Court Memo 2012-168, Repetto v. Commissioner, the IRS argued and the Tax Court agreed that the Repettos had entered into a listed transaction as contemplated by IRS Notice 2004-8, but had failed to report it properly.  The Repettos formed a partnership called Ozark Future LLC with a builder, Porschen Construction, Inc., to build spec homes.  Eventually the Repettos formed a Subchapter S corporation called SGR and transferred their ownership in Ozark Future to the newly formed corporation.  In 2003 the Repettos met with the CPA for Mr. Porschen and another person who was both an attorney and CPA.  The attorney suggested that the Repettos form 2 corporations, each of which would be owned 98% by their respective Roth IRAs.  The new Roth IRA corporations would provide services to SGR, and the relationship with between SGR and Ozark Future would remain the same.  Although the Repettos did not have a good understanding of the structure, they agreed to have the attorney set it up.  In order to set this up with Roth IRAs, the Repettos made an excess contribution to their Roth IRAs.  After the Roth IRAs and the corporations were set up, SGR entered into 10 year agreements for the Roth IRA corporations to provide services to SGR at SGR’s place of business, which was the Repettos’ home, including bookkeeping, marketing and other administrative functions.  The Roth IRA corporation owned by Mrs. Repetto’s IRA paid her a small salary in 2004-2006, and also had a medical and dental care expense reimbursement plan beginning in 2004.  The total dividends declared to Mr. Repetto’s Roth IRA were $117,600 and the amount declared to Mrs. Repetto’s Roth IRA was $127,400.  The Tax Court relied on the substance-over-form and sham transaction doctrines to find that the service agreements were nothing more than a mechanism for transferring value to the Roth IRAs.  The service agreements did not change who provided the services to SGR, since the Repettos continued to do all the work as they had done prior to when the purported service agreements were entered into. In the end, among other penalties the Repettos had to pay excise tax penalties under IRC Section 4973 based on the value of their Roth IRAs at the end of each year, plus additional penalties for failure to timely file a return since they failed to attach Form 5329 to their tax return to report their excess contributions, plus more penalties for having failed to properly report their participation in a listed transaction.  The Repettos’ reliance on the CPA and attorney who set up the plan did not save them from the penalties, since the advice was from the promoters of the investment or advisers who had a conflict of interest.

As of the writing of this article, there is another case pending before the Tax Court (Peek and Fleck v. Commissioner) involving a Roth IRA owned corporation which was formed by the Roth IRAs of two otherwise unrelated parties.  The corporation was originally owned by traditional IRAs which were later converted into Roth IRAs.  The IRA owned corporation purchased an operating business which was sold some years later for a significant capital gain.  The IRS is alleging that the taxpayers, who were employed by the corporation, violated the prohibited transaction rules by 1) guaranteeing personally a note signed by the corporation owned by their IRAs, and 2) having their IRAs invest in the corporation pursuant to an understanding or arrangement that the corporation would thereafter provide benefits to them as individuals, including the payment of wages to them and lease payments for facilities from the corporation to an LLC owned by their wives individually.  I will update this article when the final decision comes out, but it looks bad for the taxpayers at this time, in my opinion.

It is noteworthy that in each of these cases the IRA owners were actively involved in business activities which allowed them to shift value to their Roth IRAs from their personal services.  Two other issues could arise from checkbook control IRA owned entities, but these issues have not been litigated as far as I know.  First, the direct or indirect provision of goods, services, or facilities between a plan (including an IRA) and a disqualified person (including the IRA owner), is a prohibited transaction under IRC Section 4975(c)(1)(C).  At some point the IRS may allege a prohibited transaction under this section for someone who is a manager or director and officer of a company owned by their IRA.  Second, IRC Section 408(a)(2) requires the trustee of IRA funds to be a bank or non-bank custodian.  It is possible that attempting to avoid the proscription against IRA owners handling their own IRA funds with the simple imposition of an entity might be some day be attacked as invalid by the IRS.

Perhaps the only good news is that none of the attacks on IRA owned entities mentioned in this article have dealt with a situation where the entity only made investments as opposed to running a business and where no prohibited transactions were otherwise involved.  Even in this “perfect” scenario there is danger, as the prohibited transaction rules are somewhat complex and the IRA owner may inadvertently cause the IRA owned entity to enter into a prohibited transaction with complete innocence.  Yet, as stated in the case of Leib v. Commissioner, “good intentions and a pure heart are no defense” when it comes to the prohibited transaction rules.

One thing which is patently obvious to me about this area – if you are going to have your IRA own a checkbook control entity, you and/or your advisor had better have a very good understanding of 1) the prohibited transaction rules under IRC Section 4975, 2) the Plan Asset Regulations contained in 29 C.F.R. §2510.3-101, 3) Interpretive Bulletin 75-2, which is contained in 29 C.F.R. §2509.75-2, and 4) at least when it comes to a business or debt financed property owned by an IRA or an IRA owned entity, how Unrelated Business Income Tax (UBIT) contained in IRC Sections 511-514 comes into play.  If you are being advised by someone to set up a checkbook control IRA owned entity and they cannot explain how these rules apply to your entity clearly and how they interact with each other, then run the other way.  To fail to understand completely the rules is like jumping out of an airplane without a parachute – it may be incredibly fun on the way down, but eventually you’re going to go SPLAT!

© Copyright 2012 H. Quincy Long.  All rights reserved.

Self Directed IRA Myths – Groom Law Group

Written by Richard Matta of Groom Law Group

A search of the internet quickly reveals that there are hundreds, if not thousands, of websites promoting one of the hottest financial concepts – the so-called “self-directed individual retirement account.” These range from sites offering simple “hands off” custody and recordkeeping services, to traditional broker-dealers marketing trading accounts, to promoters of “how to” books, to what amount to little more than modern-day snake-oil sales pitches. Similarly, bookstore shelves are lined with guides to building IRA wealth through nontraditional investments.

Many of these products are quite legitimate, and the sponsors work hard to provide meaningful information to help accountholders distinguish between legally acceptable investment practices and activities that may result in unfavorable tax consequences or, worse, complete loss of the tax-advantaged IRA status. Sometimes it is simply impossible to cover a subject in a comprehensive manner, and the materials warn accountholders to hire knowledgeable counsel. Nonetheless, in the opinion of the author, most of these materials perpetuate certain myths – even among the lawyers – that range from merely incomplete to outright wrong.

Why? In part, because neither the Internal Revenue Service (“IRS”) – which has jurisdiction over IRAs themselves – nor the Department of Labor (“DOL”) – which has jurisdiction over prohibited transactions – has in the past devoted significant resources to IRA issues, nor have the two agencies devoted much effort to coordinating their views. Thus, while a great deal of learning has developed under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), in connection with qualified retirement plans, in many cases this information has not carried over to IRAs. Until the last few years, most IRAs were small, and were marketed as “retail” products by different channels (and sometimes different financial institutions entirely) from those that dealt with the “institutional” ERISA market.

What are some of these myths? Mainly, they are concepts that have arisen in connection with the establishment of a limited liability company (“LLC”) as a wholly-owned subsidiary of an IRA, for the purpose of making non-traditional investments – what are often called “alternative investments” on the institutional side – i.e., things other than traditional mutual funds, stocks and bonds such as venture capital, real estate, derivatives and the like. These myths include the following, all taken verbatim from various self-directed IRA websites:

There appears to be no question that funding the LLC after the IRA’s initial purchase of shares constitutes a prohibited transaction because the LLC becomes a disqualified entity after funding

Comment: As discussed below, we believe this is simply wrong.

“Once the LLC is funded, you no longer need the custodian to write the checks. The LLC can write its own checks, and since you’re the manager, you have control

Comment: Though this may be the right answer, the author has not seen a single IRS ruling that confirms this is correct in the case of an LLC owned 100% by an IRA. (Where the IRA owns less than 100%, the authorities are somewhat clearer.) The Swanson case, discussed below, emphatically does not support this conclusion. There are good legal reasons why this may be false.

If you and your brother had a company and you owned 49.5%, then your IRA could buy, sell or loan to it without penalty.”

Comment: Wrong – this is a highly risky proposition. Ironically, the DOL advisory opinion most frequently cited as support for the proposition that this is not prohibited actually says that a prohibited transaction is likely to result.

Can I make a loan to my brother, aunt, cousin or stepchild so that they can use the money as a down payment on a home? Yes. According to IRC 4975, siblings, aunts, uncles, cousin and “step relations” are not included in the definition of disqualified persons. Thus any dealings between your IRA and these would not be a prohibited transaction.” (A variation on this is that you can hire your brother to manage real estate owned by your IRA, and pay him a salary with IRA assets.)

Comment: Also wrong. This is related to the prior question about a company owned by the accountholder and his/her brother, and the answer is the same – it very well  could be a prohibited transaction. Getting it wrong means loss of the IRA’s tax exempt status.

Each of these myths is discussed in more detail below.

Several of these concepts derive from Swanson v. Commissioner, 106 T.C. 76 (1996), cited by at least one IRA custodian as a “landmark” decision around which “an entire industry has been built” but which, in the opinion of the author, was much ado about nothing. The IRS raised the wrong arguments and failed to raise the right ones, and the tax court appears to have arrived at the “right” answer only by accident, via a nearly incomprehensible analysis. As discussed below, one key “holding” of the court was not a holding at all, and is also inconsistent with later authorities. Swanson is a weak foundation on which to rest a multi-billion dollar industry.

Myth No. 1: An entity 50% or more owned by an IRA is a disqualified person

The issue here at first blush appears to be rather straightforward. According to the tax court in Swanson (or as best we can understand the court’s reasoning):

Step 1. The IRA accountholder in that case was a fiduciary with respect to his own IRA. As a fiduciary, he was a “disqualified person” with respect to the IRA.

Step 2. The accountholder was also a “beneficiary” of the IRA. As such, he was deemed “beneficially” to own the shares of a corporation that was owned 100% by his IRA.

Step 3. Under the attribution rules of Code section 4975, any corporation owned 50% or more by a disqualified person (directly or indirectly) is also a disqualified person.

Consequently, once the IRA acquired 50% or more of the corporation, any subsequent dealings between the IRA and the corporation would be a prohibited transaction. Straightforward, yes, but erroneous. The court’s analysis rests upon the following constructive ownership rule:

Stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust shall be considered as being owned proportionately by or for its shareholders, partners, or beneficiaries….

Swanson, 106 T.C. at 86, n. 15 (quoting Code section 267(c)(1)). Because the IRA was a trust, this means that the accountholder, as the trust’s sole beneficiary, was deemed constructively to own stock of any corporation held by his IRA. So far, so good. However, being a beneficiary alone did not make the accountholder a “disqualified person,” and neither would it make the corporation a disqualified person. Rather, the court found the accountholder was a disqualified person because he was a “fiduciary” with respect to his IRA. However – and this is an important but rather subtle point – a fiduciary acting only as such is not a disqualified person. A fiduciary is only a disqualified person when acting in his own interest, or in the interest of other persons, i.e. , “outside” the IRA.

This conclusion was spelled out rather plainly by the Department of Labor only one year after Swanson. And it is the DOL, not the IRS, that has primary jurisdiction to interpret these rules. Specifically, in 1997 DOL issued an advisory opinion to the Financial Institutions Retirement Fund regarding its holding of the stock of a wholly owned corporation named “Pentegra.” DOL Adv. Op. No. 97-23A (Sept. 26, 1997). The plan capitalized Pentegra with $400,000 in exchange for 100% of its stock. The plan’s trustees requested an advisory opinion that subsequent transactions between the plan and Pentegra would not be prohibited transactions. The concern was that because the trustees as plan fiduciaries held legal title to the Pentegra stock, 50% or more of Pentegra’s stock would be deemed “owned” by the trustees, causing Pentegra to become a party in interest and disqualified person with respect to the plan, under the exact same theory that was applied by the court in Swanson. DOL concluded that such ownership would not make Pentegra a party in interest (under ERISA) or disqualified person (under the Code):

Although, pursuant to ERISA section 3(14)(G), plan fiduciaries would hold all the value of Pentegra stock, they would hold such shares on behalf of the plan, not on behalf of themselves or a third party. As explained below, it is the opinion of the Department that, under the circumstances described, such transactions would not be prohibited because, under the terms of the “plan assets/plan investments” regulation (29 C.F.R. 2510.3-101), they would be treated as “intra-plan” transactions rather than transactions between a plan and a party in interest.

It is true that the Pentegra advisory opinion only addressed a 100% owned subsidiary (as did the Swanson case). However, nothing in the opinion suggested that it would not also apply where a plan owns 50% or more, but less than 100%, of the subsidiary entity (the 1980 DOL advisory opinion addressed a single fiduciary owning 100%, but on behalf of multiple plans). However, any remaining doubt was dispelled in a later opinion issued on behalf of Verizon Investment Management Corp. Adv. Op. No. 2003-15A (Nov. 17, 2003). In that case, Verizon set up an investment vehicle for various Verizon plans as well as plans of unaffiliated companies. The Verizon Master Trust, through its bank trustee (a fiduciary), owned more than 50% (but less than 100%) of the fund. Verizon sought confirmation that this ownership would not cause the fund to become a party in interest or disqualified person with respect to the Verizon plans. In confirming this conclusion, DOL noted that:

Consistent with section 3(14) of ERISA, a plan’s ownership of fifty percent or more of a partnership entity will not cause that partnership to become a party in interest with respect to that investing plan. In our view, the application of section 3(14)(G) should not change that result merely because a plan’s interests in a partnership are held by a fiduciary on behalf of the plan. Although [bank fiduciary] would hold more than fifty percent of the value of the [partnership] interests, it would hold such interests on behalf of the Verizon Plans, not on behalf of itself or a third party. As a result, it is the view of the Department that the [partnership] will not be a party in interest with respect to the Verizon Plans. Therefore, transactions between the Verizon Plans and the [partnership], including initial and subsequent contributions to the [partnership] by the Verizon Plans and distributions from the [partnership] to the Verizon Plans, would not be prohibited under section 406(a) of ERISA.

[Emphasis added.] Although the DOL cited only the relevant sections of ERISA, they noted in a footnote that this conclusion also extended to the parallel sections of Code section 4975, and thus it is directly applicable to LLCs or other entities owned by IRAs.

Myth No. 2: Putting your IRA assets into an LLC gives you “checkbook control.”

 Scores of websites tout the “Checkbook IRA LLC” or variations thereon as allowing the accountholder to take control of his or her IRA assets away from the custodian. Under this theory, the IRA accountholder directs the custodian to purchase “shares” (units) of the LLC, opens up a checking account in the name of the LLC, and thereafter simply signs the LLC’s checks without any participation of the custodian.

There are valid legal arguments why this might work if the IRA owns less than 100% of the shares of the LLC (which is a different and more complicated concept), but does it work where the IRA is the sole owner of the LLC? The answer is far from clear. IRS regulations state that an individual retirement account “must be a trust or custodial account” whose assets are “held by a bank” or by an approved non-bank custodian. Proponents of the LLC structure apparently argue that the “assets” of the IRA in this instance are simply the shares of the LLC (which are held by a bank), and that any checking account set up by the LLC belongs to the LLC, not the IRA. This is absolutely true under state law (and has important ramifications in terms of limited liability and asset protection.). But it does not follow that the IRS would agree for tax purposes. In fact, there are good reasons why it may not agree.

A similar issue arises under ERISA, and it is helpful to begin there. Under ERISA, assets of a retirement plan also must be held in trust. DOL has adopted “plan assets” regulations that determine under what circumstances you “look through” an entity (such as an LLC) to determine that its assets are deemed to be assets of a plan. These rules also apply to IRAs. In this case, the rules indicate that when a plan (including an IRA) owns 100% of the shares of an LLC, the LLC’s assets always are deemed to be assets of the plan (they may also sometimes be plan assets even if the plan owns less than 100%). Back to the trust rules – other ERISA regulations expressly state that in the case of a “plan assets” entity such as an LLC, assets held by the LLC (such as a checking account) are exempt from ERISA’s trust requirement.

The IRS has not adopted a similar exemption from the IRA trust/custody requirements. Nonetheless, most practitioners assume that the IRS would apply a similar analysis to IRA investments in plan assets vehicles, and there is certainly evidence that they have not challenged such investments in pooled plan assets funds (hedge funds, for instance).

However, there is a different reason to ask if the IRS would allow checkbook control in the case of a 100% owned LLC. The reason is simple – a single-member LLC that does not elect to be taxed as a corporation 5 is a “disregarded entity” for tax purposes. According to the IRS:

A disregarded entity is [one] that is treated as an entity not separate from its single owner. Its separate existence will be ignored for federal tax purposes unless it elects corporate tax treatment. In other words, for federal tax purposes – and we see no reason why this does not extend to the IRA custody rules – an IRA-owned LLC does not exist. Accordingly, in the eyes of the IRS, assets held in the name of the LLC are no different from any other assets of the IRA, and arguably remain subject to the IRA bank custody requirements.

What is the risk? In theory, the IRS could argue that “checkbook LLC” assets that are controlled by the IRA accountholder have been constructively distributed and are subject to immediate taxation.

Myth No. 3: So long as you own less than 50% of an LLC, you are not prohibited from transacting business between the LLC and your IRA 

In a 1988 advisory opinion, the DOL was asked whether a loan from an IRA to a corporation owned approximately 47% by the IRA accountholder would be a prohibited “lending of money or other extension of credit” under Code section 4975(c)(1)(B). Applying (correctly) the reasoning discussed above under Myth No. 1, the DOL concluded that the IRA accountholder was a “fiduciary” with respect to the IRA, and thus a disqualified person. However, DOL further acknowledged that the corporation was not a disqualified person because the accountholder owned (in his personal, rather than fiduciary, capacity) less than 50% of the corporation’s stock. Accordingly, DOL agreed that the loan was not a prohibited transaction under section 4975(c)(1)(B).

Citing this opinion, more than one website suggests that so long as you keep your ownership in an entity below 50%, you are free to transact business between the entity and your IRA.

However, although it is correct that the transaction was not a prohibited loan, it does not follow that it was not otherwise a prohibited transaction. To the contrary, the last paragraph of the advisory opinion reaches the opposite conclusion:

Accordingly, a prohibited use of plan assets for the benefit of a disqualified person under section 4975(c)(1)(D) or an act of selfdealing under section 4975(c)(1)(E) is likely to result if [the accountholder] directs the IRA to loan funds to the Corporation. [Emphasis added] It is not entirely obvious why DOL was not a bit clearer in pointing out that the applicant did not ask exactly the right question. One possible answer is that while the existence of a prohibited loan essentially is per se a prohibited transaction, whether a transaction involves a “use” of plan assets or “self-dealing” involves an element of subjective intent. However, if you caused your IRA to lend money (or buy, sell or lease assets, or pay fees) to a business in which you have any substantial interest, it is hard to imagine that it is not your intent to derive a personal benefit from the transaction. (Or at least it would be hard to prove.)

In a 2004 decision, the Tax Court concluded that a taxpayer engaged in a prohibited “use” of 401(k) plan assets when he cause the plan to loan money to three entities in which he owned minority interests (roughly 25 to 33%). Rollins v. Commissioner, T.C. Memo 2004-260 (Nov. 15, 2004). In a 1987 decision, the Second Circuit found (among other things) that the investment of a plan’s assets in a company in which two plan fiduciaries collectively owned approximately 11% (one was also president of the company) was an act of self-dealing. Lowen v. Tower Asset Management, Inc., 829 F.2d 1209 (2d Cir. 1987).

Can these cases be reconciled with Swanson, where the taxpayer caused a corporation he owned “outside” his IRA to pay commissions to a corporation owned by his IRA? Perhaps – one possible difference is that in Swanson the flow of funds was from the taxpayer’s personal account to his IRA, not the other way around. However, we may never know, as it is not clear that either the IRS or the court examined the underlying commission payments in that case except for unrelated business income tax purposes.

Myth No. 4: You are free to loan your IRA assets (sell or buy assets, etc.) to anyone so long as that person is not a disqualified person

 This is a variation on Myth No. 3. The idea seems straightforward enough: if a family member (or corporation, or LLC, etc.) is not a disqualified person, then it is not a prohibited transaction to use your IRA assets to loan money to, or buy property from, or pay a salary to, such person. True, the absence of a disqualified person means that there is no transaction “with” a disqualified person. But, the transaction can also involve “self-dealing,” which is a separate prohibited transaction.

How can it be self-dealing if the benefit flows not to me personally, but to my brother? Because the definition of self-dealing is far broader than is commonly understood. Code section 4975(c)(1)(E) provides that self-dealing means any “act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account .” [Emphasis added.] Regulations adopted pursuant to this rule note that:

These prohibitions [against self-dealing and kickbacks] are imposed upon fiduciaries [such as self-directed IRA accountholders] to deter them from exercising the authority, control or responsibility which makes such persons fiduciaries when they have interests which may conflict with the interests of the plans for which they act. In such cases, the fiduciaries have  interests in the transactions which may affect the exercise of their best judgment as fiduciaries. Thus, a person may not use the authority, control or responsibility which makes such person a fiduciary to cause a plan to pay an additional fee to such person (or to a person in which such fiduciary has an interest which may affect the exercise of such fiduciary’s best judgment as a fiduciary) to provide a service.

Treas. Reg. § 54.4975-6(a)(5). This regulation goes on to say that:

A person in which a fiduciary has an interest which may affect the exercise of such person’s best judgment as a fiduciary includes, for example, a person who is a disqualified person by reason of a relationship with such fiduciary described in section 4975(e)(2)(E), (F), (G), (H), or (I). [That is, certain disqualified persons such as family members and certain businesses in which the person is an owner, officer, director, etc.]

However, the mere fact that a family member or business enterprise is not a disqualified person does not mean that the accountholder does not have an interest in the person that may affect his/her best judgment as a fiduciary. The regulation clearly states that disqualified persons (including certain family members) are examples of persons in which you have an interest that may affect your judgment as a fiduciary. It does not follow that you do not have an interest in your brother, aunt, step-child, etc. DOL in one situation suggested that owning as little as 1.8% of a business was at least relevant to the question of whether a fiduciary had an impermissible interest. At best, some practitioners have suggested that the above regulation might shift the burden of proof from you (to prove you have no interest in a person) to the government (to prove that you do) – it is neither a bright line nor a safe harbor.

If I did make a loan to my brother, how could I prove that I did not have an impermissible personal interest in doing so? Perhaps I could demonstrate that that it was in the best interest of my IRA to make the loan, because he was a good credit risk and had other lenders lined up to make the same loan, or because he agreed to pay a higher-than-market rate of interest and provided excellent collateral. But, is it worth the risk, which could entail loss of the IRA’s tax exemption?

***

 Mr. Matta is a Principal with the Groom Law Group, Chartered. However, the views expressed herein are the personal opinion of the author and do not necessarily reflect official positions of his firm. The statements contained herein should not be considered legal advice and should not be relied upon by anyone without seeking advice of their own counsel. To comply with U.S. Treasury Regulations, we also inform you that, unless expressly stated otherwise, any tax advice contained in this memorandum is not intended to be used and cannot be used by any taxpayer to avoid penalties under the Internal Revenue Code, and such advice cannot be quoted or referenced to promote or market to another party any transaction or matter addressed in this memorandum.

 

Entity Investments in Your IRA – Advantages, Cautions and Legal Considerations

This article is part of a series of articles discussing some issues arising when investing your IRA into an entity, such as a limited liability company, corporation, limited partnership, or trust.  Other articles in this series include prohibited transactions and disqualified person, unrelated business income (UBI) and unrelated debt-financed income (UDFI) as it relates to entity investments, the plan asset regulations and other regulations which may apply, and formation and management issues, including the “checkbook control” LLC which has become so popular in the self-directed IRA industry.

There are advantages, cautions, and legal considerations when investing in an entity within your IRA.  Advantages of having your IRA own an entity include:

1)         Your IRA’s funds may be held in the entity’s name at a local bank.  This can be an advantage when getting cashier’s checks for the foreclosure or tax lien auction, paying earnest money or option fees, or paying contractors who prefer local checks, among other things.

2)         Certain types of investments, such as real estate closings or investments at foreclosure auctions, may in some circumstances be easier to facilitate through an entity.

3)         Investing your IRA’s funds through an entity may give your IRA some asset protection.  Always check with local legal counsel!

4)         In certain limited circumstances, you may be able to act as a manager, director or officer of your IRA-owned entity without compensation.

5)         If the entity’s shares are all that the IRA owns, administration fees may be lower.

6)         If the director, officer or manager is a trusted friend, you may more easily control what happens with your IRA’s funds.

Cautions when investing your IRA through an entity include:

1)         Check with your CPA or tax advisor on the local, state and federal tax implications of the entity you want your IRA to invest in.

2)         Select competent legal counsel to guide you who is familiar with the restrictions imposed by the Internal Revenue Code, including the prohibited transaction rules of Section 4975, as well as the plan asset regulations.  Otherwise, you may inadvertently engage in a prohibited transaction.  Make sure that the investment in the entity is not prohibited in itself and also that the company is not structured in a way that the operations of the company will lead to a prohibited transaction.

3)         All fees for the formation of the entity and for the preparation of any necessary tax returns as well as any taxes due must be paid from funds belonging to the IRA.

4)         Unless the entity is taxable itself, to the extent it owns debt-financed property or operates as a business, unrelated business income tax (UBIT) may attach to the profits from the entity.  Remember, there is no distinction between general and limited partners.

5)         Your third party administrator generally does not review the formation document or the by-laws, operating agreement or partnership agreement.  The nature of a self-directed IRA is that the IRA holder is responsible for the contents of the agreement, and usually must read and approve the subscription agreement and operating or partnership agreement prior to the administrator signing.  Typically, the only review that is undertaken is to make sure that the ownership of the asset is correctly listed in the name of the IRA.  Also, bear in mind that the administrator does not review any investment for compliance with IRS guidelines, so the IRA holder and his or her advisers should be very familiar with any restrictions.

Other things for you and your legal counsel to consider include:

1)         You should review the entity agreements to make sure that an IRA or qualified plan is permitted to be a shareholder, member or partner.  The agreement should specify the voting procedure for shares held by an IRA or qualified plan.

2)         There should be no transfer or buy-sell restrictions that would restrict the shares if the IRA is distributed either because the IRA holder dies or because the shares are distributed as part of a Required Minimum Distribution (RMD), or if the IRA holder decides to move the shares to a different custodian or administrator.

3)         The IRA holder and other related disqualified persons generally cannot receive compensation from the company.

4)         Depending on the ownership percentage by the IRA and other disqualified persons, it may be a prohibited transaction to fund additional capital calls.  If so, only the amount of the initial commitment can be funded.  Many administrators or custodians have restrictions on future capital calls.  The concern is that if the IRA and other disqualified persons fund more than 50% of the entity the entity will become a disqualified person to the owning IRA and future capital contributions might be considered a “transfer to, or use by or for the benefit of, a disqualified person of the income or assets of the plan” in violation of Internal Revenue Code §4975(c)(1)(D).

5)         If the IRA holder is or may soon be subject to required minimum distributions, either the IRA holder must have sufficient resources left in the subscribing IRA or other traditional IRA’s to cover the RMD, unless there will be guaranteed sufficient distributions from the entity to fund the RMD.  Otherwise, shares of the entity may have to be distributed.  This would cause significant difficulties both for the IRA holder and for the entity.

6)         Because of the limited review by the custodian or administrator of the formation documents and the investment, the IRA holder and his or her advisor should do the normal due diligence on the company, including investigating all of the principals involved reviewing the financial strength of the company, verifying with the Secretary of State that the company is in good standing, and checking with the Securities and Exchange Commission , the Better Business Bureau and any other governmental or non-governmental agency to see if any complaints have been filed against the company.  The IRA holder is 100% responsible for evaluating the company and the investment.

Entity Investments in Your IRA – Prohibited Transactions and Disqualified Persons

This article is part of a series of articles discussing some issues arising when investing your IRA into an entity, such as a limited liability company, corporation, limited partnership, or trust.  Other articles in this series include advantages and cautions when making entity investments, unrelated business income (UBI) and unrelated debt-financed income (UDFI) as it relates to entity investments, the plan asset regulations and other regulations which may apply, and formation and management issues, including the “checkbook control” LLC which has become so popular in the self-directed IRA industry.

As with any self-directed IRA investment, when investing your IRA in an entity you must know what transactions are prohibited and who is disqualified from doing business with your IRA or benefiting from your IRA’s investments. The general rule, as defined in Internal Revenue Code (“IRC”) Section 4975(c)(1), is that a “prohibited transaction” means any direct or indirect

A)       Saleor exchange, or leasing, of any property between a plan and a disqualified person;

B)        Lending of money or other extension of credit between a plan and a disqualified person;

C)        Furnishing of goods, services, or facilities between a plan and a disqualified person;

D)        Transfer to, or use by or for the benefit of, a disqualified person of the income or assets of the plan;

E)        Act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account; or

F)         Receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.

Essentially, the prohibited transaction rules are intended to discourage disqualified persons from dealing with the assets of the plan in a self-dealing manner, either directly or indirectly. The assets of a plan are to be invested in a manner which benefits the plan itself and not the IRA holder (other than as a beneficiary of the IRA) or any other disqualified person.  Investment transactions are supposed to be on an arms length basis.  There are various exceptions and class exemptions to the prohibited transaction rules, but unless you know of a specific exception, the wisest course is to stay away from a transaction involving one of the above situations.

Note that the last two restrictions listed above (E and F) apply to a special class of disqualified persons who are also fiduciaries.  These two provisions are designed to ensure that the fiduciary does not participate in a transaction in which he or she may have a conflict of interest.  At least in the context of a self-directed IRA, the IRA holder is considered to be a fiduciary of the plan.  Other fiduciaries may include officers, directors and managers of entities owned by IRA’s.  Fiduciaries of retirement plans owe a duty of undivided loyalty to the plans for which they act.  The prohibitions are therefore imposed on fiduciaries to deter them from exercising the authority, control, or responsibility which makes them fiduciaries when they have interests which may conflict with the interests of the plans for which they act.  Any action taken where there is a conflict of interest which may affect the best judgment of the fiduciary is likely to be a prohibited transaction.

All prohibited transactions involve a plan and a disqualified person.  There are nine different classes of disqualified persons.  They are:

1)         A fiduciary, which is defined to include any person who - exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control respecting management or disposition of its assets; renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of such plan, or has any authority or responsibility to do so; or has any discretionary authority or discretionary responsibility in the administration of such plan.

Note that this definition of a fiduciary is much broader than in traditional trust law, and at least with a self-directed IRA includes the IRA holder who exercises control over the management or disposition of its assets.

2)         A person providing services to the plan.  This can include attorneys, CPA’s and your third party administrator.

3)         An employer any of whose employees are covered by the plan.

4)         An employee organization any of whose members are covered by the plan.

5)         An owner, direct or indirect, of 50 percent or more of the voting power of stock in a corporation, the profits or capital interest in a partnership, or the beneficial interest in a trust or other unincorporated enterprise which is an employer or employee organization described above.

6)         A member of the family of any of the above individuals, which is defined to include only a spouse, ancestor, lineal descendant and any spouse of a lineal descendant.

Caution:  Although other members of the family are not disqualified persons (for example, brothers, sisters, aunts, uncles, step-children), dealing with close family members may still be a prohibited transaction because of the indirect rule.  For example, in the IRS Audit Manual it states:  “Included within the concept of indirect benefit to a fiduciary is a benefit to someone in whom the fiduciary has an interest that would affect his/her fiduciary judgement (sic).  An example would be the retention by the fiduciary of his/her son to provide administrative services to the plan for a fee.”  This is true even though the son’s provision of services to the plan may be exempt under the “reasonable compensation” exception.

7)         A corporation, partnership, trust, or estate owned 50% or more, directly or indirectly, by the first 5 types of disqualified persons described above.  Note that indirect ownership may include ownership by certain related parties such as spouses.

8)         An officer, director (or an individual having powers or responsibilities similar to those of officers or directors), a 10 percent or more shareholder, or a highly compensated employee (earning 10 percent or more of the yearly wages of an employer) of a person who is an employer or employee organization, the owner of 50% or more of an employer or employee organization, or a corporation, partnership, trust, or estate which is itself a disqualified person.

9)         A 10 percent or more (in capital or profits) partner or joint venturer of a person who is an employer or employee organization, the owner of 50% or more of an employer or employee organization, or a corporation, partnership, trust, or estate which is itself a disqualified person.

As I always say, “Don’t mess with the IRS, because they have what it takes to take what you have!” A Quest IRA self-directed IRA is an excellent tool to help your retirement savings grow, often at rates far exceeding those of ordinary IRA’s.  Knowing these rules is a critical step in learning to use your self-directed IRA in a way that will safely lead to vastly improved retirement wealth.

Entity Investments in Your IRA – Who Cares About the Plan Asset Regulations?

This article is part of a series of articles discussing some issues arising when investing your IRA into an entity, such as a limited liability company, corporation, limited partnership, or trust.  In this article we discuss the plan asset regulations and how they may impact your investment in an entity.

What are the plan asset regulations and why should you care about them if you are investing your IRA through an entity?  If the plan asset regulations apply to your entity investment, there are two major effects.  First, your IRA is deemed to own not only the equity interest in the entity but also an undivided interest in the underlying assets of the entity for purposes of the prohibited transaction rules of Section 4975.  To see how this works, suppose you want to sell a piece of real estate to your IRA.  Unfortunately, the prohibited transaction rules say you cannot sell any property to your IRA.  So can you form an LLC owned by your IRA and sell the property to that LLC instead?  The answer is no, because under the plan asset regulations selling the property to your IRA-owned LLC is the same as selling it directly to your IRA, which is prohibited.

Second, if the plan asset regulations apply, the officers, directors and managers of an entity may be considered fiduciaries of the investing IRA, which means the prohibited transaction rules apply to them and other disqualified persons related to them.  This is a critical issue and has many implications.  Basically all of the prohibited transaction restrictions which are imposed on the IRA owner now also apply to the managers of the LLC.  As fiduciaries they are responsible for making decisions in the best interests of the IRA as opposed to their own best interests or the interests of parties related to them.  For example, suppose an LLC is formed which is subject to the plan asset regulations.  Because the manager of the LLC is now a fiduciary of the investing IRA, neither the manager nor any other disqualified person related to the manager may sell property to, exchange property with, or lease property from the LLC.

Because of the serious implications of these regulations, when investing your IRA through an entity you should evaluate whether or not they apply.  If you are forming an entity or advising clients as an attorney, knowing when these rules apply is crucial since it may affect how the entity is structured and whether or not you agree to accept retirement plan money.

When do the plan asset regulations apply?  The plan asset regulations apply to any investment which is not a publicly offered security or a mutual fund unless either 1) the entity is an operating company (essentially, a business), which can include a real estate operating company or a venture capital operating company or 2) equity participation in the entity by benefit plan investors is not significant (meaning total retirement plan investors own less than 25% of each class of securities).   This means that the plan asset regulations will apply unless the entity either is running a business (in which case the unrelated business income tax rules apply) or unless all retirement plan investors together own less than 25% of each class of securities.  Even if the entity meets the requirements for an operating company, the regulations still apply if an IRA or a related group of IRA’s own all of the outstanding shares of the entity.

According to an additional set of regulations which stem from the Department of Labor’s Interpretive Bulletin 75-2, even the investment in the entity itself may be a prohibited transaction if a fiduciary (including the IRA owner) causes the plan to invest in an entity and as a result of that investment the fiduciary or another disqualified person derives a current benefit.  For example, if the IRA invests in or retains its investment in an entity and as part of the arrangement it is expected that the entity will hire the fiduciary or a related disqualified person, such arrangement is a prohibited transaction.  Under those same regulations, if a transaction between a disqualified person and an IRA would be a prohibited transaction, then it will ordinarily be a prohibited transaction if the IRA and other disqualified persons collectively have voting control in the entity.

There is no doubt that this is a complex topic which is hard to explore in a short article.  In most cases, the plan asset regulations will apply to your IRA’s entity investment.  If so, you should be aware of the following implications:

1)         Your IRA’s assets include a proportionateinterest in each company asset.

2)         Company managers, directors, officers and advisers are likely fiduciaries of the IRA.

3)         Because they are likely fiduciaries, certain compensation and indemnification plans for officers and directors may give rise to prohibited transactions.

4)         Prohibited transactions may result if the company engages in business transactions with disqualified persons, including the company’s managers, directors, officers, advisers and related parties to them.

If you hire an attorney or a company to assist you in setting up an IRA-owned LLC or other entity, including the “checkbook control” LLC, make sure they have a complete understanding of the prohibited transaction rules of Section 4975 and the associated regulations, the plan asset regulations, and the regulations from Department of Labor’s Interpretive Bulletin 75-2.  Sadly, there is a perception that investing an IRA through an entity is somehow a “prohibited transaction washing machine” which will protect the IRA from all the pesky rules of Section 4975.  In fact, the opposite is true, since the additional layers of complexity make it more likely that an inadvertent prohibited transaction may occur.

For those who want to know more, the prohibited transaction rules may be found in Internal Revenue Code (26 U.S.C.) Section 4975.  The regulations for Section 4975 are in 26 C.F.R. 54.4975-6.  The plan asset regulations are in 29 C.F.R. 2510.3-101.  The regulations relating to Department of Labor Interpretive Bulletin 75-2 are found in 29 C.F.R. 2509.75-2.

Entity Investments in Your IRA – Swanson v. Commissioner and the “Checkbook Control” IRA-Owned LLC

One of the most popular ideas in the self-directed IRA industry today is the “checkbook control” IRA.  You may have wondered what exactly it means to have “checkbook control” over your IRA’s funds.  In this article we will examine the celebrated case of Swanson v. Commissioner, on which the idea of “checkbook control” is based.  The entire text of the Swanson case is available on our website at www.QuestIRA.com.

The essential facts of Swanson are as follows:

1)         Mr. Swanson was the sole shareholder of H & S Swansons’ Tool Company (Swansons’ Tool).

2)         Mr. Swanson arranged for the organization of Swansons’ Worldwide, Inc. (Worldwide). Mr. Swanson was named as president and director of Worldwide.  Mr. Swanson also arranged for the formation of an individual retirement account (IRA #1).

3)         Mr. Swanson directed the custodian of his IRA to execute a subscription agreement for 2,500 shares of Worldwide original issue stock. The shares were subsequently issued to IRA #1, which became the sole shareholder of Worldwide.

4)         Swansons’ Tool paid commissions to Worldwide with respect to the sale by Swansons’ Tool of export property. Mr. Swanson, who had been named president of Worldwide, directed, with the IRA custodian’s consent, that Worldwide pay dividends to IRA #1.

5)         A similar arrangement was set up with regards to IRA #2 and a second corporation called Swansons’ Trading Company.

6)         Mr. Swanson received no compensation for his services as president and director of Swansons’ Worldwide, Inc. and Swansons’ Trading Company.

The IRS attacked Mr. Swanson’s setup on two fronts.  First, the IRS argued that the payment of dividends from Worldwide to IRA #1 was a prohibited transaction within the meaning of Internal Revenue Code (IRC) Section 4975(c)(1)(E) as an act of self-dealing, where a disqualified person who is a fiduciary deals with the assets of the plan in his own interest.  Mr. Swanson argued that he engaged in no activities on behalf of Worldwide which benefited him other than as a beneficiary of IRA #1.

The court agreed with Mr. Swanson, and found that the IRS was not substantially justified in its position.  The court said that section 4975(c)(1)(E) addresses itself only to acts of disqualified persons who, as fiduciaries, deal directly or indirectly with the income or assets of a plan for their own benefit or account.  In Mr. Swanson’s case the court found that there was no such direct or indirect dealing with the income or assets of the IRA.  The IRS never suggested that Mr. Swanson, acting as a “fiduciary” or otherwise, ever dealt with the corpus of IRA #1 for his own benefit.  According to the court, the only direct or indirect benefit that Mr. Swanson realized from the payments of dividends by Worldwide related solely to his status as a participant of IRA #1.  In this regard, Mr. Swanson benefited only insofar as IRA #1 accumulated assets for future distribution.

The second issue the IRS raises was that the sale of stock by Swansons’ Worldwide to Mr. Swanson’s IRA was a prohibited transaction within the meaning of section 4975(c)(1)(A) of the Code, which prohibits the direct or indirect sale or exchange, or leasing, of any property between an IRA and a disqualified person.  Mr. Swanson argued that at all pertinent times IRA #1 was the sole shareholder of Worldwide, and that since the 2,500 shares of Worldwide issued to IRA #1 were original issue, no sale or exchange of the stock occurred.

Once again, the court sided with Mr. Swanson.  The critical factor was that the stock acquired in that transaction was newly issued – prior to that point in time, Worldwide had no shares or shareholders.  The court found that a corporation without shares or shareholders does not fit within the definition of a disqualified person under section 4975(e)(2)(G).  It was only after Worldwide issued its stock to IRA #1 that petitioner held a beneficial interest in Worldwide’s stock, thereby causing Worldwide to become a disqualified person.  Accordingly, the issuance of stock to IRA #1 did not, within the plain meaning of section 4975(c)(1)(A), qualify as a “sale or exchange, or leasing, of any property between a plan and a disqualified person”.

On the surface it seems like the court endorsed the idea of an IRA holder being the sole director and officer of an entity owned by his IRA.  In other words, by having the IRA invested in an entity such as an LLC of which the IRA owner is the manager, the IRA owner gets to have “checkbook control” over his or her IRA’s funds.  This sounds like a great idea.  However, before jumping too fast into this area, there are some issues to consider.

One thing to remember is that the LLC does not insulate the IRA from the prohibited transaction rules.  Amazingly, the IRS and the court in Swanson v. Commissioner ignored completely the fact that Mr. Swanson’s non-IRA owned corporation, Swansons’ Tools, paid commissions to Worldwide, thereby reducing Swansons’ Tools’ taxable income and indirectly benefiting Mr. Swanson.  Especially after the recent case of Rollins v. Commissioner, it seems clear that this would be a prohibited transaction.  In the Rollins case, Mr. Rollins loaned money from his 401(k) plan to corporations in which he served as president but of which he owned only a minority interest.  The corporations were clearly not disqualified persons, but the court nonetheless held that there was an indirect benefit to Mr. Rollins, who was the largest shareholder and an officer of each corporation.

The IRS also might have argued that Mr. Swanson’s service as the president and sole director of Worldwide was a prohibited transaction as described in 4975(c)(1)(C), which prohibits the furnishing of goods, services or facilities between an IRA and a disqualified person.  Although Mr. Swanson stated that Worldwide had no “active” employees, one has to wonder at what point the services rendered to an IRA-owned entity become a problem.  Another question which was not raised in the Swanson case was whether or not an IRA owner having checkbook control over his IRA funds through a 100% IRA-owned entity violates IRC Section 408(a)(2), which requires that the custodian of an IRA be a bank or other qualified institution.  Why have that requirement at all if the IRA owner can get around it merely by having his or her IRA own 100% of an LLC managed by the IRA owner?

Although the Swanson case appears to be good case law, a great deal of care is merited when relying on this case.  Several questions which were not raised in the Swanson case remain unanswered.  As noted by the court, Mr. Swanson was “following the advice of experienced counsel.”  Even then, Mr. Swanson had to fight the IRS in tax court to win his case.  For most people, even getting into a battle with the IRS is a losing proposition.  Some people, perhaps through ignorance of the rules, appear to be abusing Swanson-type entities.  For example, in IRS Notice 2004-8 on abusive Roth transactions, the IRS states that it is aware of situations where taxpayers are using a Roth IRA-owned corporation which deals with a pre-existing business owned by the same taxpayer to shift otherwise taxable income into the Roth IRA.  If the IRS has become aware of the problem, there may come a day when they decide to go after these types of arrangements more actively.

When relying on the Swanson case to set up a checkbook control LLC or other entity, always use experienced legal counsel who is very familiar with how to set up this type of entity and who will be there to guide you on issues such as the prohibited transaction rules, the plan assets regulations, unrelated business income tax issues and the other rules and regulations which may apply.  What happens after the LLC is formed is just as important as the initial setup and can get you into just as much trouble.  To attempt a “checkbook control” entity without knowledge of all the rules and regulations or competent counsel to guide you is sort of like jumping out of an airplane without a parachute – it may be fun on the way down, but eventually you’re going to go SPLAT!