I enjoyed the January 10 letter titled “How To Use Your IRA /401k to Fund a Survival Retreat Property“. I’d like to offer a few comments that your readers might find helpful.
My bona fides: I am a tax attorney who has dealt with self-directed IRA’s in audits and in Tax Court. I have gotten my clients some very good results in those arenas. I deal primarily with real estate in IRA’s. The same rules that govern real estate would apply to other non-traditional investments via Self-Directed IRA’s (“SDIRA”).
ROBS: The transaction that was described by “An Anonymous CPA” in the January 10th article was not a typical self-directed IRA deal. Rather, he described a very specialized sub-species of 401(k) deals known as “Rollovers as Business Start-Ups”, or “ROBS”. Understanding that context is key. The CPA’s information was accurate insofar as ROBS transactions go. While there are some common features, the posted information does not really apply to SDIRA’s in general. For more information on ROBS a little googling will uncover several outfits that promote such transactions. Most such outfits are one-trick ponies; they do ROBS and nothing else. One important caveat on ROBS: While technically legal (at least as far as I can tell, I’ve never researched ROBS to the nth degree, I refer ROBS work to the specialists), the IRS does not like them. The Association for Advanced Life Under-Writing posted the following on their website in a May 21, 2009 article:
“The IRS has placed a high priority, especially in the Small Business/Self-Employed Division, on so-called ROBS (rollovers as business startups) of which this transaction would be considered a part, even though it did not involve a rollover. Apparently there has been substantial advertising and marketing of the Roth IRA business technique and the Internal Revenue Service is determined to shut it down through the use of repetitive and detailed audits.”
While I have not dealt with such an audit, I think the quote is correct. ROBS are complex transactions, and one little misstep would allow an IRS auditor to impose severe penalties. If one wishes to execute a ROBS transaction, paying $6k+ for highly-specialized advice would be an absolute must. Further: Most of the ROBS specialists make a living off of selling ROBS and are therefore not very objective (“To a guy with a hammer everything looks like a nail”). In IRS parlance, they’d be viewed as “promoters”. It would probably make sense to have a second opinion from someone who does not make a living selling them.
Prohibited Transactions: As the name implies, Prohibited Transactions (“PT’s”) are bad. Specifically, if an IRA engages in a PT:
- The entire IRA ceases to exist. All of the money in it is distributed and most or all of it is taxed as ordinary income. If the amount is large, the tax bracket will be quite high.
- If one is under 59.5 years old, he’d almost certainly pay a 10% penalty on the amount distributed.
- Additional penalties would apply, usually in the 20% to 30% (of the taxes) range, but sometimes higher.
- Interest charges will apply as well.
- In general, we advise clients that a PT in an IRA means that that 50%+ of the IRA will go to the government.
- The size of the PT has no impact on whether the IRA gets blown. A $100 PT could blow a million dollar IRA. For this reason I am very, very conservative when it comes to PT’s. Anything that could even arguably be a PT should be avoided like a female intern avoiding a Clinton job offer.
- PT’s in 401(k)’s are “less bad”. Heavy penalties would still apply, but a PT does not destroy a 401(k) the way it does an IRA. 401(k)’s have other advantages, including larger contribution limits and better asset protection features. 401(k)’s can be invested or “self-directed” in almost exactly the same manner as IRA’s.
- I will describe PT’s in very basic terms. This description is not a substitute for good, customized advice. Rather, it’s designed to provide an overview of an important and complex subject. This topic is rarely covered as it should be. I put PT’s into three basic categories when I speak on the subject:
- First: “Doing Business” with Certain People (IRC 4975(c)(1)(A) and (B))
- No buying, selling, lending, extending credit, guaranteeing loans, leasing, provision of services or furnishing of facilities to/from disqualified persons (“DP”)
- Subtle but important: “Furnishing of facilities” – e.g., IRA assets in your basement would be a problem even if you did not charge the IRA for the use of the space. Basement = facilities. Bad.
- Key Disqualified Parties
- Lineal descendants and ancestors, including those of a spouse
- Direct or indirect
- “Indirect” means no matter how you structure it, if the end result is the same as if it had been done directly, your IRA is toast. For example, instead of lending money to your father (who is a DP), you lend it to your cousin who lends it to his dog who lends it your dad. It’s indirectly the same as your IRA lending money to your father and therefore it’s a PT.
- The IRS is very, very sophisticated when it comes to looking for indirect PT’s. They call and interview a number of persons during IRA audits and they ask probing questions. Thinking that “they’ll never catch it” would be a dangerous conceit.
- YOU are a DP as to your own IRA, see below under “fiduciary”.
- IRA Service Provider is a DP
- For example, the lawyer who provides services to your IRA is a DP. As such your IRA cannot, for example, lease property him.
- Fiduciaries are DP’s
- These are people who can direct the IRA’s investments. You can do that, as can an investment adviser whom you’ve hired to help invest the IRA’s assets.
- Second: Services
- Technically a sub-category of discussion above – but not discussed or examined enough by supposed “how to” gurus, and one that often trips people up. I’ve never seen a good discussion of this issue on the net. So I treat it as a category of its own.
- As a “fiduciary”, YOU are a DP with respect to your IRA
- The statute therefore says that you (a fiduciary and therefore a disqualified party) cannot provide ANY services to the IRA.
- The statute does not exempt services if they are provided for free.
- So if you provide any services to your IRA, you have a PT.
- Stick to directing your IRA, have others do the work
- For example, you should NOT manage properties owned by your IRA. Nor should any other DP.
- Do enough work, and you have a “service”
- You can direct the IRA or direct others to do work on behalf of the IRA – but nothing more. You can research and choose investments – but nothing beyond that.
- Investments can be anything that’s not banned. Certainly real estate, physical gold and silver (subject to certain restrictions), ammo, firearms that are not “collectibles”, etc.
- The term “services” is not defined. When push comes to shove and the IRS creates a definition (one fine day in court), the court will defer to the IRS per the (unconstitutional, created in FDR’s time to enable the Praetorian bureaucracy) Administrative Procedures Act.
- Third: The Sole Benefit Rule – the IRA’s assets must be invested for the sole benefit of the IRA. You may not use its assets for your benefit – no matter how small or indirect that benefit is. Several recent cases have hammered taxpayers for some pretty indirect benefits.
- For example, if the IRA makes a loan to a company that is not a DP and the loan indirectly benefits you (e.g. – you own a small interest in the company or you work for the company, directly or indirectly) such a loan would be prohibited.
- This means NO personal use of the property, no matter how minor or indirect.
- Hunt on the IRA’s property once and you’ve blown the IRA. Stay overnight. Cut some firewood. Do a little shooting. If any of that gets caught, the IRA is simply done.
- The IRS HAS caught such things. People fear them. When they start interviewing people close to the IRA holder (I have seen it done), you’d be amazed at who squawks. It’s human nature.
- If someone close to you uses the property in the manner described above (a friend, a co-worker, a family member), same result.
- I repeat: NO personal use of IRA property, no matter how indirect or how trivial.
Distributing half a house: As another reader posted, one can distribute partial interests in IRA property. This allows one to control the amount of income tax (in the case of a Traditional IRA, it wouldn’t matter in the case of a Roth) incurred each year.
Swanson case: That case is grossly over-hyped by promoters. They imply a ruling that is much broader than what the case actually said. No need to discuss the dull details. I’d simply add “cites Swanson a lot” to my “Danger Will Robinson IRA Promoter BS Detector”.
Government Seizure: I think a direct seizure like Argentina’s is unlikely in the US. My reasons:
- While our Republic is in its death throes, certain traditions still have considerable residual power. For example, legislation or regulations require advance notice and follow a long, highly visible path. Ample warning would likely exist to react (e.g. – eat the penalties and distribute). Executive orders (that is, the Diktat so beloved by our Dear Leader) are really not a realistic means of executing such a seizure – the law itself is too clear. EO’s work when you can make a small tweak that has great effect (e.g. – we are not enforcing this subparagraph – you know, the one about deporting illegals, etc.). This could change if things got bad enough to enable the man on the white horse to do as he pleases – but we are not quite there just yet.
- Too many people have IRA’s and 401(k)’s. An act as dramatic and direct as confiscation would wake even the sheeple.
- Too many people in power have and use them as well – remember Romney’s $20M to $100M SEP IRA?
- Indirect action will get the same result much more quietly (e.g. – QE) because most people will not do “extreme” things like invest in physical gold and silver. The little frog gets boiled slowly but thoroughly, no need to toss him in the microwave and make a mess that might get attention.
Equity Trust Company: (ETC) Ain’t what it used to be. For a number of reasons their service has declined dramatically. For example, deed transfers now take much longer, and are sometimes botched or forgotten entirely. Not ideal if for some reason one needs to make a fast transfer or distribution. There are lots of self-directed IRA custodians, do your research and find one that fits your needs. I hope ETC regains its former excellence, I do not think it likely.
Bottom line: IRA’s, 401(k)’s and other tax-deferred or tax-free retirement vehicles are excellent means of efficiently funding non-conventional assets such as land, buildings, timber, gold and the like. But our Byzantine tax system has added a price to such vehicles in the form of complex legal requirements. Ultimately the tax savings are worth the hassle. But please DO accept the hassle and get good advice. Ignoring the legal hassle or cutting corners (“I did it myself, how to is on the internet, it must be true!”) will cause a bitter harvest in favor of the IRS down the road. Do it right. – Prepper Tax Dude