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May 31, 2019
Since the concept of individual retirement accounts (IRAs) was introduced in 1974, there’s been a lot of misunderstanding about how they work and what types of investments are eligible to be held.
From a strictly legal perspective, there are very few things that an IRA owner is prohibited from investing in with their retirement account. In fact, the IRS code only identifies life insurance and collectibles as prohibited investments. However, because such accounts must be held by third party custodians, it didn’t take long for banks and stock brokerage companies to realize that if they would act as the custodian, they could effectively limit what was offered through such accounts to only those investments which generated profits for them. In fact, custodial services are often offered by such firms for free or for fees so small that they don’t even cover the related administrative costs.
While there were a few small custodians offering to hold non-traditional investments in the early days of IRAs, with limited scope and consumer knowledge coupled with small marketing budgets and an internet at its infancy, educating the masses of their services was nearly impossible. In the wake of the dot com bust at the turn of the century, as investors sought alternatives and real estate began to attract considerable interest, independent custodial firms popped up to facilitate “non‐traditional” investments within IRA accounts (i.e., things other than stocks, bonds, mutual funds and savings accounts). Being at a severe marketing disadvantage to the big banks and brokerage houses, these companies led with consumer education. The internet has made much of this valuable information readily available to investors who want to truly “self-direct” their retirement accounts.
However, even with an independent custodian, self‐direction alone may not solve each account holders investment needs and desires. Most notably, non-traditional investments are not sold on an exchange like publicly traded stocks. This can create a few challenges for custodians and the self-directed Accounts they serve. First, because only life insurance and collectibles are prohibited investments, clients can essentially invest in any asset class they deem profitable for their account. As a result, client’s creativity can create administrative burdens for the custodian who is responsible to buy, hold and sell the asset on behalf of the client. Second, without an exchange for these asset classes, each and every transaction the custodians processes must be done manually, making the investment process a couple days versus seconds for public securities.
As a result, investors had to once again find ways to maximize the opportunities afforded within a self-directed account and solve the issues that arose working through a custodian for each investment.
Insert the Checkbook Control IRA – also referred to as an IRA LCC.
The general concept of the Checkbook IRA is very simple. Rather than just fund an account with your custodian and then go through the transaction funding process on a transactional basis (one deal at a time), you set up an entity (typically an LLC) and direct your custodian to purchase 100% of the shares of the LLC. In this case the self-directed IRA becomes the sole “owner” of the LLC and as a result can designate the account owner as the non-member manager of the LLC. As the manager of the LLC, the account holder can direct all investments eliminating the transactional process through the custodian.
With Great Power Comes Great Responsibility
Being in complete control of your IRA funds without custodial involvement can be incredibly attractive to most investors, however, its not an open opportunity to do as you please. Since the LLC you are managing is 100% owned by your IRA, by extension all the rules that apply to IRA accounts extend to the LLC. So, if you’re looking for a way to avoid the self-dealing rules of IRAs and direct the IRA LLC funds into the hands of parties considered “prohibited” by the IRS, this strategy is not going to work for you. If you’re looking to follow the rules, but have more investment control, continue reading!
Below you will find the pros and cons of establishing a checkbook control IRA. It is important to apply each of these against the unique investment strategy you intend to deploy. There are many cases where the IRA LLC can be an effective part of an investment strategy and many cases where it is more work and expense than its worth. As always, good legal and tax advice is critical to understanding whether a checkbook control IRA is the best approach for you.
1. Full Investment Direction – As the non-member manager of the LLC, you have all the discretion to select investments that meet the IRS requirements. This freedom can provide additional investment opportunity as some custodians prohibit investments based on administrative feasibility despite the fact the asset class is not prohibited by the IRS.
2. Asset Management – By purchasing the investments through an LLC, you gain full oversight over the management of the assets. Expense payments, for example, can be paid directly from the LLC, eliminating the need to go through the custodian for each and every expense.
3. Quick Investment Funding – Having direct control over the LLC funds allows you to make decisions in real time without having to make requests to a custodian. This allows investors to purchase items at auction without issue or issue deposits on real estate without having to wait for the custodian to process the request.
4. Asset Protection – Many investors like the additional layer between their investments and their IRA which the LLC can provide. It can also provide a level of anonymity as the assets are titled in the LLC name instead of the custodian FBO account holder.
5. Fee Consolidation – for investors seeking to hold multiple assets within the LLC, cost savings can become an attractive benefit as many custodians are only charging a fee to custody the LLC, not a separate fee for each asset the LLC owns. Just beware this is not always the case. When you factor in the LLC setup fees and annual state registration fees, it may actually cost more, which is further explained in the cons section.
1. Record Keeping – By holding the assets through an LLC, you as the manager assume all the record keeping responsibilities. Assets held directly with the custodian are typically tracked at the custodial level keeping you from having to track all the funds in and out of the account for each unique investment.
2. Added Fees – In a lot of cases the IRA LLC can reduce fees in the long run, however, there are many cases where it actually increases the cost. Because the LLC has establishment costs and has an annual state registration fee, it can add to the overall cost of the self-directed account. For accounts that hold one or two investments, especially passive investments, fees should be carefully considered.
3. Prohibited Transactions – The risk of committed a prohibited transactions can rise when making investments through an LLC. This occurs because the IRA owner who is making the investment decisions is often uneducated about all rules and requirements of IRAs, which fully extend to the LLC. While custodians are not responsible to review and approve your investments specifically, there are many times where they can identify and point out potential red flags. Making your investments without custodial involvement eliminates that opportunity to discuss or identify potential land mines the could get you in trouble with the IRS.
4. Subsequent Transfers – Although Courts have ruled that the initial transfer of your retirement funds (the initial purchases of the LLC interests) into your LLC is not a Prohibited Transaction, the law is less clear when it comes to subsequent transfers. If you find you need to add additional capital to your LLC, you should consult a qualified advisor to be sure such a transaction doesn’t trigger a severe penalty.
As you can see, the checkbook control structure can be a very attractive way to self-direct your retirement account, however, its not a one size fits all approach. Careful consideration should be given to your investment strategy with a full understanding of the IRS rules you need to operate within. Furthermore, its important to understand the additional responsibilities and potential fees that may entail to ensure a checkbook control is worth the added effort.
So, if you feel a checkbook control IRA is the right strategy for you, find an independent custodian to hold the IRA account, engage a tax/legal professional to establish the LLC and begin reviewing the IRS rules to makes sure you know how to operate the LLC appropriately!
Jason DeBono, Vice President & COO of NuView Trust Company