Academic journal article Journal of Accountancy

Self-Directed IRAs: A Tax Compliance Black Hole: Nontraditional Investments Favored by Many Self-Directed IRAs Can Lead to Unexpected Taxation of Unaware IRA Account Holders

Academic journal article Journal of Accountancy

Self-Directed IRAs: A Tax Compliance Black Hole: Nontraditional Investments Favored by Many Self-Directed IRAs Can Lead to Unexpected Taxation of Unaware IRA Account Holders

Article excerpt

EXECUTIVE SUMMARY

* Self-directed IRAs (SDI RAs), in which investors choose their own, often nontraditional, investments, have grown enormously in popularity.

* The custodians of these IRAs often leave investors on their own when it comes to compliance and tax issues, and many, if not most, investors are un aware that potentially significant issues can arise.

* Unforeseen results can include the need to file a Form 990-T for the IRA and liability for tax on certain types of income that may be considered unrelated business income or unrelated debt-financed income.

* SDIRA investments can result in taxpayers unwittingly engaging in prohibited transactions, which can disqualify the IRA.

* Advisers should be prepared to help clients avoid some of these compliance problems by educating them about what investments are permitted in SDIRAs and what can raise tax compliance issues.

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The appeal of investing retirement funds outside of the typical securities market has driven a surge in the use of self-directed IRA (SDIRA) investment structures. These structures come in various forms, but they all start when an IRA account holder forms an SDIRA with a custodian (e.g., a bank or trust company) that is amenable to holding "nontraditional" types of investments. In other words, the feature that makes an IRA "self-directed" is not its general legal framework, but rather the fact that the SDIRA's custodian permits a wide array of investments and maximum control by the account holder.

Investments within SDIRAs frequently include real estate, closely held business entities, and private loans and can include any other investment that is not specifically prohibited by federal law---anything other than life insurance and collectibles can be held in an SDIRA. The SDIRA itself can be structured as a self-employed plan (SEP), a savings incentive match plan for employees (SIMPLE), or a traditional or Roth IRA, and is normally funded by a transfer from an account holder's other IRA or a rollover from a qualified retirement account (e.g., a 401(k)). However, one common theme is that the IRA account holder wants to diversify away from 100% stock market-based investments and/or believes that better investment returns exist outside the securities market.

Once the SDIRA is formed and funded, there are two general options for investing the SDIRA's cash. The account holder can either instruct the custodian to execute an investment directly out of the SDIRA, in which case the SDIRA becomes the legal owner of the asset, or the account holder can invest substantially all of the SDIRA's assets into a limited liability company (LLC). In the latter case, the SDIRA is usually, but not always, the 100% owner/member of the LLC (SDIRA/LLC). The SDIRA/LLC can then execute investments, generally with the LLC's manager as the SDIRA account holder, and thus the LLC becomes the legal owner of the asset in question (e.g., real estate). Both investment methods are legally viable, but each leads to legal and tax challenges.

Based on the author's conversations with thousands of SDIRA and SDIRA/LLC investors (and their advisers) throughout the country, without a doubt there are significant tax compliance problems within this colorful marketplace. In fact, it is likely that less than 50% of SDIRA and SDIRA/ LLC investors handle the legal and tax issues correctly, and many of these investors are unaware that these problems even exist. Unfortunately, these pitfalls can result in the complete invalidation of the SDIRA due to a "prohibited transaction" and/or current tax consequences within the SDIRA itself.

The following two examples, which are based on real-life client scenarios (although details have been changed to protect client confidentiality), illustrate issues clients and their tax advisers must be aware of when investing using an SDIRA or SDIRA/LLC. Ideally, these traps are considered before venturing into the world of nontraditional retirement account investing. …

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