Tax Considerations for Self-Directed IRA
Impact of Using a Limited Liability Company (“LLC”)
Tax Treatment of Income-UBTI and UDFI
State Tax Consequences of Using a LLC
IRS Tax Filing Requirements
Impact of Using a Limited Liability Company
It is important to state at the outset that using an LLC generally does NOT change the tax treatment of income and losses for the IRA that owns the LLC. It also does not change the consequences of engaging in a Prohibitive Transaction or having Unrelated Business Taxable Income (“UBTI”). However, it may change how the income is reported and the chances for engaging in a Prohibitive Transaction.
A limited liability company (LLC) is not a separate tax entity for “tax” purposes. It is what the IRS calls a “pass-through entity,” like a partnership or sole proprietorship. All the profits and losses of the LLC “pass through” the LLC to the LLC owners (called members), who report this information on their tax returns. The LLC itself does not pay federal income taxes. In the case of an LLC that is entirely owned by an IRA, all income of the LLC is passed through to the IRA as though the IRA directly earned the income.
However, as mentioned earlier the use of the LLC can change the way the income from the LLC is reported and this will be discussed below under “Filing Requirements”) below.
Tax treatment of income – UBTI and UBFI
The unique aspect about IRAs are the tax advantages. In a traditional IRA most contributions to it are tax deductible, the earnings grow tax-deferred, and the earnings are not taxed until distributed to the IRA account holder. In a Roth IRA the contributions do not give rise to a tax deduction, but the distributions to the account owner are tax free under conditions set by tax law. A Self-Directed IRA and use of an LLC does not change this tax treatment.
There are, however two types of income from certain investments that give rise to “current” taxable income; that is taxable to the IRA in the year the income is earned. These are Unrelated Business Taxable Income (â€˜UBTI”) and Unrelated Debt-Finance Income (“UDFI”).
UBTI (Unrelated Business Taxable Income)
“UBTI” is income from a trade or business regularly carried on by the IRA which is not substantially related to the IRA’s tax-exempt purpose. Interestingly, the tax code defines any active trade or business to be unrelated to the IRA’s purpose. It is important to be aware of the types of income that will NOT give rise to UBTI. These include, but are not limited to:
- Rent from real property
- Sales proceeds from real property (note: a high level of “flipping” or real estate development could give rise to UBTI)
- Dividends (e.g. paid to the IRA as a result of the IRA owning C Corporation stock)
Example: IRA purchases 10% of an LLC that invests into a “fix and flip” real estate strategy. The LLC flips on average 20 homes a year. While the determination of whether there is a trade or business depends upon the particular facts and circumstances, this level of activity will likely be viewed as a trade or business that gives rise to UBTI.
If UBTI is generated in a taxable year, the IRA must pay the tax (not the LLC) for that year and must file the appropriate forms with the IRS (see Filing Requirements below). Obviously, you want to avoid having UBTI as it negates the tax advantages of using an IRA or LLC owned IRA.
The attorneys affiliated with IRA Village (irataxlawyers.com) can help if you have questions or issues as to whether a proposed investment will generate UBTI.
UDFI (Unrelated Debt-Financed Income)
Another way for an IRA’s income to be currently taxable is under the “unrelated debt-financed income” (UDFI) rules. UDFI occurs when the IRA receives (either directly or indirectly through a “flow-through” entity, like an LLC) income from “debt-financed” property. For example, if an IRA purchases real estate using a non-recourse loan for 60% of the purchase price, 60% of the income generated from the investment will be subject to taxation. This represents the debt-financed portion of the investment.
If an IRA owned LLC incurs UDFI, the tax is paid by the IRA (not the LLC) and the appropriate forms must be filed.
State Tax Consequences Using an LLC
Most states tax LLC profits the same way the IRS does: The LLC owners pay taxes to the state on their personal returns, while the LLC itself does not pay a state tax. For an LLC owned by IRA, the income will generally not be subject to state tax as the IRA is tax-exempt under most state law.
Additional taxes in some states
A few states, however, do charge the LLC a tax based on the amount of income the LLC makes, in addition to the income tax its owners pay. For instance, California levies a tax on LLCs that make more than $250,000 per year; the tax ranges from about $900 to $11,000.
Annual fees in some states
In addition, some states impose an annual LLC fee that is not income-related. This may be called a “franchise tax,” an “annual registration fee” or a “renewal fee.” In most states, the fee is about $100, but California exacts a hefty $800 “minimum franchise tax” per year from LLCs.
IRA Tax Filing Requirements
The good news is that if a Self-Directed IRA owns 100% of an LLC, and if there is no UBTI or UDFI, then there is not a federal “income tax” filing requirement. The LLC does not have to file a federal income tax return, and the Self-Directed IRA does not have to file a federal income tax return. However, the Self-Directed IRA custodian each year must file Form 5498 which is an information form on which contributions and the value of the Self-Directed IRA are reported.
However, this result changes if the LLC incurs UBTI or UDFI. The result also changes if the LLC has more than one owner (i.e. if more than one IRA or individual also invests in the LLC). This is because the tax status of the LLC changes depending upon whether there is more than one owner.
LLC with Only One Owner and No UBTI and UDFI
The IRS treats an LLC with only one owner (called a Member) as a sole proprietorship for tax purposes. This means that the LLC itself does not pay taxes and does not have to file a return with the IRS. Any income of the LLC is passed through to the one owner and he or she reports the income on a federal income tax return. However, because the income received by a Self-Directed IRA is tax-exempt, the Self-Directed IRA has no income to report and no federal income tax return to file.
LLC with More Than One Owner and No UBTI and UDFI
The IRS treats an LLC with more than one owner as partnership for tax purposes. Like one-member LLCs, co-owned LLCs do not pay taxes on business income; instead, the LLC owners each pay taxes on their share of the profits on their personal income tax returns. This means that as the partnership earns income, it passes the tax liability of that income back to its owners. The partnership itself does not pay taxes. Every partnership must file an informational tax return and prepare income statements for all the owners of the company. The return itself is IRS Form 1065 and the income statement to the owners is Schedule K-1.
In the case of a Self-Directed IRA that is one of the owners of an LLC, the LLC would prepare and file a Form 1065 with the IRS to report the earnings of the LLC. However, no tax would be due as an LLC treated as a partnership incurs no tax itself. Also, the LLC would complete Schedule K-1 forms -for each owner of the LLC. The K-1 forms would show the respective share of the income for each owner. The two or more IRA owners are not taxable on the income reported on the K-1 (as a tax-exempt entity) and do not have to file a federal “income tax” return.
UBTI or UDFI
If an LLC owned by an IRA incurs UBTI or UDFI the Form 990-T must be completed to report the income and pay the tax. It is generally only these two instances that give rise to taxable income for the Self-Directed IRA owned LLC.
As the LLC is a “pass-through” entity and pays no tax, the tax is owed by the Self-Directed IRA. It is the account owner of the IRA that has the responsibility to prepare the Form 990-T. Since the tax is owed by the Self-Directed IRA, the return is prepared under the name of the Self-Directed IRA using the EIN of the IRA. It must be emphasized that tax must be paid only from funds held by the Self-Directed IRA.
This is a form filed annually by the Self-Directed IRA custodian. It is an information form and is not used to report income or pay any tax. This form is an informational filing which tracks a number of things like how much was contributed to the account over the course of the year (e.g., any rollovers, distributions, etc.). It is essentially a form whose primary purpose is to track the value of your IRA each year. The Custodian collects the information on your IRA, completes the form, and files it with the IRS.
This form involves an issue that arises when a Self-Directed Roth IRA account holder provides services to the LLC. Remember the account holder who provides services to the LLC cannot receive compensation for such services. However, in certain instances in which the manager performs significant services without receiving compensation for which he or she would normally pay an independent party, the IRS wants to know about such situations to determine if there has been a disguised contribution to the Self-Directed Roth IRA. These types of transactions must be disclosed as a listed transaction by a Roth IRA owner via IRS form 8886. This is a particularly complex issue that probably does NOT apply to most owners of Self-Directed IRAs.
Attorneys at our affiliated law firm (irataxlawyers.com) can help you sort through these issues.
When a Self-Directed IRA uses an LLC for investment purposes, it is crucial that the manager of the LLC keep proper records. Normally an IRA custodian would fulfill this function, but when an LLC is used to give the IRA account holder total control over spending and investment decisions, the custodian no longer has access to the specific investments made and the income earned by the investments.
So, it is incumbent on the LLC to keep track of all income, expenses, purchases and investments made. This function is normally assigned to the manager of the LLC and that person is generally the IRA account holder in an LLC in which the IRA is the sole owner. Where there is more than one owner of the LLC, the members jointly appoint the LLC manager.