In Part I, we talked about prohibited transaction rules in general; in Part II, we talked about prohibited parties specifically; and in Part III, we talked about prohibited entities. Now that we’ve covered some ground, let’s put it all together and look at some examples of how this would play out in real life, specifically with an IRA LLC. Reading through the tax code can, and generally does give one a headache, so let’s go through how this might actually work.
In one of my favorite movies The Philadelphia Story, Cary Grant remarks to Katherine Hepburn’s character “…you’re far and away your favorite person.” It’s safe to say that we relate well to ourselves, and if we use you and your CheckBook IRA LLC in these examples instead of some fictional character, you’ll probably come away with a better understanding of the rules.
Your father calls one day and remarks in passing that he has invented a pair of shoes to the bottom of which are attached a set of spikes, allowing the user to arriate his lawn while taking a stroll. He plans to begin production right away, but he needs some start-up capital and would like you to provide it by loaning some of your self directed IRA LLC money to his newly formed Corporation, of which he is the sole shareholder.
Can your CheckBook IRA LLC provide the necessary startup capital to your father’s Corporation? Or to your father individually?
No, and no. The first question to ask is whether or not the parties involved in this transaction are disqualified or prohibited parties. According to IRC 26 § 4975 (e)(6), your father is a prohibited party or disqualified person, because he is your lineal descendant, so you couldn’t loan the money directly to him. What about a loan from the your Check Book IRA LLC to his company? If we refer to 26 § 4975 (e)(2)(G) we’re reminded that any entity owned 50% or more by a disqualified person is a prohibited or disqualified entity. Since your father, a prohibited party, is the sole or 100% owner of the Corporation, that company is a prohibited entity and is therefore off-limits as well.
It’s important to note here that any transaction of any form with your father or his Corporation would be a prohibited transaction. Even if the proposed deal was not a loan but something else. For example if the IRA LLC bought some equipment to build the shoes and then rented or leased that equipment to your father’s Corporation, or if you were to actually buy shares in the Corporation with the IRA LLC. You can see that it doesn’t matter what form the transaction takes, it’s still a transaction. So, with a prohibited party, the form of the transaction is not important. The point is that a transaction will take place, whatever form it may take.
You’ve purchased a lovely little house in the downtown area with your CheckBook IRA LLC. You bought the house from the bank in a short sale, and given the purchase price, you’re confident the rental income will pencil out to a profit. A week later you find that your son has been accepted to a University which sits not three block from the house. After having recovered from heart palpitations induced by the fact that the tuition fees amount to a small fortune, you come up with the idea that you could rent the lovely little house to your son; partly out of parental affection, but also so that you can recover some of those blasted tuition fees.
Could the CheckBook IRA LLC rent or lease the lovely little house to your son? Or could your son stay there for free?
No, and again, no. Your son is a lineal descendant, and is therefore a prohibited party. So, if the IRA LLC rents or leases the house to him it would be a prohibited transaction. What about if he stayed there for free? There wouldn’t be any “deal or transaction” would there? Actually the code covers that as well. In IRC 26 § 4975 (c)(D) it states any use by or for the benefit of a disqualified person by the assets of the plan is a prohibited transaction. So, even though your son wouldn’t be paying any rent, he would be using an asset of the CheckBook IRA LLC. Result? Prohibited transaction.
While reclining in your favorite lawn chair at the annual family picnic, your brother-in-law mentions he’s thinking of getting a home improvement loan. You know that his house is debt-free because he inherited it from his parents. When he tells you the amount he intends to borrow, you quickly do the math in your head and conclude that, assuming you could get a first mortgage position or trust deed, the loan amount compared to the value of the property is very low and would therefore be a low-risk investment.
Could the CheckBook IRA LLC loan the money to your brother-in-law with the property as collateral?
Yes. If we look at the disqualified or prohibited parties list, we find that your brother-in-law does not fit within that category. He is not a lineal descendant, nor is he the spouse of a lineal descendant; neither is he a “fiduciary” to the IRA LLC. He is therefore not a prohibited party. As a result, any deal or transaction between him and the CheckBook IRA LLC would be allowed. Note that the transaction must be at fair market value; you couldn’t offer an unsecured loan with 0% interest.
A friend of yours named Bob has invented and is close to securing a patent on a medical device that regrows skin by extracting a burn victim’s stem cells and spraying them back onto the burned area. Your friend needs an infusion of funds to complete the last leg of the patent process and would like you to provide it by holding an equity position in his company Skin ReGen, Corp. He is offering a 20% share for let’s say $100,000. There are several owners of Skin Regen, Corp. and a couple of them are members of your family. The ownership breakdown of Skin ReGen, Corp. is:
- Bob - 80%
- Your son - 8%
- Your mother - 12%
Neither your son, nor your mother have any management control of Skin Regen, Corp.
Could the CheckBook IRA LLC purchase a 20% equity position in Skin ReGen, Corp.?
Yes…but. Let’s deal with the yes first. Since this transaction would be between the CheckBook IRA LLC and Skin ReGen, Corp., we must first see if Skin ReGen is a prohibited entity. Here’s the sequence: 1. Your son and mother are both prohibited parties to the IRA LLC. 2. Your son’s and mother’s combined ownership in Skin ReGen is 20%. 3. Any entity owned 50% or more by any one or more prohibited parties is a prohibited entity. Your son’s and mother’s combined interest is less than 50%… 4. Therefore, Skin ReGen (at least in terms of ownership) is not a prohibited entity.
But we have more to consider before you go ahead with this investment (this is the “but” part :))
We have to look at two more things: control and indirect benefit. In this example we know that neither your son nor your mother have any control over Skin ReGen. They aren’t Officers of the Corp., they’re not on the Board. They hold no fiduciary position whatsoever with the company; they’re just shareholders. That solves the control issue. Neither of them has sufficient control of the company to taint a possible transaction between Skin ReGen and the CheckBook IRA LLC.
Remember back in Part I, we pointed out language in the code that said a prohibited party could not benefit directly or indirectly from an investment of the IRA LLC. So, will your son or mother benefit directly or indirectly from this transaction? Using the information given in the example, they would not benefit directly or indirectly. But, here is an example of what could constitue a benefit thereby triggering a prohibited transaction:
- What if your son had been wanting to sell his shares in the company, but Skin ReGen had placed a restriction on his ability to sell the shares until more capital was brought into the company? There’s a good chance that by purchasing 20% of Skin ReGen, the CheckBook IRA LLC would be guilty of a prohibited transaction because it would enable your son to then sell his shares back to Skin ReGen. This is commonly referred to as an “enabling investment.” Look at it this way: if the IRA LLC had not bought shares in Skin ReGen, your son would not have been able to sell his shares. The investment by the IRA LLC makes possible something that was not (your son’s ability to sell his shares), and it makes it possible for a prohibited party (your son). Result? Prohibited transaction.
There are endless examples one could go through, and we’ll be posting more in the future. For now, try to focus on the underlying concept and principles. Understanding the prohibited transaction rules is of paramount importance because there are consequences for failing to abide by them. If you don’t understand these rules yet, you’re not ready for a CheckBook IRA LLC. Don’t hesitate to call us if you have questions about the rules, or a particular deal you’re thinking of doing. In the meantime…
Invest intelligently. Enjoy the rewards.