Category: Retirement Plan Strategies

Active Traders Should Consider An Entity For Tax Savings

May 3, 2016 | By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

Forming an entity can save active investors and business traders significant taxes. Active investors can limit wash sale losses calculated between their individual taxable investment accounts and IRAs with an entity account. Business traders solidify trader tax status (TTS), unlock employee-benefit deductions, gain flexibility with a Section 475 election and revocation and limit wash-sale losses with individual and IRA accounts. For many active traders, an entity solution generates tax savings in excess of entity formation and compliance costs.

An entity return consolidates your trading activity on a pass-through tax return (partnership Form 1065 or S-Corp 1120-S), making life easier for you, your accountant and the IRS. It’s important to segregate investments from business trading when claiming TTS, and an entity is most useful in that regard. It’s simple and inexpensive to set up and operate.

Additionally, entities help traders elect Section 475 MTM (ordinary-loss treatment) later in the tax year — within 75 days of inception — if they missed the individual MTM election deadline on April 15. And it’s easier for an entity to exit TTS and revoke Section 475 MTM than it is for a sole proprietor. It’s more convenient for a new entity to adopt Section 475 MTM internally from inception, as opposed to an existing taxpayer whom must file a Form 3115 after filing an external election with the IRS.

Don’t worry, prior capital loss carryovers on the individual level are not lost; they still carry over on your individual Schedule D. The new entity can pass through capital gains if you skip the Section 475 MTM election to use up those capital loss carryovers. After using up capital loss carryovers, your entity can elect Section 475 MTM in a subsequent tax year.

Business traders often use an S-Corp trading company or an S-Corp or C-Corp management company to pay salary to the owner in connection with a retirement plan contribution, which otherwise isn’t possible in a partnership trading company (unless a trader has other sources of earned income or is a dealer member of a futures or options exchange).

Trading in an entity can help constitute a performance record for traders looking to launch an investment-management business. Finally, many types of entities are useful for asset protection and business continuity. A separate legal entity gives the presumption of business purpose, but a trader entity still must achieve TTS.

Avoid wash sales with an entity
Active investors in securities are significantly impacted by permanent and deferred wash sale losses between IRA and individual taxable accounts.

Trading in an entity helps avoid these problems. The entity is separate from your individual and IRA accounts for purposes of wash sales since the entity is a different taxpayer. An individual calculates wash sales among all their accounts. Ring fencing active trading into an entity account separates those trades from the individual wash sale loss calculations. The IRS is entitled to apply related party transaction rules (Section 267) if the entity purposely tries to avoid wash sales with the owner’s individual accounts. In that case, the entity will not avoid wash sale loss treatment.

If you don’t purposely avoid wash sales, you can break the chain on year-to-date wash sales in taxable individual accounts by switching over to an entity account mid-year or at year-end, and prevent further permanent wash-sale losses with IRAs. If the entity qualifies for TTS, it can consider a Section 475 MTM election exempting it from wash sales (on business positions, not investment positions); that also negates related party rules.

Play it safe on related party transaction rules by avoiding the repurchase of substantially identical positions in the new entity after taking a loss in the individual accounts.

Business traders: consider an entity
Many active traders ramp up into qualification for TTS. They wind up filing an individual Schedule C (Profit or Loss from Business) as a sole proprietor business trader the first year. That’s fine. They deduct trading business expenses on Schedule C and report trading gains and losses on other tax forms. They can even elect Section 475 MTM by April 15 of a given tax year to use ordinary gain or loss treatment (recommended on securities only). But a Schedule C owner may not pay himself compensation and the Schedule C does not generate self-employment income, either of which is required to deduct health insurance premiums and retirement plan contributions from gross income. (The exception is a full-fledged dealer/member of an options or futures exchange trading Section 1256 contracts on that exchange; they have SEI per Section 1402i.) The business trader needs an entity for those employee-benefit plan deductions.

Safeguard use of Section 475

Pass-through entities
We recommend pass-through entities for traders. A pass-through entity means the entity is a tax filer, but it’s not a taxpayer. The owners are the taxpayers, most often on their individual tax returns. Consider marriage, state residence and state tax rules including minimum taxes, franchise taxes and more when setting up your entity. Report all entity trading gains, losses and expenses on the entity tax return and issue a Schedule K-1 to each owner for their respective share — on which income retains its character. For example, the entity can pass through capital gains to utilize individual capital loss carryovers. Or the entity can pass through Section 475 MTM ordinary losses to comprise an individual net operating loss (NOL) carryback for immediate refund.

The best types of entities
We like the S-Corp because it pays compensation (officer’s salary) to the owner, which efficiently unlocks health insurance premium and retirement plan contribution deductions. You can form a single-member LLC or multi-member (spousal) LLC and the LLC can elect S-Corp tax treatment within 75 days of inception or by March 15 of the following tax year. (Another option is to form a corporation and it can elect S-Corp tax treatment, too.) A general partnership can also elect S-Corp status in every state except Connecticut, the District of Columbia, Michigan, New Hampshire, New Jersey and Tennessee.

But the S-Corp is not feasible alone in some states or cities, including California and New York City. In those places, we suggest a trading company partnership return — either a general partnership or LLC — and a management company S-Corp or C-Corp. You can convey interests in the pass-through entity to family revocable trusts or even irrevocable trusts. (See our blog post Business Traders Maximize Tax benefits with an S-Corp.)

Year-end Entity planning
There are important tax matters to execute with entities before year-end. For example, S-corps and C-corps should execute payroll before year-end. A Solo 401(k) defined contribution plan or defined benefit retirement plan must be established before year-end. (Watch our Webinar recording: Year-End Planning For Entities: Payroll, Retirement and Health Insurance.)

This is an excerpt from Green’s 2016 Trader Tax Guide.

Webinar 5/17:  Entity & Benefit Plan Tax-Advantaged Solutions 2016. We plan to offer a recording afterwards. 

 

 


Defined Benefit Plans Offer Huge Tax Breaks

November 23, 2015 | By: Robert A. Green, CPA

Click to read Green's blog post

Click to read Green’s blog post

Consistently high-income business owners, including trading businesses with owner/employees close to age 50, should consider a defined-benefit retirement savings plan (DBP) for significantly higher income tax and payroll tax savings vs. a defined-contribution retirement savings plan (DCP) like a Solo 401(k).

DBP calculations are complex
DBP calculations are more complex than a DCP profit-sharing plan. With a DBP, an actuary is required to consider various factors in calculating retirement benefits and annual contributions to the DBP.

The first factor is three-year average annual compensation and the IRS limit is $265,000 (2015/2016 limits). W-2 compensation may be higher, but the actuary may only input the IRS limit. Compensation determines the accumulated retirement benefit and retirement plan distributions/income during retirement years. The IRS limits retirement benefits per year to $210,000 (2015/2016 limits). Based on the maximum factors possible, the accumulated retirement benefit would be approximately $2.6* million.

If the participant plans 10 years of service retiring at age 62, with a 5% growth rate the retirement plan contribution would be $207,000* for the initial years. If that same person has 15 years of participation the annual retirement contribution would be $120,500*. (*Calculations provided by PACE TPA.)

Meet with a DBP administrator/actuary
When you meet with a DBP administrator/actuary, look at some “what if” scenarios with different levels of compensation and years to retirement.

There’s plenty of room for different scenarios between a Solo 401(k) limit of $59,000 for age 50 or older vs. a DBP contribution, which can range between $60,000 and $300,000 per year in the initial years. Traders operating in an S-Corp have the option to use a lower officer compensation amount.

What’s the catch?
A DBP requires annual funding contributions, whereas a DCP does not. With a DBP, the owner/employer commits to saving the actuary-determined accumulated retirement savings amount.

Closing a DBP without a valid reason could lead the IRS to disqualify the plan, making the accumulated benefit taxable income in the year of disqualification. Closing a trading company due to significant trading losses should be a valid reason. On DBP termination, most plan documents allow a tax-free rollover to an IRA or other qualified plan or a lump-sum taxable distribution. The 10% early withdrawal tax rules apply on qualified plan distributions before age 55 (see below).

You should consult your DBP administrator on a timely basis — before June 30 or 1,000 hours of service — to modify the DBP when necessary. For example, if you’re making significantly less income in the first three years, the administrator may be able to lower required contributions. Some DBP administrators recommend maximum allowed funding in early years, which serves to reduce minimum funding requirements in later years. This makes sense as you may make less money as you approach retirement.

You can do direct-access investing or trading inside the DBP account. Leading brokers may allow trading in stocks, bonds, ETFs and restricted trading in options. Avoid margin interest, which triggers unrelated business income tax (UBIT). Caution: Investment losses in the DBP will require larger contributions to make up those losses. Conversely, stellar trading gains can serve to reduce contributions too.

Compensation defined
In an S-Corp, only wages are considered in compensation; pass-through Schedule K-1 income is not. Conversely, with an operating business partnership tax return, all self-employment income (SEI) including guaranteed payments and pass-through income for active partners is included in compensation. A trading partnership has underlying unearned income, which is not SEI.

Payroll tax savings
Under DBP rules, average compensation is determined over the initial three years of the plan and compensation amounts afterward don’t affect DBP contributions and benefits. After three years, a trader may significantly reduce officer compensation, which has the effect of reducing payroll taxes. Payroll taxes include FICA 12.4% up to the SSA wage base amount of $118,500 (2015 and 2016 limits) and unlimited 2.9% Medicare tax. Plus, upper income taxpayers have a 0.9% Medicare/Obamacare surtax on wages. That leaves traders enjoying the tremendous income tax savings with a much smaller offset of payroll taxes. This option to reduce payroll taxes is not available with a Solo 401(k).

An S-Corp trading company has underlying unearned income, which should be an acceptable reason to the IRS for why the S-Corp may not otherwise comply with IRS guidelines for reasonable officer compensation. Conversely, a regular S-Corp operating business like an investment manager receiving management fees or an IT consultant must adhere to IRS guidelines for reasonable compensation. Currently, the guidelines call for 25% to 50% of net income before wages to be officer compensation.

Establish a DBP and execute payroll before year-end
Speak to a DBP administrator well before year-end to establish the plan by Dec. 31. You can fund the plan up until Sept. 15 of the following year — the extended due date of the S-Corp tax return.

You also need to execute officer compensation payroll before year-end.

Although the DBP is based on a three-year average of compensation, you may open a DBP in the first year of S-Corp trading company. Without a three-year average in that first year, there’s a narrower range of minimum vs. maximum contributions each year. If your income drops considerably in the second year, contact the DBP administrator, who can probably modify the plan to lower compensation amounts. After the three-year average of compensation is set, the administrator can’t modify it lower. You also can’t unwind accumulated retirement benefits earned to date.

Types of DBP plans
For an S-Corp trading company with a single owner/employee or a spousal S-Corp with two employees and no outside employees, we recommend a traditional or personal DBP or a “cash balance” DBP with a separate DBP investment account established for each owner employee.

Two spouses working in an S-Corp trading company can take advantage of the hybrid plan: A DBP integrated with partial Solo 401(k) (elective deferral and 6% profit-sharing rather than the normal 25% profit-sharing). If there’s only one employee, the traditional DBP or cash balance DBP is used.

Anti-discrimination rules
There are many anti-discrimination rules and requirements for high-deductible qualified plans intended to prevent the owner/employee from enjoying huge benefits with “top-heavy plans” while omitting or short-changing non-owner employees. Plan designers offer options like vesting over several years for complying with these rules but still favoring owners where possible.

Affiliated service group (ASG) rules apply in a similar context. If you own a business with many employees, you can’t exclude those employees by owning a separate (affiliated) S-Corp trading company with a high-deductible qualified plan for you alone. Consult an employee-benefit plan attorney.

Consult your tax advisor
After you speak with a DBP administrator, actuary, and perhaps an employee-benefit plan attorney, consult your tax advisor on choosing the compensation amount, which drives the related targeted retirement savings goal under the DBP. For S-Corp operating businesses, officer compensation must adhere to IRS guidelines for reasonable compensation, too.

Make sure you are comfortable committing to the annual minimum funding amounts of the DBP. If you want a lower commitment, choose a lower compensation amount. If the DBP calculation shows an annual contribution under $60,000, you are probably better off choosing a Solo 401(k) as it does not require annual funding and its limit is $53,000 for under age 50 and $59,000 for age 50 and older (2015 and 2016 limits).

With Solo 401(k) retirement plans, our CPA firm doesn’t want to see a S-Corp loss after deducting compensation and the retirement plan contribution. We apply this same rationale to the first year of a DBP plan. It’s wise to have sufficient S-Corp year-to-date trading income and expect similar trading gains in subsequent years so there won’t be an S-Corp loss from these large deductions. Once you start the DBP, mandatory contributions may generate a net loss in the S-Corp and that is acceptable. Explain the net loss and DBP funding commitment in a tax return footnote.

Your S-Corp trading company must qualify for trader tax status (business expense treatment), otherwise you can’t have officer compensation and retirement plan contributions in an investment company.

Costs and tax filings
DBP administrators charge $1,200 to $2,000 to design and establish a DBP. DBP administrators also charge around $1,200 to $2,000 per year for plan administration to keep the plan up to date along with modifications based on your evolving needs and changes in the law. Employee-benefit attorneys charge closer to $3,000 to $5,000 or more for DBP design and an attorney is not required. Net tax savings far exceeds these reasonable fees. In many cases, the DB administrator covers the cost of an independent actuary.

Charles Schwab offers a Personal Defined Benefit Plan and they have good resources on their site.

The IRS and The Employee Retirement Income Security Act of 1974 (ERISA) have many stringent rules and requirements for DBPs and it’s imperative to stay in proper compliance. Keep your DBP administrator aware of changes so they can make necessary modifications to the plan on time. There are many pitfalls to avoid with DBP and it’s not as simple as a Solo 401(k) or IRA.

As with all qualified plans, the sponsor of a DBP most likely must file an annual IRS Form 5500 tax return due July 31 of the following year for calendar year entities and plans. A 2½-month extension to Oct. 15 is allowed on Form 5558. Several administrators help with this tax form.

Tax-free growth and retirement distributions
Unless you are making non-tax-deductible contributions to a Roth IRA or Roth Solo 401(k) plan, with traditional retirement plans including qualified plans and IRAs, you get an income tax deduction from gross income for the contribution amount.

With a Roth plan, tax savings are permanent. Conversely, with a traditional qualified plan like a DBP or DCP, there is only tax deferral. Enjoy tax-free growth in the plan until taking taxable retirement plan distributions in retirement years. For traders who do more short-term investing, this annual tax savings is huge. Use a retirement plan calculator and you’ll see the power of tax-free compounded growth. Consider the time-value of money with tax deferral as well.

Under current tax law, retirement-plan distributions are ordinary taxable income. “Early withdrawals”(before retirement years age 59½ in an IRA or age 55 in qualified plans) are also subject to a 10% excise tax penalty on IRS Form 5329. Qualified plans including Solo 401(k) and DBP can offer qualified plan loans, which avoid early withdrawals. Qualified plans are a form of deferred compensation, but there are no payroll taxes on retirement plan distributions or contributions.

In qualified plans, there are required minimum distributions (RMD) by a participant’s required beginning date (RBD). The RBD rule is similar to the RMD rule for IRAs with distributions required no later than by age 70½.

Bottom line
If you are close to age 50, have consistently high annual income, can afford to commit to large tax-deductible contributions and want to smooth your taxable income in retirement taxed at lower tax brackets, then a DBP may be for you. The tax savings is enormous and with tax-free compounded growth it’s an incredible retirement savings tool.

 

 


Eight Ways Profitable Traders Save Taxes

August 23, 2015 | By: Robert A. Green, CPA

forbes_logo_main

Click for Green’s post on Forbes

Traders thrive on market volatility, profiting from rapid changes in prices up or down as they take long and short positions. It’s different for investors: When market indexes drop into correction or bear market mode, they generally lose money or reduce gains.

There’s been significant market volatility in 2015 and many stocks are in correction or bear market mode. I’ve had tax consultations with many traders that are making a fortune from price volatility, catching the swings in price both up and down.

In my last blog post, I wrote about five ways traders should best deduct trading losses, figuring some traders may not have recognized a stealth correction in many stocks and commodities in enough time to profit from it. In this blog post, I address tax savings for profitable traders because there are many traders who have done very well.

Here are eight ways profitable traders save taxes.

1. Business expenses with qualification for trader tax status
Investment expense treatment is the default method for investors, but if you qualify for trader tax status, you can use the more favorable business expense treatment.

Business expense treatment under Section 162 gives full ordinary deductions, including home-office, education, Section 195 start-up expenses, margin interest, Section 179 (100%) depreciation, amortization on software, seminars, market data and much more. Conversely, investment expenses are only allowed in excess of 2% of adjusted gross income (AGI), and not deductible against the nasty alternative minimum tax (AMT). Investment expenses are further restricted with “Pease” itemized-deduction limitations for taxpayers with AGI over $300,000 (married) and $250,000 (single). Many states limit itemized deductions, too.

Highly profitable traders often have significant expenses including staff, an office outside the home, additional equipment and services and significant employee-benefit plan deductions for retirement and health insurance. Their 2% AGI threshold for deducting investment expenses is very high, so they really appreciate full business expense deductions from gross income.

Learn how to qualify for and claim trader tax status in our Trader Tax Center.

2. Home office expenses

Most traders work in their home with a trading workstation, multiple computers, monitors, mobile devices, TVs, office furniture and fixtures. They exclusively use one or more rooms, storage areas and a bathroom.

A typical allocation percentage might be 10% to 20% of the home. Include every expense of the home including mortgage interest, real estate taxes, utilities, repairs, maintenance, security and more. Also, take depreciation of the home and on improvements. Office equipment and furniture is depreciated directly in the business often with Section 179 (100%) depreciation.

The home office deduction requires income, which can include trading gains. You can have a home office and office outside the home, too. Don’t be shy with this deduction; it helps document your business activity. Investors may not take a home office deduction, trader tax status is required.

3. Business travel, education and seminars
Many traders travel around the country and world to trading conferences, seminars and for education courses. If you qualify for trader tax status, education, seminars, conferences and related travel costs qualify as a business expense. But investors may not deduct education, seminars, conferences and related travel expenses in accordance with Section 274(h)(7).

The IRS is a stickler for separating business versus personal travel, meals and entertainment (see Pub 463). If your spouse accompanies you on a trip and is not active in the trading business, the spouse’s share of expenses are deemed personal. If you spend another week on your trip for vacation reasons, that part of the trip is also personal.

If you entertain other traders and industry players, you may have business meals and entertainment expenses. Be careful with the rules for lavish expenditures.

4. Health insurance premium deductions
Obamacare is forcing many traders into buying health insurance or otherwise owe a shared responsibility payment if they don’t qualify for a hardship exemption. Highly profitable traders don’t qualify for exchange subsidies and they seek AGI deductions for high health insurance premiums. (Out-of-pocket health care expenses including deductibles and co-payments are not allowed as an AGI-deduction and the threshold for itemized deductions for medical expenses is high.)

Self-employed businesses and pass-through entities may take a 100% deduction of health insurance premiums from AGI on individual tax returns. The problem for traders is that trading gains are not self-employment income (SEI) and they can’t have an AGI deduction for health insurance premiums or retirement plans. There is a way to fix that.

Traders need to form a S-Corp trading company (or C-Corp management company) to pay officer’s compensation which allows an AGI deduction for health insurance premiums and retirement plan contributions. Execute payroll before year-end and add the health insurance premium to the officer’s W-2 wages. The officer then takes the AGI deduction on their individual tax return.

5. Retirement plan contribution deductions
Generally, the best defined-contribution retirement plan for business traders is a Solo 401(k) plan. It combines a 100% deductible “elective deferral” contribution ($18,000 for 2015) with a 25% deductible profit-sharing plan contribution on an employer-level plan. There is also a “catch up provision” ($6,000 for 2015) for taxpayers age 50 and over. Together, the maximum tax-deductible contribution is $53,000 per year and $59,000 including the catch up provision (based on 2015 IRS limits). A SEP IRA only has a profit sharing plan.

Only traders with trader tax status on an S-Corp trading company (or with dual entity C-Corp management company) can satisfy the requirement for contributions to a retirement plan. That’s because trading gains are not considered SEI, which is required for retirement plan contributions. The trader needs wages from a S-Corp or C-Corp since a sole proprietor trader can’t pay themselves wages.

Retirement plan contributions are only allowed for traders who qualify for trader tax status and who use an S-Corp or C-Corp management company to create compensation as pointed out above.

High-income traders should consider a defined-benefit plan which allows much higher tax-deductible contributions. The maximum limit for 2015 is $210,000 and the actual amount is determined by an actuary.

Retirement plan contributions are made in connection with officer’s compensation, so trader tax status is imperative on these large combined amounts. Investment partnerships are not allowed to pay guaranteed payments to partners; only a trading business partnership may do so. Partnerships pass through losses reducing SEI, whereas S-Corps do not. We prefer the S-Corp for creating the wages needed for maximizing employee-benefit plan deductions.

6. Tax-advantaged growth in retirement plans
In traditional retirement plans, income growth is tax-deferred until taxable distributions are made in retirement subject to ordinary tax rates. Early withdrawals before age 59½ in IRAs and age 55 in qualified plans are also subject to a 10% excise tax penalty. Contributions to traditional retirement plans are tax deductible and hence there is tax-deferral only.

In Roth IRA and Roth 401(k) retirement plans, income growth is permanently tax-free because contributions to a Roth account are not tax deductible. When converting a traditional retirement account to a Roth account, taxes are due on the entire conversion amount. Afterward, the Roth is permanently tax-free. You can reverse the Roth conversion up to Oct. 15 of the following year if you are unhappy with it.

Highly profitable traders generally trade significant retirement assets alongside trading in taxable accounts. Taxable accounts qualify for trader tax status and retirement accounts do not. These traders seek to maximize deductions in connection with taxable accounts and minimize allocations if any to retirement accounts. Consult a CPA trader tax expert on this point.

7. Lower 60/40 capital gains tax rates on 1256 contracts
Profitable traders seek lower tax rates when possible. If you want to trade the Nasdaq 100 index you have two options: an ETF security (NASDAQ: QQQ) taxed at ordinary rates applicable on short-term capital gains, or an emini futures contract (CME: NQ), which is a Section 1256 contract taxed at lower 60/40 capital gains rates.

Section 1256 contracts bring meaningful tax savings throughout all tax brackets. These contracts have lower 60/40 tax rates, meaning 60% (including day trades) are taxed at the lower long-term capital gains rate and 40% are taxed at the short-term rate, which is the ordinary tax rate. At the maximum tax brackets for 2015, the top Section 1256 contract tax rate is 28%, 12% lower than the top ordinary rate of 39.6%. The long-term rate is 0% at the 10% and 15% ordinary tax brackets.

Section 1256 contracts are marked-to-market (MTM) on a daily basis. MTM means you report both realized and unrealized gains and losses at year-end. (Don’t confuse it with Section 475, which is also MTM but has different tax effects.) Many traders have small or no open positions on Section 1256 contracts at year-end. With MTM at year-end, a trader can’t hold a position for a long-term capital gain which requires a 12-month holding period, so Congress negotiated 60/40 capital gains rates. Active traders should take advantage of that tax break.

8. Long-term capital gains taxes
Long-term capital gains on sales of securities are subject to lower capital gains tax rates up to 20% which apply on securities held 12 months or more. Profitable traders often have segregated investment positions in securities — in addition to their trading activity — for which they seek deferral of taxes at year-end and eventually lower long term rates if held 12 months. (Caution: If you use Section 475 MTM, its imperative to properly segregate your investment positions.)

When market conditions change for their investments, rather than sell before 12 months or by year-end causing taxes on unrealized gains, they manage risk with option trades around the underlying position. For example, if they are long Apple stock and are concerned with its price dropping, they can purchase Apple put options for downside risk protection. They are still long Apple and they can continue to defer their unrealized gains in Apple at year-end.

Profitable traders can do these eight things to lower their tax bill by a significant amount. Why over pay Uncle Sam?

 


MLPs Can Generate Tax Bills In Retirement Accounts

October 31, 2014 | By: Robert A. Green, CPA

Forbes

MLPs Can Generate Tax Bills In Retirement Accounts

It’s a surprise to many people that MLPs generate taxable income in retirement plans requiring a tax filing and payment of taxes.

Traders and investors are interested in using their IRA and other retirement plan accounts (collectively referred to as “retirement plans”) for making “alternative investments” in publicly traded Master Limited Partnerships (MLPs). Most MLPs conduct business in energy, pipelines, and natural resources. (Learn more about publicly traded partnerships at The National Association of Publicly Traded Partnerships, see its list of PTPs Currently Traded on U.S. Exchanges and read its warning about MLPs and Retirement Accounts.) Retirement plans also make alternative investments in hedge funds organized as domestic limited partnerships or offshore corporations.

Publicly traded partnerships (including MLPs) and hedge fund LPs use the partnership structure as opposed to a corporate structure. That allows organizers to pass through significant tax breaks on a Schedule K-1, including intangible drilling costs (IDC) and depreciation to individual investors. Taxes are paid on the investor/owner level, so the partnership structure avoids double taxation. Conversely, corporations owe taxes on the entity level and investor/owners pay taxes on dividends received from the corporation. (Real Estate Investment Trusts do not use a partnership structure.)

Tax problems for retirement plans investing in MLPs
Most MLPs conduct business activities including energy, pipelines and natural resources. But hedge funds do not — they buy and sell securities, futures, options and forex, which are considered portfolio income activities. Private equity and venture capital funds using the partnership structure also may pass through business activity income.

When retirement plans conduct or invest in a business activity, they must file separate tax forms to report Unrelated Business Income (UBI) and often owe Unrelated Business Income Tax (UBIT). MLPs issue Schedule K-1s reporting business income, expense and loss to retirement plan investor/owners. That’s the problem! The retirement plan then has UBI, and it may owe UBIT. Instead of the MLP being a tax-advantaged investment as advertised, it turns into a potential tax nightmare investment.

Form 990-T
According to Form 990-T and its instructions “Who Must File,” when a retirement plan has “gross income of $1,000 or more from a regularly conducted unrelated trade or business” it must file a Form 990-T (Exempt Organization Business Income Tax Return). While the retirement plan may deduct IDC and depreciation from net UBI, gross income will probably exceed $1,000 causing the need to file Form 990-T. UBIT tax brackets go up to 39.6%, which matches the top individual tax rate. (See the UBIT rates and brackets in the instructions.) File Form 990-T to report net UBI losses so there is a UBI loss carryforward to subsequent tax years.

Don’t overlook the need to file Form 990-T
Noncompliance with Form 990-T rules can lead to back taxes, penalties and interest. It can lead to “blowing up” a retirement plan, which means all assets are deemed ordinary income. And if the beneficiary is under age 59½, it’s considered an “early withdrawal,” subject to a 10% excise tax penalty. Schedule K-1s are complex, and UBI reporting can be confusing especially if the retirement plan receives several Schedule K-1s from different investments. Don’t look to brokers for help; most have passed off this problem to retirement plan trustees and beneficial owners (and that is you!).

In our July 2013 blog and Webinar “The DOs and DON’Ts of using IRAs and other retirement plans in trading activities and alternative investments,” we cautioned investors on making alternative investments in their retirement plan accounts. We talked about UBIT, self-dealing and prohibited transactions. We explained that U.S. pension funds invest in offshore hedge funds organized as corporations since the offshore corporations are “UBIT blockers.”

If your retirement plan is invested in a publicly traded partnership, assess your tax situation immediately, catch up with Form 990-T filing compliance and consider selling those investments. It’s better to buy them in a taxable account.

Unrelated Business Income Defined by the IRS site.

“For most organizations, an activity is an unrelated business (and subject to unrelated business income tax) if it meets three requirements:

  1. It is a trade or business,
  2. It is not substantially related to furthering the exempt purpose of the organization.

There are, however, a number of modifications, exclusions, and exceptions to the general definition of unrelated business income.”

Darren Neuschwander CPA and Star Johnson CPA contributed to this article. 

 



Tax Relief For Canadians Living In The U.S.

October 9, 2014 | By: Robert A. Green, CPA

In the past, many Canadians living in the U.S. were surprised and dismayed to learn they owed U.S. taxes, penalties and interest on income accumulating inside their Canadian retirement plans. These U.S. residents figured their Canadian retirement plans were automatically afforded the same tax-deferral treatment as U.S. retirement plans, with income only being taxable when distributed from the plan. They were unaware they had to file an IRS election for deferral treatment.

That wasn’t the only surprise — many Canadians didn’t realize they had to report Canadian retirement plans on U.S. Treasury FBAR filings (foreign bank account reports).

We’re happy to see the IRS acknowledged the tax-deferral problem and it now provides relief. In Revenue Procedure 2014-55, the IRS repeals the need for filing a tax election, which means Canadian retirement plans automatically qualify for tax deferral. The new rules are retroactive, so it abates back taxes, interest and penalties and that spells “relief.”

This relief applies to U.S. taxpayers with Canadian registered retirement savings plans (RRSPs) and registered retirement income funds (RRIFs). The IRS altered regulations governing annual reporting requirements, mostly doing away with the election requirement and there is no longer a need to file Form 8891 (U.S. Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans).

Foreign retirement accounts must still be reported on FinCEN Form 114, Report of Foreign Bank and Financial Account. (Read more on International Tax Matters in our Trader Tax Center.)


Last Chance To Reverse 2013 Roth IRA Conversion By Oct. 15, 2014

October 7, 2014 | By: Robert A. Green, CPA

If you converted a traditional IRA to a Roth IRA in 2013, the IRS allows you to “recharacterize” the conversion if necessary. (See IRS law on this at Reg. 1.408A-5.) But the due date of Oct. 15, 2014 is quickly approaching. You can reverse a 2013 Roth conversion by executing a direct transfer of funds from it back into a traditional IRA. If you already filed your 2013 individual tax return reporting the Roth conversion amount in gross income, you’ll need to file an amended tax return to reduce the income accordingly. Generally, when financial markets rise, there are fewer recharacterizations, but if your account dropped in value, it may be a good idea.


IRA Rollover Rule Changes

June 12, 2014 | By: Robert A. Green, CPA

By Darren L. Neuschwander, CPA

There’s an important change in the rules for both traditional and Roth IRA rollovers, which are transactions that let you withdraw funds from one IRA and redeposit them in another IRA without paying income tax on the transaction.

Rollovers are a popular way of moving IRA money around from one investment to another. They are also a way to get a short-term tax-free loan from your IRA as long as you redeposit the funds to the same or another IRA no later than 60 days from the date you made the withdrawal.

One tax-free rollover from an IRA is allowed per year. The one-year waiting period begins on the date you received the IRA distribution, not on the date you roll the funds back into an IRA.

For about 30 years, IRS publications and proposed regulations have supported the general understanding among tax professionals that the one-year waiting period applies separately to each IRA an individual owns. Now, following a recent tax court case (Bobrow, T.C. Memo 2014-21), the IRS stated via Announcement 2014-15 that it will treat all of your IRAs as one IRA for purposes of the one-year waiting period. This more restrictive interpretation to IRA rollovers applies to transactions starting with tax-year 2015 and forward.

Pre-2015 IRA distribution example: Suppose you have four IRAs: A, B, C and D. In March of 2014, you withdrew the balance from A and rolled it over into C within 60 days. In August of 2014, you withdraw the balance from IRA B and roll it over into IRA D within 60 days. Assuming you haven’t previously made any rollovers, neither withdrawal will be taxed because both IRAs A and B are treated separately for purposes of the one-year waiting period.

Post-2014 IRA distribution example: Assume the same facts as in previous example, except the year of the transactions has changed from 2014 to 2015. In this case, the withdrawal from B will be a taxable distribution and also could be hit with a 10% early distribution penalty if you are under the age of 59 ½ . Only the withdrawal from A would be a tax-free rollover. To make matters worse, if the funding of D from the B withdrawal exceeded any allowable regular IRA contribution for 2015, it would be treated as an excess contribution subject to an additional 6% tax unless you withdraw the excess amount by 2015.


New IRS guidance on SE tax deductions affects partnership AGI-deduction strategies

January 14, 2014 | By: Robert A. Green, CPA

Update on March 4: Potential solution for 50/50 HW partnership returns. In general, we recommend 50/50 as that is how married couples generally share property. Pay administration fees during the year and if you need more cash flow, the husband and wife can reinvest capital to finance ongoing fee payments. Consult with us about your administration fee agreements and payment schedules.

Update on Feb. 21: With a two-spouse partnership return, you can maximize AGI deductions (health insurance and retirement plans) with the active-trader spouse owning just 1% (or a minority) of capital, rather than 99% (or a majority) of capital. However, that may not be feasible or wise considering joint property issues. In these cases, it’s better to consider an S-Corp election, or add a C-Corp, so the partnership can remain 50/50. Active traders owning 99% (or a majority) should consider changes soon. 2014 S-Corp elections are due by March 15, 2014. Consult with us about these changes.

In Green’s 2014 Trader Tax Guide, see Chapter 7 Entities & Chapter 8 Retirement Plans for our updated strategies on entities and retirement plans.

Business traders reporting an administration fee on an individual tax return Schedule C paid from their trading business partnership in order to unlock AGI deductions for health insurance and retirement plan contributions need to consider some changes as a result of new IRS guidance. The IRS released draft instructions to Form 8960 (Net Investment Income Tax) in January 2014. The instructions state that trading business expenses should be deducted against self-employment income (SEI), and any excess amount generating negative SEI may be deducted against Net Investment Income (NII). These draft instructions are based on the IRS’s final NII regulations released in December 2013.

Business traders using an S-Corp or C-Corp with payroll rather than a partnership administration fee are mostly unaffected by this new IRS guidance. But partnerships need to consider these suggested solutions. We’re adopting this new guidance for 2013 tax returns and subsequent years.

The partnership fee/AGI-deduction strategy can still work on some partnership tax returns.
Prior to 2013, the simplest entity for a husband and wife was a general partnership filing a partnership tax return. To unlock AGI deductions for health insurance and retirement plans, the partnership paid an administration fee to the trading owner’s individual Schedule C, creating the earned income needed for the AGI deductions. But the trading business expenses passed through from the partnership — including the fee payment — were not included in SEI. With new IRS guidance requiring an SEI deduction for partnership expenses, it’s harder to achieve the SEI that is necessary for purposes of maximizing these AGI deductions.

Consider this example of a husband and wife 50/50 general partnership or LLC filing a partnership tax return for 2013. The partnership has trading business expenses of $20,000 before paying an administration fee to the husband, who is the active trader (assume the wife is non-active). Before the new IRS guidance, the partnership could pay an administration fee of $30,000 to the husband to cover AGI deductions for health insurance (close to $12,000) and Individual 401(k) elective deferral ($17,500). Now, the partnership needs to gross up the fee to cover the husband’s 50% share of partnership Schedule E SEI deductions. Therefore, the partnership needs to pay a fee of $80,000 to have a net SEI of $30,000. Fifty percent of the trading partnership’s loss (equal to $50,000 in this example) from trading business expenses ($100,000) is allocated to the husband. (The $100,000 is comprised of the $20,000 expenses and $80,000 fee.) The wife’s 50% allocation with negative SEI has no effect, as SEI and SE tax is calculated separately.

This change is not as simple as it may sound. The partnership needs to generate more income to justify a higher fee — an increase of $50,000 — and it needs the cash flow to execute it. If the husband owned a lower percentage of the partnership, the fee increase can be lower. But, in many HWGP entities, the non-active owner holds 1% of profit and loss, and that is a problem for this potential solution. They should consider changing to 50/50 or even 20/80.

If you want net SEI of $30,000, calculate the fee payment as follows. Trading expenses x allocation percentage = a negative SEI. You want to add an amount to get to $30,000 positive SEI and divide it by the other spouse’s allocation percentage to get the administration fee amount. For example, with 20/80, the negative SEI is: $20,000 x 20% = ($4,000). To get to the target $30,000 SEI, pay $34,000. Next, gross up $34,000 by dividing it by 80% which equals the administration fee of $42,500 (and is only $12,500 more than the $30,000 target). Total expenses are $62,500 ($20,000 expenses + $42,500 fee). Total expenses x the 20% allocation = a negative SEI of ($12,500) + the administration fee of $42,500 = target SEI of $30,000.

If the partnership approach doesn’t work for you, arrange salary not administration fees
The key issue for claiming health insurance and retirement plan deductions is to arrange these employee benefits in connection with a salary. The IRS does not allow partnership tax returns to pay a salary (payroll) to owners; it requires guaranteed payments or administration fees. The solution is to convert an LLC or a general partnership to an S-Corp, or add a C-Corp as a 1% partner, because an S-Corp or C-Corp pay salary to owner/employees.

An existing general partnership or multi-member LLC filing a partnership return can elect to be taxed as an S-Corp for 2014, by filing a federal Form 2553 S-Corp election by March 15, 2014. Some states rely on the federal form and other states have their own election form. Very few states don’t conform to federal “check the box regulations” allowing general partnerships or LLCs to elect S-Corp tax treatment. Consult with us about whether an S-Corp election is beneficial for you, and allowed in your state.

These solutions are less disruptive and lower in cost than opening, and closing entities. You can keep your existing trading business, including its trading accounts and bank accounts, in place.

S-Corp tax treatment is inappropriate for a hedge fund or trading company with special allocations like “carried-interest” to owners as that is considered a second class of equity and is not allowed. These types of partnerships should consider adding a C-Corp as a 1% owner.

A general partnership or multi-member LLC filing a partnership tax return can add a new C-Corp as a 1% owner of the partnership. There are few changes for the partnership: It keeps filing a partnership tax return and pays the C-Corp an administration fee and 1% or more allocation of profits. The C-Corp then has sufficient income to pay the owner a salary to unlock C-Corp-level employee benefits for health insurance and retirement plan contributions.

C-Corp owners have added benefits that are not available with partnership and S-Corp returns. The owner can have a medical reimbursement plan, which increasingly is an attractive idea considering higher deductibles and out-of-network health costs under ObamaCare plans. You can also shift individual income to lower C-Corp tax rates or operate the C-Corp close to break even if state corporate taxation is a concern.

Retirement plan changes
The other change you need to make is converting an individual-level retirement plan to the entity level. Salary-based retirement plans require entity-level retirement plans. This is fairly easy to accomplish, however some brokers may be confused about a general partnership electing S-Corp treatment, so consult with us.

For 2013, if you used a partnership and you reclassified distributions to administration fees, you may want to reclassify them back to distributions so you don’t need to file a 2013 Form 1099-Misc. by the end of February. But if you do file the 1099-Misc., it may not unlock many AGI deductions per the new guidance: The fee payments included in the partnership loss offset the fee income for both gross income and self-employment income purposes. It depends on the fee recipients share of the partnership loss.

If there is insufficient 2013 net self-employment income, you can’t fund retirement plans, so make sure there is no excess retirement plan funding for 2013 subject to IRS penalties. If you already excess funded a plan for 2013, withdraw those excessive funds as soon as possible to avoid penalties.

There’s time to fix 2014, but no time to fully fix 2013
Traders using partnerships can rearrange their tax affairs to get all the tax breaks for 2014 and subsequent years, but 2013 is a transition year so they get left holding the bag on fewer tax breaks such as no or limited AGI deductions based on their trading businesses. They do keep their business expense treatment, Section 475 and other trader tax benefits.

Unfortunately, you can’t reclassify administration fees to payroll, as payroll is a formal contemporaneous filing. It’s not a big deal to handle payroll with an outside firm like paychex.com.

Good news/bad news
This seems like positive news for business traders and other taxpayers, since SEI deductions are more valuable than NII deductions. SE taxes include FICA and Medicare tax, whereas Net Investment Tax (NIT) only includes the 3.8% Medicare tax. Deducting trading business expenses against self-employment income first is generally a good thing and we are not against this new guidance.

Sole proprietor traders with other earned income activities will generally be happy with this new IRS guidance. They can now deduct their trading business expenses from SEI and pay less SE tax. But they also have less earned income for retirement plan calculations.

The bad news is the new guidance causes issues for business traders using AGI-deduction strategies for health insurance and retirement plan contributions arranged through trading business partnership tax returns. Those strategies were constructed based on trading business expenses not being deductible against SEI. With the new IRS guidance, the partnership loss on Schedule E — increased by the administration fee payment — is also deductible against SEI, so the administration fee on Schedule C cannot generate positive SEI needed for the AGI deduction for a 99/1 HWGP.

Our prior position excluding trading business expenses from SEI
To date, we’ve taken the position that trading business expenses — like related trading business gains and losses — should be excluded from SEI.

While Section 1402 (SE tax rules) first state that Section 162 “trade or business” expenses for individuals and partnerships are deductible against SEI, they go on to exclude trading capital gains. IRS publications, trader tax court cases and Website statements all clearly state that business trading gains and losses are excluded from SEI. Unfortunately, we don’t see trading business expenses discussed specifically anywhere. Leading tax publishers have also said this matter was unclear in the law.

We’ve taken a conservative position: Since trading gains and losses are excluded from SEI, so should their related trading business expenses. When tax law is unclear, it’s often appropriate to turn to general tax concepts and theory, which includes a matching concept. If the income is non-taxable, generally the expenses to generate that income are also non-deductible. That’s how it works with tax-exempt income — the investment fees and margin interest to generate that income are non-deductible.

To clarify this matter, we asked an IRS official involved with the new NII regulations about these questions. The IRS person unofficially said the IRS thinks trading business expenses offset SEI first, and then NII. He pointed to example 4 in “Reg §1.1411-9. Exception for self-employment income,” which was released in December. We conclude it’s prudent to adopt this new guidance on 2013 tax filings. We believe our tax filings for 2012 and prior years are correct based on existing tax law at that time.


Contributing to multiple retirement plans

August 23, 2013 | By: Robert A. Green, CPA

Please read this update from the IRS because we get this question from clients several times a year.

In the latest edition of Retirement News for Employers, the IRS reviews the amount of contributions and salary deferrals that can be made by an individual eligible for participation in multiple retirement plans. The types of plans that must be aggregated in calculating the individual limit for a calendar year are provided, as well as how to handle contributions made in excess of the annual limit. Examples are included that demonstrate the interaction of catch-up contributions (available to individuals age 50 or older by year-end) with the annual limits.


The DOs and DON’Ts of using IRAs and other retirement plans in trading activities and alternative investments

July 24, 2013 | By: Robert A. Green, CPA

Watch the related Webinar recording. 

Alert! Many traders may be triggering IRS excise-tax penalties for prohibited transactions including self-dealing, and/or UBIT taxes by using their IRAs and other retirement funds to finance their trading activities and alternative investments in problematic ways. One example of this type of trouble may be the “IRA-Owned LLC” or trust trading account. In many cases, traders also risk losing tax-exempt status on their retirement plans. This content is a serious warning to stay clear of trouble, not just a technical discussion of quirky rules.

Traders are increasingly tapping into their IRA and other retirement funds to finance their trading and investment plans. This trend has been growing since the 2008 financial crisis when many taxable accounts melted down, and proliferating rapidly this year.

The good
For the past several years, GreenTraderTax has offered ways to tap into retirement funds without triggering tax problems. We recap these safe strategies below. But first, let’s tackle the new inappropriate retirement-plan schemes and structures.

The bad
There are many companies marketing these structures, often with educational content. One popular structure is the Self-Directed IRA-Owned LLC, or in a minor variation, the “Custodian IRA-Owned Trust.” Vendors want to put your retirement funds to work and generate commissions with more active trading. Educational firms may realize it’s your only good source of funds for establishing a trading activity, so they recommend these schemes.

While many of these Websites offer good articles about related IRS, DOL and ERISA laws and rulings, take it with a grain of salt. Many vendors make self-serving conclusions, and generally give insufficient consideration to prohibited-transaction and self-dealing rules, which are complex, nuanced and often misunderstood. Attorneys confirm these schemes create substantial risks of tax non-compliance, prohibited-transactions and/or (the wider net of) self-dealing, opening the door to potential trouble from the IRS and DOL.

You should engage your own independent employee-benefits attorney and CPA to help you make the right decisions and to troubleshoot how to handle structural and compliance matters going forward. Unless you are talking about serious money, why bother with all this potential trouble and costs (including legal fees) if it probably won’t work anyway?

And, the ugly
Scheme vendors put too much stock in their 1996 tax court ruling “Swanson v. Commissioner” (Note 1). They utilize the ruling to sell their scheme “Self-Directed IRA-Owned LLC with Checkbook Control.”

How do these schemes work? Working with your IRA administrator or a new intermediary custodian, you arrange for your IRA to own 100% of a newly formed single-member LLC. You then open an LLC trading margin account with the broker of your choice.

You pay trading expenses through an LLC bank account or the LLC trading account with check writing privileges and debit card. That’s LLC “Checkbook Control.” The intermediary custodian has control of the LLC interest itself, but not checkbook control in the LLC.

In a minor variation, the “Custodian IRA-Owned Trust” opens a trust trading margin account rather than an LLC account. The purpose is basically the same. They have checkbook control on the trust level. Both the LLC and trust are disregarded entities.

Many traders abuse that checkbook control by loading up expenses that are otherwise non-deductible on their tax returns. Only investment expenses that directly relate to the IRA’s own trading (Section 212) are payable from the retirement account, not business expenses (Section 162) such as education and home-office expenses which benefit the trader personally.

It’s fishy
What does this tell you so far? You’ve gone through a lot of trouble to navigate around restrictions to open a margin account for the benefit of your IRA with your online broker. The broker’s compliance department said no to a margin account for your IRA. The broker doesn’t want to be associated with or responsible for these schemes in any way, so it refers outside vendors. The rules are strict: IRAs may have cash accounts, not margin accounts and the IRA administrator is supposed to have checkbook control. Doesn’t this scheme sound fishy so far?

Note: A few brokers do allow IRAs to have margin accounts but for very limited purposes where the risk of loss cannot exceed the assets in the account (such as covered calls).

Swanson vs. Commissioner is no swan song
Many attorneys think both the IRS and the tax court mishandled the Swanson ruling. The Swanson court ruled there wasn’t a prohibited transaction with a disqualified person when the IRA acquired 100% interests in two newly formed corporations (a key point that is often glossed over – these were corporations, not LLCs). But it did not consider whether there might be a prohibited transaction after that point going forward. In particular, the Swanson court did not address self-dealing rules. Swanson likely triggered self-dealing rules in his role as IRA beneficiary and fiduciary versus his personal interest in the Swanson C-Corp operating business. Self-dealing is generally the Achilles heel of these structures.

Attorney Richard Matta* of Groom Law Group (Note 3), “the IRS missed another big elephant in the room – the IRA-owned corporations received income, but it is not clear that they actually did anything to add value. If they did add value, who performed the services – the IRA owner? That is considered a disguised contribution. If they did not add value and the transfers were gratuitous, that looks like not only a disguised contribution but potential tax fraud. These issues were never explored by the IRS or the court.”

Some vendors tell the most of the story
QuestIRA.com (Note 2) states the Swanson case is not clear case law precedent. According to the site, “Some people, perhaps through ignorance of the rules, appear to be abusing Swanson-type entities. For example, in IRS Notice 2004-8 on abusive Roth transactions the IRS states that it is aware of situations where taxpayers are using a Roth IRA-owned corporation which deals with a pre-existing business owned by the same taxpayer to shift otherwise taxable income into the Roth IRA.” (I.e., disguised contribution or tax fraud.)

QuestIRA goes on to say the Swanson court skipped over “IRC Section 408(a)(2), which requires that the custodian of an IRA be a bank or other qualified institution.” Mr. Matta points out that the IRS views a single-member LLC as a disregarded entity, which means in the eyes of the IRS the LLC does not exist. Matta says if the LLC does not exist but check-writing authority is now in the hands of the IRA owner, a strong argument can be made that the IRA assets are no longer properly custodied. While some may argue to the contrary, supporting authority beyond the near-useless Swanson case is weak to non-existent.

In other words, the fact the Swanson court did not rule against Swanson (on very different facts) is not precedent and offers no comfort. The IRS failed to raise the “real” issues and the court could only rule on the questions before it. Don’t count on the IRS to get it wrong the next time.

Why set up a disregarded entity? 
One popular reason is for traders to give their IRA access to an otherwise forbidden margin account, since an IRA generally may only open a cash account. Day traders need pattern day trader (PDT) rights with 4:1 intraday leverage, versus 2:1 leverage for regular margin Reg T accounts. Cash accounts are 1:1, which means no leverage. The bigger the buying power, the more risk you can take on your limited funds. A related reason is that in order to move money quickly, you need checkbook control – asking a bank custodian to transfer funds simply takes too long for traders.

On the other hand, the IRA owner doesn’t want to move non-taxable IRA assets into a taxable entity. A SMLLC or revocable trust doesn’t file a tax return and pay entity level tax; all activity is reported inside the IRA anyway, effectively back to stage 1. (The corporations in Swanson had special tax status so they avoided tax in a different way.)

Margin interest triggers UBIT
Paying margin interest expense to a broker on securities purchased on margin overnight triggers UBIT in a retirement account. Basically, this means you owe regular taxes in your retirement plan related to unrelated business taxable income (UBTI). Margin interest expense opens that trap door. (UBIT is beyond the scope of this article.)

Do personal guarantees trigger UBIT or self-dealing? 
What happens when an individual needs to personally guarantee an IRA-Owned LLC or trust margin account? Brokers typically don’t open margin accounts without some kind of guarantee. In two advisory opinions, DOL indicated that personal guarantees may constitute a form of self-dealing. Can it also trigger UBIT? Probably not since it’s not actual “borrowing.” Bottom line, IRA-owned margin accounts for securities trading can lead to trouble.

Our problems with the Swanson court
I think the Swanson court didn’t show how his IRA-Owned SMLLC structure and related transactions benefited Swanson for the purposes of assessing self-dealing. It’s not the job of the court to raise issues that the IRS missed, only to address the questions before it.

As the owner of the C-Corp operating business, Swanson benefited personally by diverting and deferring taxable business income in his related-party-operating company to his IRA-Owned SMLLC. The transaction between his IRA-Owned SMLLC and operating business were probably not negotiated at arm’s length and the payments to the IRA through the SMLLC conduit could be deemed excessive IRA contributions subject to another excise tax.

The owner’s management services for the SMLLC were not pro-bono; he was compensated through other means like the taxable income diversion and deferral tactic discussed earlier. The Swanson court discusses the fiduciary owner not acting in his own interest, but I think he did act in his own interest. Certainly, enough to trigger the wider self-dealing rules, even if not the narrower non-fiduciary prohibited transaction rules.”

“Regular” prohibited transaction vs. fiduciary self-dealing
As noted, there are two types of prohibited transactions, those involving specific transactions “between” an IRA and a disqualified person, which I will call a “regular” prohibited transaction, and those involving fiduciary conflicts, including self-dealing. Certain “linear” family attribution rules (parent, child, grandchild, but not brother, sister, uncle and aunt) apply to regular prohibited transactions. (There are also attribution rules for corporate entities.) Regular prohibited transactions are subject to these linear attribution rules.

Conversely, self-dealing is not linear and is much wider in interpretation. Even if your LLC invests in a company in which you own less than 10% of the equity, while that’s less than the regular prohibited transaction threshold, it still can be viewed as self-dealing if there’s a conflict of interest and you are enriched in one role versus the IRA. Enrichment does not necessarily mean a direct transfer of money – any indirect benefit can involve self-dealing.

Too good to be true? 
If these too-good-to-be-true structures help you tax and business wise, it’s probably likely the IRS could argue self-dealing and maybe a regular prohibited transaction, too.

A different example: If your IRA lends money to your brother’s business, the IRS could argue self-dealing based on your conflict of interest as a family member and fiduciary role for your IRA. How is that loan really in the best interests of your IRA? It’s more about family generosity and planning.

Don’t rely on being lucky with IRS exams
Swanson got lucky in tax court, but the process cost him plenty. Attorneys argue Swanson doesn’t set proper precedent, yet too many IRA-alchemist vendors claim their solutions work because Swanson won in tax court.

Listen to an attorney in the know
Self-Directed IRA Myths (2009) written by respected employee-benefits attorney Richard Matta is excellent. You should also watch his 2012 video on the same subject. (Note 3.) (Mr. Matta will be a panelist in future Webinars and also reviewed this content*.)

Mr. Matta pulls no punches in criticizing the Swanson court: “Several of these concepts derive from Swanson v. Commissioner, 106 T.C. 76 (1996), cited by at least one IRA custodian as a “landmark” decision around which “an entire industry has been built” but which, in the opinion of the author, was much ado about nothing. The IRS raised the wrong arguments and failed to raise the right ones, and the tax court appears to have arrived at the “right” answer only by accident, via a nearly incomprehensible analysis … [O]ne key “holding” of the court was not a holding at all, and is also inconsistent with later authorities. Swanson is a weak foundation on which to rest a multi-billion dollar industry.”

Mr. Matta advises the banking and brokerage associations and financial institutions about these rules and it’s probably one reason why they won’t touch these structures with a 10-foot pole. The cottage industry selling these continues to fly under the radar.

So, just what can you do that does pass muster? 
While the above strategies raise as many questions as they promise to put to bed, there are other strategies you can pursue with IRAs and retirement plans that are on safer ground.

These strategies don’t generate UBIT, and they generally don’t trigger penalties for prohibited transactions or self-dealing:

• Take an “early withdrawal” subject to regular taxes, plus a 10% excise tax penalty on Form 5329 if you are under age 59 ½ in an IRA and age 55 in a qualified plan. There are some exceptions to the taxes and penalties. (Learn Required Minimum Distribution (RMD) rules which are beyond the scope of this content.)

• Trade your IRA in a cash account. There may be higher commissions and more restrictions but you can still actively trade the account in securities. You may have trouble opening a futures or forex account, and you can’t get lower Section 1256 60/40 tax rates on Section 1256 contracts through an IRA. Forex brokers face their own self-dealing issues in offering IRA accounts.

• Consider a Roth IRA conversion, especially in a year when you’re subject to lower marginal tax rates or have a large net operating loss (NOL) to soak up the Roth conversion income. Then trade your Roth IRA for life without new taxes being owed. Prohibited transaction rules apply to Roth IRAs, too.

• Set up a trading business with an Individual 401(k) plan. Rollover your IRA and other retirement assets to the Individual plan. Borrow up to $50,000 — but no more than 50% of plan assets — from this qualified plan to finance your taxable trading business or for any other personal use.

• “Rollovers as Business Start-Ups” (ROBS). Formed and operated in the right way, ROBS may pass muster with the IRS. “While some IRAs got closing letters from the IRS saying okay, there are critical open prohibited transaction questions that have not yet been resolved,” Matta says.

ROBS is structured as follows: You form a new C-Corp, then rollover retirement funds into a new C-Corp employee retirement plan account in your name, invest those retirement plan funds in your C-Corp stock, and then the C-Corp can operate or invest in a pass-through trading business. ROBS has many strict requirements, pros and cons, and related compliance costs. C-Corps have a lower tax rate (34%) than the Obama-era tax rates on upper-income taxpayers starting in 2013 (44% with Medicare taxes on unearned income included).

If the C-Corp just trades itself, watch out for personal service holding company rules. The C-Corp may be able to invest in a trading business LLC. Stay tuned as we look into it more.

ROBS seems to make more sense than some of the above self-directed IRA-Owned LLC or trust solutions. ROBS only allows a C-Corp, not a disregarded entity or pass-through entity like an LLC or trust. That means the C-Corp owes taxes on income and the IRA owns that value, too. A C-Corp paying taxes is sort of like UBIT taxes owed in the short term. Also, an ROBS structure involving an operating business can deduct salaries to lower the double tax hit.

Bottom line 
Don’t take everything on the Internet at face value. Dig deeper to read the fine print. Are these more aggressive IRA and retirement-plan schemes really worth it? You need an independent attorney to monitor the plan, structure, transactions and the law each year. That’s serious money and there are no cutting corners with these solutions and compliance. (Ask the promoter of the IRA scheme if they will pay the costs of defending an IRS audit, as well as any resulting adverse tax consequences.)

If you are talking about big bucks, engage an employee-benefits attorney experienced in this area. Skip the troublesome schemes, and follow the safe retirement plan strategies we lay out above.

Getting help
Consider a consultation with either Robert A. Green, CPA or employee-benefits attorney Louis Barr, who is of counsel to Green NFH, LLC. Mr. Barr helped with this content. For big-buck scenarios, we suggest you engage Richard Matta of Groom Law Group. I enjoyed working with Mr. Matta on this content and he is very impressive.

*Thanks to Richard Matta, employee-benefits attorney at Groom Law Group for his help with this blog. 


Close