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 (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.