Does My IRA Need to Form a Company (i.e. LLC) to Purchase Assets?

Does My IRA Need to FOrm a Company to Purhcase Assets

The one investment type that has remained constant among our clients over the years is LLC investments. An LLC is a legal organization that provides the tax advantages of a partnership while limiting the legal liability of the individual partners in the same way a corporation does. LLCs are considered securities in some states and may be required to meet the standards of securities offerings.

The majority of our clients do not form a company (i.e. LLC) when they invest their IRA funds. 90% of the transactions that Midland Trust handles are straight purchases directly from the IRA. That is to say that the IRA account purchases the asset in the name of the administrator (Midland Trust, LLC FBO Client Name, Client Acct #).

Sometimes, however, an LLC can be a great choice for control of the IRA, especially when there are multiple business partners. We will discuss the advantages and disadvantages below.

As stated before, the majority of our assets are purchased directly in the name of the administrator. This is usually the case for split ownership among close family or friends. For example, we have closed properties in the following two manners many times.

1. Midland Trust FBO John Smith, IRA #12345 as an undivided 75% interest and Midland Trust FBO Linda Smith, IRA #54321 as an undivided 25% interest

  • In this example, John IRA and his spouse’s IRA purchased a piece of real estate as “tenants-in-common”. In other words, there are two owners to the property on the deed…John’s IRA and Linda’s IRA. All income or expenses for the property are to be split 75/25.

2. AdvantaIRA Trust, LLC FBO John Smith, IRA #12345 as an undivided 50% interest and John and Linda Smith as an undivided 50% interest.

  • In this example, John’s IRA is buying half of the property while John and his wife are buying the other half personally. All income and expenses will be split 50/50. The IRA gains (i.e. rent/sale income) are not subject to taxation. The personal gains are subject to taxation (unless the individual does a 1031 exchange. Ask AdvantaIRA Trust for more information about 1031 exchanges).

Why form an LLC?

Many times, we have clients that want to invest their IRA in private placements. These are investments where their money is pooled with other investors. For example, ten investors are pooling their funds for a certain real estate investment project. When the project is complete, they plan on leasing the units to future tenants. If this asset was purchased as “tenants-in-common” as the examples above, is the group really comfortable having the tenants write ten different rental checks to ten different owners? Absolutely not! In this case, an LLC is typically a good idea. The LLC can operate its business and then subsequently pay off each investor (some of which could be Midland accounts).

As far as how the LLC is set up, we typically see two methods.

  1. The IRA accounts and other individuals are listed as members (owners) of the LLC. There is an operating agreement which dictates who is the “managing member” of the LLC and who is a financial “member”. (Please contact Midland Trust if you want to be the managing member of your IRA owned LLC. There are some rules you should be aware of). The role of the managing member is to act on behalf of the LLC and eventually pay any gains to each of the members (some of which might be Midland’s).
  2. Equity position. In this case, the LLC is set up already with members already existing on the operating agreement. Instead of altering membership list of the operating agreement every time a new investor is found, the LLC will simply offer private stock in the company. For example, at $50,000 per share. The investor would then fill out a “subscription agreement” where they “subscribe” to x number of shares. As the company runs its business, eventually, profits are returned to the subscribers (shareholders), some of which could be Midland accounts. Again, IRA gains are non-taxable.

A couple of things to consider when using your IRA to invest in LLCs:

  1. Generally speaking, the IRA holder and his/her lineal descendants cannot be the managing member of the Corporation. This is because the IRS does not want you to personally have access to your IRA funds. There is a possible exception for “single member” LLCs. Again, contact Midland Trust for more information on single member LLCs with checkbook control.
  2. Your IRA cannot invest in a corporation that you (or lineal descendants) personally already have more than a 50% interest in and/or are considered a director/officer/highly compensated employee. This would be considered “self-dealing”. A good way to avoid self dealing is to set up a newly formed Corporation, in which case you and your IRA can partner together with no restrictions on percentages of interest.

Purchasing non-traditional assets with a Self-Directed IRA can help you diversify your retirement portfolio, which may guard against economic changes. An LLC investment is just one of the many options available with your Self-Directed Retirement Account. If you are interested in self directed investing with the funds in your retirement account, feel free to contact Midland or open an account today.