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Checkbook Control for Self-Directed IRAs:

What Does It Really Mean and Can Your Client Handle It?

• By Tom Anderson
• PENSCO Trust Company
• CEO & Founder
• San Francisco, CA

The self-directed IRA industry is booming, and with any new wave, there are some swells. One of those that is surfacing is the use of LLCs as a vehicle to conduct investments within self-directed IRAs. There is a lot of talk about this approach (more frequently referred to as “checkbook control”) out there in cyberspace. In fact, to help clients understand the term, we at PENSCO Trust have information on our web site (www.penscotrust.com) that details the related responsibilities of custodians, and I have a blog entry that discusses checkbook control (selfdirectedira.com). I will address the issue in more detail, but understand that at the most fundamental level, tax laws require that IRA assets be held by an approved IRA custodian or trustee and there is regulatory concern that the use of an LLC, managed by the IRA owner, circumvents this requirement.

This article will attempt to present some of the issues to keep in mind when contemplating the use of an LLC to invest IRA assets. I believe it is important that advisors have some knowledge on this topic, in the event that one of their clients asks the question "What do you know about… ?" For example, here is a comment from an attendee at a recent PENSCO Trust educational event that is representative of the type of question we receive on the topic:

"The seminar was very educational. I am convinced that I need to start my own self-directed IRA. The part I am confused about is what custodians do and whether it makes a difference if I have my own checkbook or not. From the seminar, it seems it is more responsibility for me to have my own checkbook, but I could not quite figure out what is entailed. Would you explain it to me? Or better yet, do you have some kind of chart that would help me compare?"

First, let me address the role of the custodian. An IRA custodian is like a “back office” for an IRA. Custodians keep the IRA plan in compliance with Federal regulations, perform all the necessary reporting to the client and the IRS (including tax reporting), execute transactions at the client’s direction, maintain all the records and documents associated with such instructions, and hold any negotiable documents associated with them as well. In addition, here is a link that provides information to help an investor choose a custodian: http://www.penscotrust.com/education/gettingStarted/chooseIRAcustodian.aspx

Next, I’ll address the second part of the question by providing an overview on LLCs. An LLC is a Limited Liability Company. When one runs a company, there are certain responsibilities, which vary by state. In most cases, the general responsibilities are to pay an annual franchise tax, file K-1 reports (a CPA should be hired to do this for multiple member LLCs), maintain books and records, bank accounts etc., particularly when the IRA is the sole member of the LLC. That’s because there is the potential for a prohibited transaction if one doesn’t do things correctly, which can invalidate the IRA, resulting in taxes and, if the client is under age 59 ½, potential penalties. An example of a prohibited transaction would be self-dealing to the extent that the client is gaining a personal benefit as a by-product of his IRA’s investment (e.g., taking a commission or charging a fee to his IRA).

That being said, there are ways that LLCs can serve as valuable vehicles to facilitate certain IRA investment scenarios. First, if there are multiple investors going into a single real estate deal, for example, the LLC can facilitate the acquisition and disposition of assets by allowing a single member (e.g., the managing member) to sign all documents for the other members. Alternatively, if there are multiple investors going in on an undivided property as co-tenants (e.g., without an LLC), then they all need to sign at the closing, which could prove to be impractical (e.g., a member is traveling) or tedious. Another attribute of an LLC or 'C' corporation structure is that both provide an element of asset protection by virtue of the fact that creditors/plaintiffs can't pierce the "corporate veil" of the entity in most cases. This means that the most an investor can lose is his stake in the LLC, not his personal assets or any remaining assets in his IRA(s). On the other hand, one can accomplish the same thing by dividing up the IRA into multiple IRAs and using a separate IRA for each high-risk investment. Finally, certain types of investments are better facilitated by the use of an LLC. An example would be the purchase of tax liens, the mechanics of which frequently require the investor to personally appear at the auction with a cashier’s check for the tax lien(s) of his interest. A custodian cannot issue a cashier’s check to the IRA owner, allowing him to consummate the transaction. However, the managing member of an IRA-owned LLC can issue a cashier’s check from the LLC’s bank account to accomplish a tax lien purchase.

The attribute that is touted most frequently by promoters of the use of LLCs for IRA investing is "checkbook control"; that is, the ability of the managing member (which may be the IRA owner if the IRA owner's IRA is the only member or 'C' corporation stockholder) to write checks directly to fund investment purchases, without having to go through the IRA custodian. While it is very true that this is possible (it is not illegal), it is also a cause for concern among custodians, IRA regulators, and many of those professionals serving investors who have employed the "checkbook control" approach. Why? Because some feel that there is significant risk of the IRA owner(s) creating prohibited transactions, or that IRA assets will not be properly tracked through the "checkbook control" mechanism. In fact, some regulators have indicated that they do not want the firms they regulate to accept IRA owner-only or IRA family member owned-only LLCs! There is even the potential risk that such LLCs will no longer be accepted by the self-directed industry, due to the concerns of the regulators.

In my opinion, “checkbook control” tends to be oversold by companies and facilitators that are not custodians and whose primary or sole business is to establish LLCs for people, charging fees ranging from $2,000 (plus annual maintenance fees) to $10,000. There is even a company that I understand charges clients $2,000 on top of custodian fees and the LLC establishment fees, simply to handle the “checkbook”. To me, that’s sort of like having a teenager pay his parents to drive him around on a date. Because of all the opportunities available to investors with self-directed IRAs, and the resulting surge of public interest in the concept of self-direction, many companies are trying to get in on the industry, including those advocating and selling LLC formations. Therefore, tell your clients to fully consider all the aspects and entailed responsibilities, as well as these (approximate) costs below, when deciding whether to form an LLC:

Those who advocate “checkbook control” will say that the client will be free from the custodian and, therefore, able to do whatever he wants. Well, at PENSCO Trust, and at most custodians, that isn’t quite true. Your client can do anything legal with us, and unless he wants use an LLC to do something in conflict with the regulations governing IRAs, there is no marginal advantage to using an LLC, other than the nominal reduction of transaction fees associated with having us perform the transactions directly and hold the assets. For example, we currently charge $100 per real estate purchase or sale. Thus, unless the client is buying and selling 20 times a year, he will not save any money with the LLC structure(and that’s just considering the cost to establish it). In addition, when we perform the transactions, we maintain all the records, and the client can contact us when he has any questions about potential prohibited transactions for no additional charge. Furthermore, even if your client doesn’t ask us about a prohibited transaction, if he asks us to do something that we believe may be a prohibited transaction, we will let him know.

Our ongoing, in-house training program keeps our staff highly knowledgeable about the details of self-directed IRAs, and we share our knowledge as part of our service at no additional cost to the client or his advisor. We have thousands of clients who have used LLCs as a vehicle, and thousands who haven’t. In conclusion, unless your client is involving a lot of investors together on a deal, is doing dozens of transactions per year (which your client would have to execute and keep track of), or needs some unusual level of asset protection, there is probably no need for the extra layer and cost of an LLC. And if they do decide to use an LLC, make sure that they are aware that they will need to learn all the intricacies of prohibited transactions and be responsible for the administrative work associated with running a legitimate company.