Your Self-Directed IRA: Is the Checkbook LLC a “Magic Wand”?
Checkbook LLCs (also known as checkbook IRAs) are often presented as the answer to all self-directed IRA investing. Oftentimes they are presented as having a “magic wand” with the implication that an IRA administrator simply gives you a “checkbook” for you to make all the IRA investments you choose.
Although I appreciate the appeal of controlling your retirement investment funds, there’s a lot of hype surrounding checkbook LLCs and not enough information about prohibited transactions (the fines for which can actually end up costing you more than your original transaction). In this article, we separate the hype from reality to help you determine when it makes sense to use this investment tool.
What is a Checkbook LLC?
To begin, let’s clarify what the term checkbook LLC signifies. Self-directed IRAs allow you to make investments beyond the typical stocks, bonds, mutual funds, money markets, and CDs. Individuals with a self-directed IRA have more freedom to invest in real estate, private notes, PPMs, private equities, and other non-traditional assets.
Additionally, the self-directed IRA can invest in either an existing or newly formed LLC.
The self-directed IRA becomes a “member” of the LLC by purchasing a portion of the LLC’s shares. The IRA cash investment to purchase the shares goes into the LLC’s corporate checking account at whichever bank holds the LLC corporate accounts. The LLC Managing Member now makes all investment and cash deployment decisions for the LLC.
If you are also the Managing Member of the LLC, then you have “checkbook control” of the IRA investments.
Do LLCs Make Sense for IRA Investing?
To explain this concept in further detail, we’ll use an example from a client we helped with a real estate investment. For the purposes of this article, we’ll refer to this client as Adam K. Adam K was interested in making a real estate purchase through his self-directed IRA and needed help determining whether using an LLC to house the investment made sense.
During his commute, Adam kept his eye on a run-down 3-flat that did eventually go into foreclosure. He contacted the bank that owned the property and received the operating financials. In two weeks, the deal was inked as a cash purchase and was also marked down for the quick sale. After reviewing his renovation costs and projected net rent and profit, Adam was undecided as to whether he should rehab the building, re-rent to market and then sell, or hold it for cash flow.
Adam also thought this investment might be a good fit for his IRA, which he needed to roll over from his old company 401k where he worked prior to stepping back into the family business. He found a quick download on self-directed IRAs, but frankly, he found the information confusing. Particularly overwhelming were the IRS prohibited guidelines and transactions.
Adam and I spoke and covered a range of options for this deal, including the possibility of using a “checkbook” IRA to house the investment. The following is a summary of the pivotal points we covered in determining the structure option that made the most sense for his situation.
1. What what his investment strategy and long-term plan for this investment?
Adam planned on owning two to three rental properties in the next five years but did not intend to purchase and rehab properties full time. After making repairs and bringing the rent up to market pricing, he determined the net cash flow from the building would generate a 14.00% return on his investment.
Since he was comfortable with his manufacturing company’s financial future (it was able to provide him and his family with the lifestyle they desired), he decided to make the investment with his self-directed IRA. The 14.00% return was far above mutual fund or money market returns.
The next step was to do a simple numbers analysis to see if the LLC option made more sense than owning the property directly in his IRA.
2: Do the annual expenses of an IRA-owned LLC make financial sense?
We looked at the upfront and annual maintenance costs of setting up an LLC in his specific region. We determined the following:
State LLC registration: $650.00
Annual renewal: $650.00 (paid every year the LLC is open)
Attorney fees for preparing registration and Operating Agreement: $1250.00
Accountant fee: $2500.00 annually to prepare federal and state tax return filings for the LLC (paid every year the LLC is open)
Altogether, the upfront costs to establish this LLC added up to $4,400 and would cost $3,150 every year after. Because Adam didn’t intend to invest in real estate full-time, those numbers did not make sense for Adam’s situation, as they would erase a significant portion of his annual rental profit.
Adam opted to hold the property directly in his self-directed IRA without the LLC, pushing all expenses directly through the IRA. Later, when the 3-flat was fully rehabbed and rented, he had the tenants drop off the rent checks to him even though they were made out to the IRA. In this way, he alleviated his concern about timely rent payments.
Are There Times When It Makes Sense to Use an IRA LLC?
The answer is absolutely yes. In Adam’s situation, using an LLC for this investment did not make good financial sense because he only planned on making one or two investments with his self-directed IRA.
But IRA-owned LLCs do have their place in real estate investing. If Adam did not have sufficient funds in his IRA to purchase the property, rehab it, and pay operating expenses and taxes until it was fully rented, we may have considered an LLC.
To offset the lack of IRA cash, Adam would have needed to use personal funds to purchase and rehab the 3-flat. If he used personal funds, he would also be creating personal legal exposure. One of the best ways to mitigate personal exposure is to make his contribution through an LLC, which limits liability to only the assets held by the LLC and not his personal assets.
(In terms of IRA liability, it is very difficult for anyone to seize your IRA unless it is a federal or state taxing authority or part of a divorce settlement. Consult your attorney for further clarification.)
How Does the IRS View Checkbook LLCs?
Using an LLC conduit may also be useful for investors who plan to make several high-level investments using their self-directed IRAs. For those investors, there is another equally heavy concern to weigh in on: How does the IRS view checkbook LLCs?
The simple answer? With caution.
With a checkbook LLC, you as the Managing Member become responsible for any and all state and federal regulatory compliance, in addition to the annual recurring fees for state renewals and services from attorneys and accountants for annual compliance reporting.
Your responsibilities as Managing Member of your LLC include knowing the IRS guidelines on all prohibited transactions, which is no easy feat. In extreme situations, I have even run into a prospective client who did not understand that they were responsible for filing annual LLC federal and state tax returns for their checkbook LLC.
This potential for abuse is one of the reasons the IRS pays close attention to checkbook LLCs and their tax returns.
The following questions and answers may help clarify the scope of IRS guidelines you would be on the hook for if you mismanage your checkbook LLC.
How is the LLC structured? Who are the members?
Simply put…just like any other LLC. There are Members and Managing Member(s). In almost all cases, you personally will be the Managing Member regardless of the amount of your personal contribution. This is because the IRA Administrator never wants to be placed in the position of having to make decisions for your LLC’s investments.
Does the percentage of shares owned by the IRA in the LLC have to equal the amount of the contribution?
Oddly enough… no! In theory, the Managing Member (you) can own 51% of the shares of the LLC even if the IRA initial contribution represents the bulk of the operating cash when the LLC is first capitalized.
This concept of issued shares and capitalization at a later date is a handy tool when it comes to real estate rehab investing. Inevitably, most rehab projects have unexpected costs and expenses. It is helpful to be able to place additional personal or IRA funds into the LLC to meet those expenses as they come up.
Is the LLC membership restricted to myself and my IRA?
No. Think of the LLC as a “mix & match” candy bag at the movie counter. Your 401(k), your spouse, their IRA, other non-family partners, other non-family partners’ IRA/401(k), and more can all be members of the LLC. Just remember that when you are involving family members, they have to be part of the initial formation of the LLC. They cannot be added after the LLC is established.
Do all self-directed IRA/401(k) guidelines apply to the LLC?
Yes. As, as noted earlier, as Managing Member you have to wear the same hat I do as your administrator. Investments have to be “arms-length.” You cannot purchase a property you already personally own.
And those are just a few of the eccentric self-directed IRA/401(k) guidelines from the IRS and Department of Labor.
One of the most important responsibilities of your self-directed IRA administrator is to help you remain in compliance with the IRS. Every day we review the expenses our clients submit to be paid from their self-directed IRAs. We act as your compliance officer to make certain expenses match receipts and are not being paid to prohibited third parties.
Get in Touch
I always advise my clients to call for any clarification. If you have more questions about your self-directed IRA or checkbook LLCs after reading this article, I just may be able to help you as well. To see how I can help, please contact us directly by calling 312-869-9394 or emailing steve@ctasira.com to schedule a free 20-minute consultation call.