A limited liability company (LLC) is a form of doing business. Unlike more common “C” and “S” corporations, investors or owners of LLCs are called members and not stockholders or partners (partnerships), and their investments are called membership interests and not shares (stock) or units (partnerships).
LLCs are rapidly gaining favor for the following important features:
1. They are pass-through entities like partnerships so that profits and losses pass-through the LLC untaxed to the underlying members who are then taxed at their appropriate tax rates;
2. They provide a “limit to liability” as no member is liable for the debts of the LLC and the member’s liability, therefore, is limited to the amount of their investment in the LLC;
3. LLCs have more flexibility than similar “S” corporations (e.g., LLCs can have two types of memberships unlike “S” corporations which can only have one type of stock). In addition, there some of the legal formalities (such as required meetings and minutes) that apply to “S” and “C” corporations do not apply to LLCs. However, although all 50 states have LLC structures, there currently is no uniform LLC legal definition, and it is therefore important to check the requirements for your state’s LLC structure;
4. Dividends are not taxed twice as with “C” corporations because there is no LLC tax;
5. With the exceptions of the District of Columbus and Massachusetts, there is not limit or minimum number of investors;
6. Unlike “S” corporations you can have individuals and other entities (INCLUDING an IRA!) as members;
7. They offer flexibility in the distribution of profits and losses unlike “C” corporations.
The first LLC agreement was created by the State of Wyoming in 1977, and when partnership tax status was granted by the IRS in 1988, all states created them. By 1998, LLCs were universal. They can be formed quickly and inexpensively, and are not taxed as entities in most states. It is important though to be sure that the operating agreement contain the language necessary for the LLC to receive pass- through tax status like a partnership, and for that reason alone, it should be formulated by an attorney familiar with state and federal law regarding LLCS.
Why would you want to form an LLC? When you are:
1. Concerned with tax liability should consider doing business as a limited liability company;
2. Interested in reducing otherwise legally required documentation of ongoing corporate activities such as minutes;
3. Desiring flexibility in the number and type of potential members including individuals, other corporations, trusts, pensions, IRAs, and foreigners.
How an LLC can work with your IRA For all of the above reasons, LLCs are becoming very popular as investment vehicles for people who have self-directed IRAs and want to obtain more flexibility and control with their IRA investments. In fact, there are entire businesses set up in the Untied States that are designed to help individuals establish and operate LLCs for their investments within self-directed IRAs. Frequently, these proprietors refer to the LLC’s ability to provide so-called “checkbook control” to the IRA investor. This is meant to describe the IRA investor’s ability to write a check from the LLC’s checkbook when buying investments within the LLC. This not only gives complete control to the investor, but eliminates the need to have to go through the IRA custodian for processing, which can result in unavoidable delays and extra costs.
Of course, there are some downsides, the most important of which is the potential to create a prohibited transaction. There are certain rules and regulations regarding IRA transactions that, if violated, can invalidate the IRA, resulting in taxes and penalties. Most IRA custodians are familiar with these rules and will inform their clients when they see them about to commit a violation. Although, by contract, a self- directed IRA owner is solely responsible for avoiding a prohibited transaction, custodians will try to offer their input if they see the potential for a prohibited transaction. When an investor, therefore, takes the transaction processing away from the custodian, through the creation and funding of an LLC, they are truly flying on their own. They would be advised to seek the counsel of a qualified attorney and CPA, who can assist them and help them to avoid potential problems.
Many investors using self-directed IRAs to purchase real estate, use LLCs to simplify their investing and to provide asset protection. For example, if an investor(s) is investing in a commercial or industrial property, they may want to protect their personal assets from lawsuits. The LLC protects its members from personal liability regardless of the type and magnitude of the suit. In terms of simplification, LLCs consisting of multiple members can appoint one member to process all of the required documentation associated with a real estate purchase as opposed to have a dozen or so handling the paperwork as would be the case if they invested directly into the property as co-tenants. As assets such as real estate are purchased they are acquired in the name of the LLC and not the IRA, just as if your IRA were a stockholder in IBM. The IRA IBM shareholder owns shares but does not participate in IBM’s business affairs, but shares in its success through stock appreciation and dividends, if any.
The same is true of the IRA that is a member in an LLC. It does not participate in the affairs of the LLC, once the initial funding is completed. Like the IRA that invests in IBM, it will share in the profits and losses of the LLC which are passed along to all the members.
Some of the issues that are particular to IRAs have to be known and understood by the LLC investor and/or their professional advisors.
First, an IRA cannot invest in an LLC in which the IRA owner and or any other “disqualified persons” already own 50% or more of. Disqualified persons include the IRA owner, the spouse of the IRA owners, the IRA owner’s descendants, ascendants and spouse of descendants. For example, if you and your wife and kids have an existing LLC in which you are the only owners (e.g., 100% ownership by disqualified persons), then your IRA cannot invest in that LLC. You could, however, create a new LLC and have both your IRA and the existing LLC invest in as members at the same time.
A new notice from the IRS issued in early 2004 called "2004-8", sets out guidelines related to avoiding a penalty associated with a prohibited transaction involving a Roth IRA. However, many attorneys will advise that similar triggering transactions involving traditional IRAs be avoided as well. Essentially, what 2004-8 says is that any Roth IRA owner that has a “controlling” interest in an entity (e.g., an LLC), has to avoid a transaction between that entity and any disqualified person. In addition, even if the IRA owner doesn’t have a “controlling” interest in the entity, certain transactions, that are not necessarily prohibited still have to be "listed" (e.g., filed) with the IRS. Failure to do so can result in a penalty of up to $100,000!.
For example, let’s assume that you and your Roth IRA each own a part of an entity or that just your Roth owns a part (in both cases, let’s assume the ownership interest is 15%). If you are the managing member or if the operating agreement or by-laws of the entity stipulate that you alone can make decisions (hence “control” the entity) for the entity and the entity conducts a transaction between itself and a disqualified person such as your wife, or another entity that you are an owner of, you could be considered creating a prohibited transaction (even though you are not violating the letter of the rules of any existing IRA prohibited transaction provision).
There is also a recent (November 2004) tax court case called the “Rollins” case, which contradicted previous case law when it ruled that a prohibited transaction was created when an entity that was owned partially (but not a “controlling” interest) by an IRA made a loan to another entity that was owned (33%) by the IRA owner! So, you can see that this area of the IRS rules and regulations is changing and current knowledge is necessary if an LLC's transactions involve anyone but third parties in relation to the IRA owner.
In summary, an LLC can be a good way to take control of your IRA investing, but remember, they are not a license to ignore the rules. Be sure to maintain a current knowledge of the rules to include a competent attorney or accountant on your team to help you avoid the taxman.
