What is a Checkbook IRA: Prohibited Transactions to Avoid
John Hyre: Let me talk about prohibited transactions. What’s a prohibited transaction? It’s important to know what they are because we have to avoid them at all costs. I can’t give you all of them right now. They’re too many. During my two-day, I spend six hours on it. We go through it top to bottom in great detail to the point where the blood comes out of the ears. Let me give you the ones that are most common for real estate.
We talked about, your IRA cannot do business with related parties. We talked about family being related parties and it’s direct or indirect. Family members own a company, an LLC, a corporation, whatever, that’s still family. The fact that you’ve interposed an entity does not magically change things. That’s the direct prohibited transactions. There are two I really want to focus on. One, you cannot provide a service to your IRA. If you provide a service to your IRA, it dies. Well, what if I do it for free, John?
The code doesn’t say, “If you pay yourself or if you don’t pay yourself, it’s okay.” In fact, here’s what the case law’s been. If you pay yourself for a service, the IRA dies immediately, no questions asked, black and white law, 100% guaranteed result. If you don’t pay yourself for services, what happens? We don’t know.
The IRS is not there yet. I am ahead of them. What I’m telling you, they haven’t figured out yet. They’re going to. They’re learning. They are adapting, but they have not yet caught on to the services issue. Let’s say you have an IRA and you performed a service, should you go home and cry? No, fix it before they figure it out. There’s typically six-year statute of limitations. Fix it before they get wise. It may not be a prohibited transaction, I’m just saying be conservative. If it could be one, fixed it.
What’s a service? They don’t tell us. It’s undefined. Here’s what we know, if you have a service in anything but a 401k, the account dies and a 401k it’s penalized, but they won’t tell you what’s a service. Eventually, the courts will tell us. When the IRS lawyers get smart enough to ask this question and start making these cases happen, we’ll start getting some guidance. That’ll be a few years. I want you thinking, “Is what I’m doing possibly a service? I’m going to ask you three questions, bear with me an answer. Now, I get to ask you questions.
What is your favorite color? No just kidding. Could managing a rental on behalf of your IRA be viewed as a service?
John: How about if you’re only managing the tenants? You don’t swing a hammer, you’re just negotiating leases and taking phone calls from tenants, could that be a service?
John: It could be. I don’t know if it will be, but it could be. Is managing a flip, a rehab- is managing the rehab itself, could that be a service?
John: General contractors do that. That could be a service. Could managing an LLC, the so-called checkbook LLC, could that be a service managing it yourself? Could be, and there are a lot of people selling those. For me, I don’t even like to call– I do set up a lot of IRA owned LLCs and I don’t like to call it checkbook LLCs because in my mind that’s now a pejorative. There are a lot of people out there that will sell you a template and that’s like giving a 12-year-old pyromaniac a flamethrower, the car keys, a lighter, sending them to the gas station. You know what’s going to happen.
They give you this LLC and say you’re the manager and they don’t train you how to use it and you immediately begin committing prohibited transactions because you were told you could manage it and you manage it, but they didn’t tell you what that means. Most of these people who sell templates on the internet, some of them aren’t even lawyers. There’s a couple of them out of Oregon that sell a lot. They’re not even lawyers.
Most of the lawyers that sell it are tax lawyers. Most of the tax lawyers lack something I have. I have now been in three IRA audits. One of them still ongoing. Two of them I took to Tax Court and won. I don’t know anybody, and I network in this industry. I don’t know anybody who’s had a single case, much less two, much less took them to Tax Court, much less won. I got some insight watching how those people work and if I have time, I’ll discuss what I’m seeing.
I’ll tell you one thing I know. I talked to the auditor, I used his ego against him. Again, you see, on auditors, it’s a negotiation. It’s reading the personality and playing. Having a big ego around me is dangerous. Mine’s not big, it’s solid. I know what I know and I know what I don’t know and I’ll happily admit what it is I don’t know and it’s a vast field, but I do know what I know. This agent made the mistake of having a big ego. What did I do? We had a big issue in the audit and we had a little issue.
On the little issue, I told him, “I own you. I know this issue. You can’t touch me. I’m the master blaster, you’re nothing.” I didn’t say it quite that way. I strongly implied it. Oh, that little kitten had his ball of yarn and set out to prove me wrong on the little issue. We won. He talked a lot in order to prove how much he knew because he had a chip on his shoulder about me being a lawyer. He’s used to an audit dealing with other accountants and the fact that I was a lawyer, he felt he had something to prove. That’s a weakness. That is showing me a flank. That is in the boxing ring, turning and going like this. “Oh, thank you.”
He showed me that he wanted really badly to impress me so I asked him a ton of questions about internal procedure. Who are they auditing? What are they auditing? What are they looking for and he wanted to show off and I got a lot of things he should not have told me. He told me, for example, on his desk, he had a stack of checkbook LLCs and I played dumb. You’ve got a guy with an ego, so I immediately went into, “Oh, you teach grasshopper.”
“Wow, what’s a checkbook LLC?” He told me. He said, “It’s an LLC owned by an IRA that the people run themselves.” I say, “You’re looking at that?” He says, “Yes, we’re auditing tons of them.” I said, “Well, what if there was a different manager? What if the guy wasn’t self-managing it?” He says, “Well, I don’t know if that’s okay or not, but we’re just not really looking at that.” “Oh.”
What did I say about giving the man what he wants to see? Give the man- if at all possible without harming yourself, give the man what he wants to see. When we use IRA owned LLCs, I prefer that you not be the manager. I prefer that I’m another party and it has to be a non disqualified person. Not your ancestors, not your descendants, not your spouse, et cetera. I prefer that someone else run it. A friend who’s in the real estate that you trust is perfect. Have someone else run it. Now, that’s a pain. I’ll come back. I recommend that you have a separate manager for the LLC. Is that a pain? Yes.
When you go to an auction to bid on properties, they need to be with you. If you have a closing, they need to sign papers, which is easy to do. Any more, you can do closings via FedEx. You have them write the checks. I don’t want it to even look like it could possibly be a service involved. That’s what’s the ideal. I prefer that, but it comes with a price, just like it comes with a price to have to have a separate property manager. I don’t want you managing the property. Now, for most of you, you’re already in that position anyway. The nature of this group and the nature of how you invest, a lot of you were probably highering locally, invest out of state, you couldn’t manage them anyway. That’s good. You’re already used to a certain amount of management. I like that.
Often times, I can talk the property manager into being the LLC manager. Often times, not always because there is some liability, but I tell them, “Look, you already have a fiduciary duty to the client because in most states, where your property manager, you’re licensed as a real estate agent, you already have a duty.” We’re not really adding to that duty. The managing of this LLC is probably going to take six to eight hours a year. I recommend you pay them 30 to 50 bucks. I do recommend you pay them. The IRS is presently making an argument that if you have an unpaid manager, they are effectively your cat’s paw. They haven’t won that argument. They declined to take that to court with me because I said, “Let’s go.” I’ll talk about that audit here in a minute.
On checkbook LLCs– I hate to use that term. How about IRA owned LLCs? When do they make sense? You shouldn’t automatically have one. I can think of three situations where they make sense because I’m an Occam’s razor guy. Give me equal answers to the question, I’ll take the simple one every time. Less moving parts, less complexity, less cost, every time, which is unusual for a lawyer. Lawyers often times like to complicate things. That’s because I’m not a normal lawyer. A lot of lawyers are political science majors who couldn’t get a job and went to law school. They have no understanding of economics. None.
Do you need an LLC? That’s the first question. I’ve had people walk into my office and say, “I’m ready to pay you 2500 bucks,” which is what I normally charge for one of those LLCs, an IRA owned LLC, “and we’re ready to pay you,” and I charged them $300 to talk them out of it. Why? It was the right thing to do. It’ll pay off. It’ll come back. When does it make sense? A, as I mentioned, asset protection if you’re investing, for example, in rentals and especially the lower income the rental, the more liability. It’s the nature of low-income people. “Oh, that’s so non-PC.”
Well, try this one on for size. If you’re poor for more than two years in the United States, you deserve it. I got no sympathy for you, none. I tell you from experience having been there and dealt with these guys. What you read in the paper and what the college people tell you, they have no clue. Let them take their money, not the government’s money, not the bank’s money, assuming you can tell the difference anymore and go invest in those properties and you come back and tell me about the noble poor. They’re higher liability. They do dumb things. They’re litigious. They view the legal system as a lottery where you don’t have to pay a dollar. The lower income level are the rentals, the more need for asset protection.
Does everything need asset protection? How about you lend out of your IRA, how much liability is there when you’re the lender? Bloody little. I mean, what do people trip and fall on a note?
The second reason that when an LLC for the IRA makes sense, you need money on the spot. This is the checkbook feature. You go to an auction and the money- the deposit has to be there, right then and there. You don’t have time to ask the custodian to forward the money. That makes sense. When you need a check written, I prefer you have a separate manager to write checks. Now, can you be the manager? Sure, I would have to train you.
First of all, I would say, if you’re the manager of the LLC, what did I say the IRS is looking for? Self-managed IRS– Sorry. Self-managed LLCs, whether or not you’re paid. If you pay, you blow it. If you pay yourself to do a service in the IRA, you almost certainly killed the IRA. The IRS is looking for self-managed LLC’s. They’re not looking at LLC’s managed by others in the IRA. Give them what they want to see. If you’re going to self-manage, don’t cross the line into services. Pretty much, all you should do is write checks and let someone else do everything else. You don’t do anything else. You don’t cross the line in the services. Even then, the document should be carefully and well drafted.
I guess, in theory, you could write the checks out of the LLC. What’s another advantage of a solo 401k? In a solo 401k, they’re a little different than IRAs. You don’t have to have a custodian. You can be the trustee, which is functionally the equivalent of a custodian. In a 401k solo, you can be the trustee/custodian. You can legitimately write checks out of a solo 401k. It’s just the difference between 401ks and IRAs. Now, the question is, should you? What are you good at? Are you good at details? Are you good at being on time? Are you good at book learning types of things? Because there are different types of investors.
Some of you are brilliant negotiators, great at making deals and couldn’t do paperwork to save your children’s lives. You should not be the trustee of a 401k. You have to know yourself and be honest with yourself as to how good a job are you going to do. I like that feature the 401ks. I can directly self-manage it in terms of not providing a service. I still can’t do that, but I can be the trustee who writes the checks. That takes out the need to have someone else write them.
What’s the third reason to have an IRA owned LLC? Scale. It becomes expensive to run things through a custodian, if you’re using a custodian, if it’s small numerous transactions. Small numerous transactions that the custodian charges for each one can be inefficient in terms of both time it takes and the money you pay to the custodian. A great example would be tax lien certificates. You invest in tax lien certificates, typically, I’ve seen IRAs that buy 300 or 400 of those a year and they’re about $2,000 each. Now, do you really want to be hit with a transaction fee each time you do it? No. It would make sense to set up an LLC and run it everything through there.
I’ve seen it with rehabs, where it’s inefficient to pay Lowe’s or Home Depot or whomever through the IRA. There’re just issues with it. It might be more efficient to set up an LLC and have a regular account with them, et cetera, et cetera. Those are some instances where an IRA owned LLC makes sense. If you don’t fall in that category, I would want to know why do you want to set one up? What are you going to get out of it? Why would you create complexity maybe of an answer I haven’t heard? What’s the reason? I wouldn’t do it just because someone said to do it.