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Using Self-Directed IRAs to Invest in a Closely Held Business, Other Unique Assets

Self-directed Individual Retirement Accounts ("IRAs") offer an individual the ability to invest his or her retirement funds in nontraditional assets such as a privately held business, real estate, intellectual property and precious metals.  A self-directed IRA can also provide a sometimes overlooked source of liquidity to pursue such unique investment opportunities where cash and traditional financing methods are limited or unavailable.

Many companies promote self-directed IRAs as simple, easy-to-use vehicles that are superior to traditional IRAs.  However, because self-directed IRAs are funded with pre-tax dollars, there are stringent rules that must be followed in their operation.  Failure to follow these rules can result in severe tax consequences.  The added flexibility that permits self-directed IRAs to invest in assets other than marketable securities creates additional opportunities to run afoul of these rules.

Self-Directed IRAs Generally

In many ways, a self-directed IRA is not any different from a traditional IRA or other retirement accounts.  The Internal Revenue Code (the "Code") requires that a qualified custodian hold the IRA assets on behalf of the individual account owner.  The custodian remains responsible for recordkeeping, issuing client statements and other general administrative duties.  Like other retirement accounts, a self-directed IRA is subject to annual contribution limits and it is prohibited from investing in certain assets, such as life insurance, collectible and tangible personal property.

Where a self-directed IRA differs from other retirement accounts is in the ability of the account owner to direct the IRA custodian to invest in nontraditional investments.  Each custodian will have its own limits regarding the type of nontraditional investments available to the self-directed IRAs it administers, but investments in real estate and privately held companies are extremely common.

Prohibited Transactions

While self-directed IRAs are appealing on the surface, there are significant risks associated with engaging in what are known as "Prohibited Transactions."  Common examples include:  personally using assets owned by your IRA; purchasing property for the IRA from you or a related party; selling property from the IRA to you or a related party; paying for expenses of the IRA with personal funds; loaning funds to, or personally guaranteeing loans for, the IRA; making improvements or repairs to property owned by the IRA; and, receiving compensation for managing the IRA.

Depending on the circumstances, a Prohibited Transaction may result in excess contribution penalties, accuracy-related penalties, or even worse, termination of qualified tax status.  Consider this example:  Your self-directed IRA owns rental real estate o Florida's gulf coast.  In January, you make the permitted $5,500 contribution to the IRA.  That same year, you cause certain repairs to be made to the property, which you pay for out of your personal funds (not the IRA).  You have now made an excess contribution to the IRA in the amount of the repairs.  This same treatment may apply even if you made the repairs yourself because the value of the services provided also can be considered an excess contribution.  Excess contributions that are not withdrawn in the same year are subject to a six percent excise tax for each year uncorrected.

Further, if the next year you and your family spend a week at the rental real estate vacationing - using the property for personal purposes - you have engaged in a "Prohibited Transaction" and your self-directed IRA may no longer be recognized as a qualified account under the Code.  As a result the entire value of the self-directed IRA would immediately be subject to tax, plus an additional 10-percent penalty if you are under age 59 1/2.

Conclusion

Self-directed IRAs can be a great retirement planning tool, but they are not without significant pitfalls.  Careful planning must be undertaken to avoid the severe tax consequences that await the unwary.

For more information, contact Mike Thomas at MacDonald, Illig, Jones & Britton LLP at 814/870-7711 or mthomas@mijb.com.