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Don’t Pay Yourself a Salary out of your IRA LLC – Here’s Why

  |  By Kelly Rodriques

Anyone who has met me or read my prior blogs knows that I take a great interest in protecting investors from things that can irreparably harm their retirement portfolios. I’m always on the lookout for fraudulent or misleading claims about self-directed IRAs, so that I can spread the word to investors to be vigilant. And unfortunately, these claims are all too frequent.

One thing I see from time to time are internet ads that say something to the effect of “You can set up a limited liability company (LLC) in your IRA that will allow you to pay yourself a salary.” This one doesn’t quite pass my “if it sounds too good to be true, it probably is” test. Opening an LLC through your IRA is perfectly legal – in fact, doing so was established in the 1996 Tax Court case entitled Swanson versus the Commissioner (commonly referred to as the Swanson case). But paying yourself a salary from that LLC is another story.

In fact, a 2013 tax court case (Ellis v. Commissioner, Tax Court Memo 2013-245)ruled against taxpayers Terry L. Ellis and Sheila K. Ellis in this matter. The couple had established an LLC by purchasing a 98% interest in a used car startup, where the remaining 2% was held by an unrelated party. Again, this action is legal and in fact very common. Mr. Ellis then appointed himself the manager of the business, which was still okay – just as an IRA owner is the manager of their IRA, so can they manage an asset owned by their IRA. So what’s the problem with this scenario? The answer is nothing – until he decided to pay himself a salary in 2005 and 2006.

Before getting creative with your IRA, you should understand that the IRS and the Department of Labor are both adverse to any attempt by an individual to withdraw funds from his or her IRA before retirement. Their sentiments are well known in the tax courts as well. Over the years, there have been many attempts to work around the rules, designed by people trying to find a creative way to tap their IRAs without tax or penalty. All of these, when discovered, have essentially received unfavorable rulings.

In the case of Mr. Ellis, he attempted to rely on an exception to the rules regarding payments from IRAs to IRA owners. The argument was that the salary was not considered a prohibited transaction under the reasonable compensation exception (IRC § 4975 (d)(10)). However, the tax court ruled against him on the basis that the exemption applies to compensation paid from the IRA, whereas his salary was actual compensation from the LLC. For those of us who study the prohibited transaction rules, this was not a surprising outcome, as the courts will also get creative when they feel that individuals are violating the “intent” of the rules (see the Rollins tax court case).

The court found that Mr. Ellis engaged in the transfer of plan income or assets for his own benefit, which is in violation of the rule. They also found that he violated another rule (§ 4975 (c) (1) (e)) by dealing with income or assets of his IRA for his own interest or for his account. He could have created the business and hired unrelated persons to operate it, and have his IRA receive 98% of the benefits through dividends and capital gains, but basically he tried to have his cake and eat it, too.

This court ruling doesn’t bode well for the popular and well-advertised Rollovers as Business Startups (ROBS), which involves rolling over a corporate 401(k) to an individual Solo 401(k), and then forming a company for the purpose of creating a personal income. It would not be surprising to see future cases involving ROBS, as well.

Bottom line: the tax court said that it was fine that an IRA and a partner invested to form a new company, and for the IRA owner to manager that company. But for the IRA owner to pay himself a salary was essentially what they don’t want individuals to do – transfer their retirement assets, through a salary or otherwise, to themselves prior to retirement.

This Blog does not provide investment, tax, or legal advice nor does it evaluate, recommend or endorse any advisory firm or investment vehicle. Investments are not FDIC insured and are subject to risk, including the loss of principal.