Investing Using Business Structures in a Self-Directed IRA
On the PENSCO blog, we’ve highlighted an array of unique investments that you can hold in a self-directed IRA, such as public and private REITs, glamping hotels and real estate tech. After all, the power of a self-directed IRA is that it lets you invest beyond exchange-traded assets, and our clients are just as likely to invest off the beaten path as they are to pursue a more straightforward investment, such as a rental property.
While some clients choose to invest directly in these opportunities with IRA funds, others access them by investing through a business structure, such as a Limited Partnerships (LP), a C Corporation (C corp) or a Limited Liability Company (LLC).
I thought our readers would find it helpful to explain these three entities along with their similarities and differences so I talked with Frank Bridges, founding attorney at Heritage Design Law LLC. Frank specializes in providing services to retirement savers who use their IRA funds to make private investments.
Christopher Orr: What is a Limited Partnership (LP)?
Frank Bridges: LPs have one or more general partners (GP) and one or more limited partners. GPs manage the entity and have full liability for any partnership obligations, while limited partners, as the name suggests, have no input into the management of the partnership’s business, but no liability for partnership obligations outside of their investment in the entity. This makes LP investments an attractive option for passive investors because they have no personal liability or responsibility for maintaining the entity, but they receive a share of the partnership’s profits.
Another advantage of an LP is that a limited partner’s ownership interest in the partnership can’t be taken to satisfy a judgment in favor of the partner’s creditors. All the creditor can get is a “charging order,” which requires the partnership to distribute the limited partner’s share of the profits – if the partnership decides to distribute them at all; but the creditor can’t become a limited partner with the same rights as other limited partners. Unlike corporate stock, which can be seized and voted by a stockholder’s judgement creditor, LPs protect partnership assets from any litigation personally pertaining to a partner. For investors who want to protect their personal assets, this may be a preferable structure.
However, this aspect of limited partnership interests may have little value to a retirement account, because (with some important exceptions) they aren’t subject to claims of a retirement account owner’s creditors. The creditor’s claim would have to be against the retirement account itself for the limited partnership protection to apply.
Christopher: What is a C Corporation (C corp)?
Frank: C corps are legal entities that are owned by shareholders. They can have an unlimited number of shareholders, different levels of voting rights, and C corps can also limit a shareholder’s personal liability for the entity’s business debts to the amount invested by the shareholder.
One drawback of C corps is that they must pay corporate taxes, as well as the fact that individual shareholders must pay personal income taxes on earned dividends. This leaves the door open for double-taxation, which is avoided with limited liability companies (LLCs) and LPs. Since dividends received by an investing retirement account are exempt from income tax, C corps are a good way for retirement accounts to invest in assets where income would otherwise be taxed as unrelated business taxable income (UBTI).
You may have noticed that I have not mentioned S Corporations (S corps). That is because tax law restricts S corp shareholders to individuals, estates and certain trusts. In the eyes of the IRS, an IRA, while considered a type of trust, does not meet the requirements for an S corp shareholder.
Christopher: What is a Limited Liability Company (LLC)?
Frank: This is the structure most often favored by self-directed IRA investors who want to pursue real estate investments or make loans from their IRAs. LLCs function like most corporations, but they are much less difficult to organize, and they combine favorable features of LPs and C corps.
An LLC provides the corporate advantage of limited liability protection—meaning it protects members from personal liability for debts of the LLC—with the partnership advantages of passing through income to its members without tax at the partnership level. This tax advantage allows you to avoid “double taxation.” Rather than taxing the corporation and investors separately, taxes are passed through to the investors. Unlike many C corps, LLCs are not required to use the accrual method of accounting, which mean LLCs have more flexibility when it comes to handling accounting.
The reason many individual real estate investors like this entity is because owners can claim tax losses in excess of their investments such as on leveraged real estate investments. (“Leverage” means the property is subject to a purchase money mortgage.) That advantage isn’t available to self-directed IRAs, though, and leveraged real estate investments will expose part of the IRA’s income to unrelated business income tax (UBIT).
On the other hand, most non-leveraged income from real estate is exempt from UBIT, so using an LLC ownership structure for real estate means the self-directed IRA pays no federal income tax on the LLC’s profits.
But be aware that LLCs may be subject to taxes at a state level. For example, California requires LLCs to pay a “franchise tax” in addition to any typical income tax. More information on how to set up an LLC can be found in this Forbes article that highlights 10 key steps in organizing an LLC.
The Use of LPs, C Corps and LLCs in Self-directed IRAs
Clients with self-directed IRAs have used qualified dollars to invest in all three of the business entities we’ve discussed. For example:
- A C corp can own a business that earns income that would be unrelated business taxable income if owned by a self-directed IRA; but, even though the profits are taxable at the corporate level, the dividends distributed to the self-directed IRA are exempt from UBIT. Also, the tax rate of the C corp can often be less than the rate of tax that would otherwise be payable by the IRA on UBTI.
- An LLC (or limited partnership) is favored for self-directed IRAs to own promissory notes and to own and/or operate non-leveraged real estate, because the interest income and income from real estate is generally exempt from unrelated business income tax. The profits pass through to the IRA without being taxed to the LLC (or limited partnership). The income is tax exempt for the IRA, but the IRA is protected from third party claims against the LLC (or limited partnership).
Keep in mind that states will have different requirements for each business entity and before making any investment decision it’s always best to consult with a financial advisor or a tax attorney. For instance, what may be a preferred method of corporate formation in California may be different in Texas because of state tax law. A legal professional can help you make that determination.
Frank Bridges is a guest contributor and is not affiliated to PENSCO Trust Company or its affiliates. Opinions expressed by Guest Contributors are their own and is not endorsed nor does it represent PENSCO Trust Company or its affiliates.
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.
PENSCO Trust Company performs the duties of an independent custodian of assets for self-directed individual and business retirement accounts and does not provide investment advice, sell investments or offer any tax or legal advice. Clients or potential clients are advised to perform their own due diligence in choosing any investment opportunity as well as selecting any professional to assist them with an investment opportunity. Alternative investments are not FDIC insured and are subject to risk, including loss of principal. Other than the Opus Affiliates, PENSCO is not affiliated with any financial professional, investment, investment sponsor, or investment, tax or legal advisor.