IRA's: Alternative Investments, Illiquid Assets and Limited Liability Companies
I have been assisting clients take their IRA's and Retirement Plans offshore for well over 25 years. A significant number of articles written by me have been published by various newsletters and can still be found online.
Many of these articles were focused on what you can accomplish with a truly self-directed custodian. I've had numerous conversations regarding what investment, or action, triggers a prohibited transaction. Unfortunately, the public domain contains more bad information on this topic than accurate. No doubt, one of the primary causes of confusion is a lack of information provided by the IRS. Basically, the Internal Revenue Code, (IRC), tells you what's prohibited, not what is allowed. In essence, you cannot invest in certain collectibles, (wine, rugs, art, etc.), and you can't deal with yourself or other disqualified individuals. (No self-dealing.) You want to avoid engaging in or triggering a prohibited transaction at all possible cost. (Want more on the topic? Send me an email request.) Absent these restrictions, everything else is allowed!
The other prevalent cause of confusion oftentimes comes from dealing with a custodian who imposes artificial restrictions on IRA participants. (Custodians have the right to limit customer investment selections, as they see fit, regardless of what is allowed.) Occasionally these restrictions are driven by a lack of knowledge, but more often than not the custodian is simply concerned about their own profit margin, limiting you to investments for which they receive compensation. For example, ask your local broker if you can hold real estate in an IRA. If lucky, your advisor will know it's compliant for an IRA to invest in real estate, but must inform you their firm doesn't allow it. If unlucky, your advisor will tell you it's not allowed, which is absolutely incorrect!
The question is, beyond traditional stocks, bonds, and mutual funds ,what types of investments can you make?
Alternative Investments-
Examples of Alternative Investments.
1. Real estate
2. Loans/Privately held notes (You loan money to a friend for a car, business, home purchase etc.)
3. Privately held mortgages
4. Pre-IPO stock
5. Stock in a privately held company that is not publicly traded
6. Oil and Gas
7. Limited Partnerships
8. Hedge Funds
9. Business Franchise
10. Ownership of a privately run business
*Participants must adhere to all rules, avoid self-dealing and any actions that might trigger a prohibited transaction.
For a moment let's focus on Limited Liability Companies, also known as an LLC or IBC.
LLC's- Investment Flexibility and Asset Protection
Most clients choose to use an LLC for a number of very valid reasons.
- They are concerned about the need for asset protection.
- They are seeking a much more private way to hold their investments.
- They have concerns about the unwarranted seizure of their assets.
- They understand the need to keep some of their assets outside of the U.S. for safety and diversification.
- They understand our government has greatly increased the reporting requirements surrounding non-US accounts and they know an IRA may be the best way to do so. (The newly released FBAR Form {Foreign Bank Account Reporting} contains the following Noteworthy language- "IRA Owners and Beneficiaries. An owner or beneficiary of an IRA is not required to report a foreign financial account held in the IRA.")
- The U.S. government understood and intended one of the main results of the new reporting requirements would be that less and less Foreign Financial Providers, like banks, brokerage firms and insurance companies, would be willing to open accounts for US citizens. Without question this has come to pass. The list of providers accepting US clients grows dramatically smaller each year.
An LLC can be a valuable tool for clients who are looking to invest their IRA into illiquid investments. The courts have already ruled on the legality of an IRA investing in an LLC. (Copy available upon request.) LLC's have become a very popular way to structure alternative investments. A participants decision on whether to use either a domestic or foreign LLC, will ultimately depend upon where the underlying investments are located.
Much has been written about asset protection and the use of a foreign LLC. If you would like to learn more about the protection afforded by a foreign LLC, please let me know and I will be happy to provide a number of resources. For the sake of brevity, I will exclude such a discussion in this article.
LLC's have numerous advantages. A single member LLC, owned by your IRA, will be treated as a disregarded entity for tax purposes, (unless you specifically chose otherwise). Most taxable events flow through to the underlying owner, which in this case is your IRA or Retirement Plan and are sheltered.
An LLC has membership units instead of shares of stock. Effectively membership units work the same, which would allow participants to take advantage of an in-kind distribution which provides a number of benefits and tremendous flexibility.
IRA participants, who invest in alternative or illiquid investments, should always keep in mind proper planning is required to be able to meet future distributions. In my practice, I have found participants are often under the impression they must liquidate their investments and take a cash withdrawal. This is incorrect. Participants always have the option of taking an in-kind distribution. They are still responsible to pay the tax due upon distribution. The amount of tax due would be based upon the value of distributed investments. This necessitates a participant having liquid funds available from other sources to pay the taxes due.
Here is a simple example of an in-kind distribution.
Participant owns 1,000 shares of a privately held stock. The company has notified the participant current valuation of their stock is $10 per share. The participant’s CPA® has notified him or her their required mandatory distribution, (RMD), for the year is $1,000. $1,000/$10=100 shares. The participant instructs the IRA Custodian to re-register 100 shares of stock out of their IRA and into their personal name. The Custodian reports a $1,000 distribution to the IRS and participant is responsible for the tax.
In-kind distributions can be incredibly useful. Many of my clients have purchased real estate all over the world with no intention of ever selling it. For some, it will eventually become the beachfront vacation home they have always dreamed of owning. An in-kind distribution affords them the possibility of keeping their real estate investment intact. It provides them flexibility to reduce the effective tax rate a one-time total distribution would normally trigger. It does so by spreading out the ownership/distribution over a number of years.
