The final regulations...
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1. May an IRA form an LLC, which the beneficiary will manage?
There is no prohibited transaction when an Individual Retirement Account (“IRA”) purchases an interest in a newly formed company, even if a disqualified person will later have an interest in the business. Swanson v. Commissioner, 106 TC 76 (1997). A business entity with no shares or shareholders is not a disqualified person within the meaning of IRC §4975. Although the entity may later become a disqualified person under the rule, the sale of an interest in the newly formed entity to an IRA would not fall within the plain meaning of §4975(c)(1)(A). Id.
In Swanson, taxpayer arranged for the formation of a corporation called Swanson’s Worldwide, Inc. (“Worldwide”), of which he was the initial director. Taxpayer simultaneously created an IRA at a Florida bank, over which he retained power to direct investments. On the same day, taxpayer ordered the purchase of 2,500 shares of original issue stock of Worldwide, making the IRA the sole shareholder. Taxpayer maintained, and the court agreed, that the IRS was not justified in maintaining that a prohibited transaction had occurred.
The court found that it was unreasonable for the Commissioner to maintain that a prohibited transaction occurred when Worldwide's stock was acquired by the IRA. The stock acquired in the transaction was newly issued; meaning that prior to that point in time Worldwide had no shares or shareholders. The court held that a corporation without shares or shareholders does not fit within the definition of a disqualified person under §4975(e)(2)(G). Swanson, at 88.
It was only after Worldwide issued it’s stock to the IRA that taxpayer held a beneficial interest in Worldwide's stock (constructively as beneficiary of the IRA), thereby causing Worldwide to become a disqualified person under §4975. Accordingly, the issuance of stock to the IRA did not, within the plain meaning of §4975(c)(1)(A), qualify as a “sale or exchange, or leasing, of any property between a plan and a disqualified person.” Therefore, the court notes, the “Commissioner’s litigation position with respect to this issue was unreasonable as a matter of both law and fact.” Id. at 89. Our structure always looks to establish a new Limited Liability Company (“LLC”) of which the IRA becomes the sole member. The reason for the LLC structure is to have a tax pass through entity owned by a tax deferred entity.
The conclusion in Swanson is cited affirmatively in a Field Service Announcement [FSA 200128011 (April 6, 2001)] with respect to a Foreign Service Corporation (FSC), a different type of entity with preferential tax treatment. Whereas Swanson and the FSA refer to ownership of stock in a corporation, the analysis to ownership of membership interest in an LLC versus shares of corporate stock is not significant. The Department of Labor in advisory opinions has noted that investment by an IRA into a Limited Partnership, LLC or other business entity would not in itself be a prohibited transaction. See DOL Advisory Opinion 2000-10A (allowing investment in Limited Partnership); see also DOL Advisory Opinion 2006-01A.
2. May the LLC engage in transactions that would be prohibited to the IRA?
The primary structure employed for passive investments is to create a new LLC that is wholly owned by an IRA, allowing the LLC to invest IRA funds as permitted by the Internal Revenue Code. Although the beneficiary of the IRA will manage the LLC and it’s investments, he or she will be paid no compensation, direct or indirect.
Under the “plan asset” rule it is imperative that the LLC not engage in any prohibited transactions, including the payment of compensation to the manager, if he is a disqualified person. Investment of IRA funds into a business entity is clearly permitted; however, the assets of the LLC are assets of the IRA where the plan owns 100% of the LLC. 29 CFR §2510.3-101.
This is significant because where the LLC assets are considered “plan assets” any transaction between the LLC and a disqualified person is potentially subject to the prohibited transactions section of the Internal Revenue Code. Therefore, where the IRA is the sole member of an LLC, the LLC may not engage in prohibited transactions with disqualified persons, unless an exception is met. The plan asset rule does not cover “operating companies” by it’s own terms, thus the question perhaps more properly stated is: Is the LLC an “operating company,” under 29 CFR §2510.3-101 and therefore an exception?
An operating company is an entity that is primarily engaged, directly or indirectly, in the production or sale of a product or service other than the investment of capital. The term operating company includes an entity which is a “venture capital operating company'” or a “real estate operating company.”
An entity is a “real estate operating company” if (1) at least fifty percent of its assets, valued at cost, are invested in real estate which is managed or developed and with respect to which such entity has the right substantially to participate directly in the management or development; and (2) such entity is continuously, in the ordinary course of it’s business, engaged directly in real estate management or development activities.
While there may be some ambiguity as to whether the LLC is an investment company or an “operating company” and subject to debate with the IRS, we have taken the position (even if the issue is free from doubt as in the purchase of a company which manufactures and distributes widgets) that we shall not advocate prohibited transactions by LLCs wholly owned by IRAs. This is due to tax articles which advise that operating companies need be, or be owned by, a tax paying entity to avoid scrutiny. Further analyses would be required to evaluate ownership by an IRA of a C-Corp that provides compensation to an otherwise disqualified person.
The individual 401(k), however, appears to be the preferable vehicle for business ownership as there is ample precedent for 401(k) investment into the sponsoring company. While there are limitations on corporate ownership and plan asset allocation generally, there is an exception to those restrictions for “eligible individual account plans” (including 401(k)s). Further analysis of such 401(k) ownership for active investments is beyond the scope of this memo.
3. May this LLC pay dividends to the IRA, and are they tax deferred earnings?
There is no self-dealing when the company pays dividends to the IRA, and therefore no prohibited transaction. Swanson, at 89. Self-dealing occurs only when a disqualified person deals with the income or assets of the IRA for his or her own benefit or account. IRC §4975(c)(1)(E).
In Swanson, the court went on to explain that the payment of dividends by Worldwide to the IRA did not qualify as a prohibited transaction under §4975(c)(1)(E). There is no support in that section for the contention that such payments constitute acts of self-dealing, whereby taxpayer, a “fiduciary”, was dealing with the assets of the IRA in his own interest. §4975(c)(1)(E) addresses itself only to acts of disqualified persons who, as fiduciaries, deal directly or indirectly with the income or assets of a plan for their own benefit. Here the court notes, there was no direct or indirect dealing with the income or assets of a plan, as the dividends paid by Worldwide did not become “income” of the IRA until unqualifiedly made subject to the demand of the IRA. §1.301-1(b), Income Tax Regulations.
The only direct or indirect benefit that is realized from the payments of dividends by the company to the IRA relate solely to one’s status as a participant of the IRA. §4975(d)(9) states that prohibited transactions do not apply to receipt by a disqualified person of any benefit to which he is entitled as a participant, so long as the benefit is computed and paid on a basis which is consistent with the terms of the plan as applied to all other participants and beneficiaries. Therefore, there is no prohibited transaction upon the payment of dividends to the IRA, even if the money was already a plan asset. Swanson, at 90.
4. Must an LLC, wholly owned by an IRA, file a tax return?
The federal government does not recognize LLC as a classification for federal taxation purposes. While LLCs with two or more members may elect to be taxed as a partnership or as a corporation, a business entity with a single member can choose to be classified as either an association taxable as a corporation or disregarded as an entity separate from its owner, a “disregarded entity,” which is accounted for on its owner’s tax return.
In our structure the sole member of the LLC is a tax deferred entity (namely, an IRA) that does not file a tax return. Consequently should the LLC elect to be a disregarded entity, its earnings would not be reported on any current tax return. While it is not clear that the IRS intended this result, it has been averred that the LLC may nevertheless elect to be a disregarded entity and need not file a return. We have not yet found published authority for this position.