Tax Treatment of Flipping Promissory Notes in an IRA

ryan — Tue, 24 Jan 2012 23:58:03 +0000

Question: The debate continues:) I actually have an account with another SDIRA company in FL. I use their company website as a resource but, it does not seem to give much information regarding the the tax treatment of Flipping notes in an IRA: I am networking with a lot of younger investors and there seems to be a lot of questions and little information. When we ask our tax professionals they “look at us like-you can’t do that.” Most tax and legal professionals do not seem to understand much, if anything about Self Directed Investing. So here is a follow up to the conversation if you can help us clear this up. Just to put this into context, the original question was, “what would you do with $50k in a Self Directed IRA.” I would say the average reader is in their late 30′s.

Investor: I find it very hard to believe that flipping notes could be considered appreciably different than transacting stocks quickly.

Tax Professional: I don’t think we are saying that they are “appreciably” different, just that the two investment options (stocks on public market vs. private market notes) are different in other means. I have no idea which is the correct and legal answer, but in my opinion, I see how one can argue that notes sold/transfered from flipping which deal with a buyer and a seller who negotiate between themselves and have contact between them in a private manner is functionally different than flipping stocks in a public market where the buyer and seller never negotiate and never have contact. To add to the confusion, what if you bought and immediately sold an actual business inside your 401k/IRA. Would UBIT apply?

Investor: Flipping stocks doesn’t just magically occur either. A buyer and a seller still have to agree on a price for a transaction to occur. There may be fewer things to negotiate in these transactions, but I don’t see how they are really different from a “business standpoint.” What about trading something on the pink sheets? Is that somehow different still?

Tax Professional: I almost always agree with you, but will have to agree to disagree on this. Regardless of who is right, as no final evidence has been discovered clearly (and may never be clear), we just have two different thoughts on this. I see a difference in stocks vs. flipping notes as explained, you do not as explained. No problem. Not only that, when they discuss the fact that the IRA can use debt leverage on a rehab, it makes no mention of UDFI which also triggers UBIT (unless debt is paid off 365 days before sale). As I have mentioned in the past, unfortunately, find details are often missing from TPA’s such as the one you are dealing with.

It seems like there is a lot of mis information and confusion out there regarding the subject. I certainly appreciate your thoughts, time and any information you can cite to help us clear this up. Please note that am not asking for advice-just information on where we can find facts in regards to this subject.

Quincy’s Answer: I think you’re trying to over analyze this and impose rationality and reason on the US government, which is of course quite impossible. Step back and ask yourself one question while forgetting entirely about the IRA aspect of it – would note flipping be considered a trade or business if you did it personally? If the answer is yes, then it is, by definition, a trade or business within the IRA as well, and it will generate UBIT, assuming it is “regularly carried on.” If the answer is no, then it should not generate UBIT. Whether something else like day trading stocks is or isn’t a trade or business is irrelevant. You are focusing on the IRA aspect of it when you should be focusing on whether or not it is a trade or business. In general terms, anything that you buy as “inventory” for resale to the public is going to be considered a trade or business, whether it is real estate, notes, widgets or anything else. Unfortunately, the standard of when you cross the line from being an investor to being in a trade or business is fuzzy at best and depends on many factors. Oh well, that’s the world we live in.

I have attached my short paper on UBIT. You may also find more information on UBIT in IRS Publication 598. The Internal Revenue Code sections dealing with UBIT are 26 USC 511-514. I hope that helps some. Good luck!

Response: Thank you for taking the time to help me out with this. It seems to me that it is best to error on the side of caution with this since the penalties can be so steep. I see a lot of guys buying and flipping homes in IRA’s. These guys are considered “Dealers” because they also buy and flip properties outside of IRA’s. I would say since these are bought with the intention of immediately offering them for sale to the public that they would then be subject to UBIT. The same would hold tru for a note that is immediately flipped. When you say “regulatory carried on,” do you mean this is something you do inside the IRA X amount of times per year, X amount of times during the life if the IRA?

Quincy’s Answer to Reponse: Review Page 3 of IRS Publication 598, which states: “Business activities of an exempt organization ordinarily are considered regularly carried on if they show a frequency and continuity, and are pursued in a manner similar to comparable commercial activities of nonexempt organizations.” An example is given in the publication. I agree that intent is very important. I’m not sure that an occasional flip in an IRA among many other investments will cause UBIT, but certainly if that’s all that the IRA invests in and the IRA owner also flips properties outside of his or her IRA that would weigh heavily in the consideration of whether the IRA had dealer income. While IRAs are very rarely audited, it is always important to give the IRS what they are due, because they have what it takes to take what you have.

One thing I would caution you about is not to confuse the payment of UBIT with the penalties associated with prohibited transactions. It is perfectly legal to make investments which subject your IRA to taxation, but if you do a prohibited transaction it blows up your entire IRA and you and others may owe excise taxes and penalties as well. The two subjects are completely separate, but many people, even educated ones, get them mixed together in their minds.

Does Flipping Notes, Loans or Homes Create UBIT?

Temporary relief for IRA owners who entered broker indemnification agreements

ryan — Wed, 11 Jan 2012 23:28:19 +0000

Quincy Says: As I predicted long ago, the IRS will not invalidate millions of IRAs because of the indemnification and cross-collateralization clauses in a typical brokerage style of IRA. In at least some brokerage accounts, the account agreement calls for the assets of the IRA to indemnify any other losses from individual accounts at that brokerage and vice versa. This of course has never been a problem with self-directed IRAs because we have no cross-indemnification clause. However, there were people who then used this to scare people into paying them thousands of dollars to apply for an individual prohibited transaction exemption. I maintained that if there was a problem with brokerage IRAs because of these clauses the solution would be a global solution in the form of a class prohibited transaction exemption, not an individual exemption for each IRA.

See below. Now the IRS has granted temporary relief from the scary scenario of a disqualified IRA simply for signing the typical brokerage account agreement in anticipation of a class exemption request expected to be submitted to the Department of Labor.

Make no mistake, this is big news in the IRA world. It is worthy of an article in any newsletter that is sent out, etc. While not a permanent solution yet, the light can be seen at the end of the tunnel and the immediate threat has been removed.

If you do not understand the background of this announcement and need any clarification, please feel free to contact me at Quincy@questira.com. Have a great day!

Temporary relief for IRA owners who entered broker indemnification agreements

Ann. 2011-81, 2011-52 IRB

IRS has provided temporary relief for IRAs where the owner has signed an indemnification agreement with a broker or other financial institution, or granted certain security interests in other accounts held by the institution, that may result in a prohibited loan transaction under Code Sec. 4975.

Background. If an IRA engages in a prohibited transaction under Code Sec. 4975, it ceases to be considered an IRA and loses its tax-exempt status. (Code Sec. 408(e)(2)) The direct or indirect lending of money, or other extension of credit, between a plan and a disqualified person is a prohibited transaction. (Code Sec. 4975(c)(1)(B))

For these purposes, a “plan” includes an IRA. (Code Sec. 4975(e)(1)(B)) The term “fiduciary” includes any person who exercises any discretionary authority or discretionary control over management of a plan, or who exercises any authority or control over management or disposition of plan assets. (Code Sec. 4975(e)(3)) A “disqualified person,” includes a fiduciary, and members of the family of a fiduciary. (Code Sec. 4975(e)(2))

Department of Labor (DOL) Prohibited Transaction Exemption 80-26– is a class exemption that permits interest-free loans and extensions of credit to a plan from a party in interest in instances in which the plan faces a temporary cash shortage. If certain requirements are met, these loans won’t result in a prohibited transaction.

Previous guidance. In ERISA Op Letter No 2011-09A, 2011, the Department of Labor’s (DOL’s) Employee Benefits Security Administration (EBSA) determined that where a broker required an indemnification agreement in order for an IRA owner to open a futures trading account in his IRA, Prohibited Transaction Exemption 80-26– was not available to save the agreement from being a prohibited loan under Code Sec. 4975(c)(1)(B).

Notably, EBSA found that granting the broker a security interest in the assets of the IRA owner’s personal accounts to cover the IRA’s debts to the broker would be akin to the IRA owner guaranteeing those debts. Thus, DOL concluded that the grant of the security interest in non-IRA assets would amount to a prohibited extension of credit under Code Sec. 4975(c)(1)(B) (see article in Federal Taxes Weekly Alert 11/19/2009).

Similarly, in ERISA Op Letter No 2009-03A, 2009, EBSA issued an earlier advisory opinion to this same requester holding that an individual’s grant to a brokerage firm of a security interest in the assets of the individual’s non-IRA accounts as a requirement for the individual’s establishment of an IRA with the broker would be a prohibited loan.

Now, EBSA has advised IRS that it is considering further action regarding these agreements (collectively known as cross-collateralization agreements), including consideration of a class exemption request expected to be submitted to EBSA.

Temporary relief. In response to these developments and pending further action by EBSA, IRS says it will determine the tax consequences relating to an IRA without taking into account the consequences that might otherwise result from a Code Sec. 4975 prohibited transaction from entering into any indemnification agreement, or any cross-collateralization agreement, similar to the agreements described in ERISA Op Letter No 2011-09A, 2011 and ERISA Op Letter No 2009-03A, 2009.

This relief is available only if there has been no execution or other enforcement under the agreement against the assets of an IRA account of the individual granting the security interest or entering into the cross-collateralization agreement. IRS advises that no inference with respect to the application of any Code section other than Code Sec. 4975 should be drawn from this announcement.

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Quest IRA, Inc. in 2012 – What to Watch For?

ryan — Thu, 05 Jan 2012 16:56:31 +0000

2011 was a great year that allowed Quest IRA, Inc. to be created and just like it has been since we opened the office in 2003, we had another great growth year. But the growth we have experienced over the past 9 years will pale in comparison to the exponential growth we will see in 2012!

There are many changes that are coming to Quest IRA for our clients, prospects and business partners that will allows Quest IRA to be the leader in timely opening, processing, and funding transactions while still be the national leader in localized education for each community. The website, education classes, networking events, webinars, and many other aspects Quest IRA has spent hundreds of thousand of dollars improving for you, the client.

Another BIG change to Quest IRA, Inc. will be that we will be attending many more seminars, workshops, association and organization meetings nationally and not just throughout Texas. Since we already have a office in Michigan with another office expected to be open in Seattle, WA by the end of 2012 you can expect Quest IRA to show up in your city or town very soon.

Should you have an event you would like Quest IRA to attend, sponsor, and/or present information on self-directed IRAs, please contact Ryan Kimura (ryan@questira.com or 800.320.5950 x 3584)

What happens should Quest IRA, Inc. go defuct and I have my IRA account there?

ryan — Wed, 14 Dec 2011 14:56:51 +0000

QUESTION: Mr. Long, I’ve reviewed the webinar on self directed IRAs. Simple but possibly offensive question, Entrust is the “trustee” similar to Charles Schwab… If you go out/defunct, what happens to my money/assets that you are administrating?

ANSWER: Actually, the question is not offensive at all. In fact, it shows that you are the type of person for whom a self-directed IRA works best – someone who is careful and does his homework before making an investment decision.

To start with, we have changed our name from Entrust Retirement Services, Inc. to Quest IRA, Inc. as of December 1, 2011. As of January 1, 2012, we will no longer be a franchise of The Entrust Group, Inc. I have attached our announcement letter which explains this for your information, so I won’t type what’s in the letter again in this email.

Our role is not as the trustee or custodian, but rather as the third party administrator, serving as the agent and nominee of the custodian, First Trust Company of Onaga (FTCO), a Kansas trust company. For over 30 years accountholders have trusted First Trust Company of Onaga (FTCO) as their custodian of Self-Directed Custodial Accounts. FTCO serves as custodian for over 80,000 accounts with a market value in excess of $7 billion. FTCO works extensively with IRA Administrators like us to provide superior service for Individual Retirement Accounts, Health Savings Accounts and Educational Savings Accounts. I have attached a .pdf of the Kansas Secretary of State where you can find information on FTCO, as well as a Certificate of Good Standing for Quest IRA, Inc. for your reference.

So there is a significantly sized custodian who is backing us up and watching over what we do, as are their regulators indirectly through their examination of FTCO. Additionally, we are required to have fidelity bond coverage and errors and omissions insurance. Finally, our custodian requires us to have a Business Continuity Plan which includes not only disaster recovery planning but also succession planning in case of the death of the owner of the company (which is me).

We have been doing business now for 9 years, and have grown tremendously in assets and in number of accounts. We have approximately 36 employees in 2 states, and we are growing all the time. When you say “if you go defunct” please remember that your IRA assets are held separately at all times from our company assets, so if Quest IRA, Inc. goes defunct it does not mean that your assets disappear. Instead, either the custodian or another administrator would come in and take over administration of your assets.

I certainly applaud your wish to do your due diligence before entrusting us with your hard earned retirement dollars. I believe we have the strength and stability to operate successfully for many years to come, especially with FTCO as our custodian. As has been seen from some of the turmoil of recent years, the size of the firm does not necessarily guarantee security, but I believe Quest IRA, Inc. is as steady of a company as there can be.

If we can help you with your self-directed IRA needs, please let us know. I wish you happy holidays, and a healthy, happy and prosperous 2012!

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Annoucing Quest IRA, Inc. formerly Entrust Retirement Services, Inc.

ryan — Thu, 01 Dec 2011 14:30:56 +0000

Dear Client:

The French classical author François de la Rochefoucauld once wrote “The only thing constant in life is change.” In our case, change has come to Entrust Retirement Services, Inc., and we are very excited about it!

So what has changed? First, our name will change from Entrust Retirement Services, Inc. to Quest IRA, Inc. as of December 1, 2011. This means that you should begin titling all of your IRA assets as follows beginning December 1, 2011: Quest IRA, Inc. FBO [Account Holder Name] IRA #[Account Number]. After December 31, 2011 we will no longer be able to process new investments titled in the name of Entrust Retirement Services, Inc.

Please notify everyone involved with your current IRA assets of the name change and ask them to update their records. This may include persons who make payments to your IRA on a monthly basis, vendors, partnerships, limited liability companies, and any assets for which the name can be updated without an undue burden on you. Effective December 1, 2011 please make all checks payable to Quest IRA, Inc. Please note that you are not required to re-title assets such as real estate, deeds of trust or mortgages, or other recorded assets. Our tax identification number will not change, as this is only a name change and not a separate new company.

Second, as of January 1, 2012 we will no longer be affiliated with The Entrust Group, Inc. The decision to separate from The Entrust Group franchise system was reached by a mutual agreement between Entrust Retirement Services, Inc. and The Entrust Group, Inc. We feel that operating independently will allow us to achieve more efficiency in our processes and improve customer service. For example, all checks and wires will be issued out of Icon Bank of Texas, a local Houston bank, instead of out of California. Additionally, our marketing efforts will no longer be restricted to the state of Texas as they generally have been in the past. There will be many improvements to our systems over time, and we ask for your patience during this transition. Our new website will take some time to fully implement, but our staff will be here to assist you and get you what you need, including forms or account statements.

Third, we have updated all of our 5305 Custodial Account Agreements. Enclosed you will find the new 5305 which governs your account with us. An updated Fee Schedule is also enclosed, with some minor changes and updated disclosures. The changes to your 5305 Custodial Account Agreement and the Fee Schedule will apply to your account as of January 1, 2012.

What has NOT changed is our commitment to great customer service. The same staff that you already know will be here to serve your needs, and new staff will be added as we make the transition into an independent company. Additionally, the custodian for your account, First Trust Company of Onaga (FTCO), is not changing. The only change involving the custodian is that we will have a direct relationship with FTCO as a third party administrator instead of operating through The Entrust Group.

Also enclosed is our annual request for Fair Market Valuation, which is required by the Internal Revenue Service. Please complete the form and return it to us with substantiation attached by no later than January 16. 2012. More information about the fair market value requirement is available on the attached instruction letter.

Thank you again for the opportunity to serve your retirement account needs. We appreciate your business, and look forward to serving you for years to come. Please do not hesitate to call us if you have any questions.

Sincerely,

H. Quincy Long President

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Happy Thanksgiving to All!!!

ryan — Wed, 23 Nov 2011 17:05:22 +0000

I am thankful this year for the great growth of the company and the launch of Quest IRA, Inc. I am thankful that 2012 will soon be upon us and the “World Famous” staff I have put together at Quest IRA will build a national brand for self-directed IRAs.

Thanks to all of our clients, prospects and business partners that make all of this possible. Be safe, stay warm and we at Quest IRA, Inc. want to again say, “Thank You” and have a wonderful Thanksgiving!!!

Sincerely,

H. Quincy Long

President/CEO of Quest IRA, Inc.

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Contributions to a SEP IRA and ROTH IRA in the same year?

ryan — Fri, 11 Nov 2011 14:44:20 +0000

Question: I have a sep IRA, already contirbute maximum to Sep IRA this year, can i also contribute to Roth IRA in additional to Sep IRA? Thank you.”

Answer: The answer is yes, you can. The SEP IRA is an employer plan, and it is the employer who is making the contribution (even if you are self-employed). The Roth IRA is only dependent upon you having earned income at least in the amount of the contribution and not in excess of the income limits. Even if you exceed the income limits, you can contribute to a traditional IRA and then do a Roth conversion.

I invested with crooks and was awarded a judgment but…

ryan — Fri, 28 Oct 2011 19:16:54 +0000

Question: In 1997 my bank rolled over $150,000 to a rollover account in florida. At this time the monies were stolen. I was awarded a judgment against the 4 persons that took the monies but have only collected $6,000 so far. If, and when I collect any or all monies, do they belong in my IRA account that they came from? And can a third party like a bankruptcy trustee access the judgment and any monies collected to pay off any creditors?

P.S.
I never did see or have control of these funds. They were transferred into a self directed IRA and stolen from there. I have been told that a bankruptcy trustee can not use these funds to pay off any creditors and any funds recovered should go back into my ira and if treated as a withdrawal it would be taxable event. If this true is their any law and or cases to support this?

Answer: With regard to your question below, it is somewhat difficult to answer without more information, and in any event the question is best answered by your bankruptcy attorney as well as the attorney who is helping you collect this judgment. My first question would be who has the judgment, you or your IRA? If you were the plaintiff individually, then the money collected may not be exempt from the bankruptcy estate since it isn’t in the name of your IRA, whereas if the judgment is in the name of your IRA it is may be exempt as an asset of your IRA, not you individually, depending of course on state law where you are as well as whether you chose state or federal exemptions in your bankruptcy. Your attorney will be able to give you better information than I can.

The bottom line is that there are insufficient facts to really answer your question, and what you really need is legal advice from an attorney who has all the facts in front of him or her. I’m sorry I can’t be of more assistance to you. Good luck in your future endeavors and thanks for the question.

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Can I loan money to a company I own? And what about Rollover for Business Startup (ROBS)?

ryan — Wed, 12 Oct 2011 18:57:12 +0000

Question: A husband and wife both have a Roth IRA & husband has a 401(k). He plans to leave his corporate job & start his own business. If Roth & 401(k) funds are transferred to self-directed IRA, can husband & wife use IRA funds to loan start up money to husband’s new business, as along as they pay interest on the loan to IRA? Is this an acceptable or prohibited transaction and how should the loan be structured? If prohibited, is therea way to structure the loan so as to be an acceptable transaction?

Answer: Thank you for your inquiry. The short answer to your question is no, neither the Roth IRAs nor your 401(k) which is rolled into an IRA can loan start up money for your new business venture. There is a list of persons with whom the IRA is not permitted to do business, called disqualified persons. A business owned entirely by you would be a disqualified person, and therefore the proposed loan would be a violation of Internal Revenue Code Section 4975(c)(1)(B), which says that the direct or indirect “lending of money or other extension of credit between a plan and a disqualified person” is a prohibited transaction.

I have heard of people using their 401(k) plans to start a new business by using what the IRS terms a ROBS arrangement (Rollovers for Business Startups), but the IRS clearly does not like these arrangements and believes that the way many of them operate result in a prohibited transaction. I have attached some information in this regard. If you do want to go down this path, be sure that whoever you choose is very familiar with the IRS position and that you feel they have adequately dealt with the issues. Certainly there are many companies out there offering the ROBS set up. It is fairly expensive to do, though, since it involves setting up a C corporation, having the C corporation adopt a 401(k) plan, rolling the IRA or former 401(k) into the 401(k) for the new company, and purchasing shares of the company as employer securities. You cannot roll your Roth IRAs into the 401(k) plan, only traditional IRAs.

Finally, you should be aware that Entrust cannot give you tax, legal or investment advice, and so we could never advise you on how to structure a particular investment or provide you with the forms to do so. Good luck with your new business venture. Have a great day!

IRS ROBS Paper

IRS ROBS Analysis

IRS ROBS Fail Paper

Can you provide you input on IRA Owned LLCs?

ryan — Thu, 29 Sep 2011 15:27:12 +0000

Question: Quincy can you give us input on whether we need to set up an IRA LLC or is there a better entity for self directed IRA’s? Is selling interest in a LLC the best way to pool IRA money?

Answer: The question of whether to set up an LLC for a particular transaction or series of transactions depends on a lot of factors. For example, are you going to use the LLC for transactions on a regular basis, or is the LLC set up for a single transaction? What is the cost of setting up the LLC in the state where you are located? Are there any income or annual fees to maintain the LLC? How much will the LLC cost to set up and maintain? As I always say, “every port of refuge has its price.” You simply have to analyze the costs and decide whether or not it is worth forming an LLC for your anticipated investments. I have seen many people use trusts as a viable and less expensive alternative to LLCs, but once again there may be state law issues which affect your decision.

Another question is who will manage the LLC? Personally, I believe it is not a great idea for an IRA owner to manage an LLC which the IRA owns, for a lot of reasons. I understand that guidelines on IRA owned entities have been written by the Department of Labor and are under review by the IRS prior to being released sometime later this year. These guidelines will hopefully shed light on a lot of the issues facing IRA owned entities.

Another factor to be considered is whether or not the operation of the LLC will subject the IRA to Unrelated Business Income Tax (UBIT). If an IRA operates a business, either directly or through a non-taxable entity such as an LLC, the owing IRA will be subject to taxation and will need to file a Form 990T each year (unless that LLC elects to be treated as a C corporation for tax purposes). This may impact the return and complicate matters somewhat, but does not at all mean the project shouldn’t be considered (I have investments in my retirement plan that require me to file a 990T each year). It is conceivable or perhaps even probable that the continuous purchase and sale of notes in the LLC would cause the owning IRAs to owe UBIT, if that is your intent. You should note that no disqualified person (including, but not limited to, the IRA owners and their immediate familymembers) may receive any current benefit from the transactions engaged in by the LLC. For example, no commissions may be earned by any disqualified person for purchasing notes within the LLC.

The answer to your second question has significant Securities and Exchange Commission issues, so if you form an LLC and sell its shares you will want to be careful not to make it a “public” offering, or at the very least you should consult with a securities attorney prior to raising capital. A full discussion of the securities law implications is beyond the scope of a quick email, and is subject to who the members of the LLC are and how they acquire the membership interests. I have used both trusts and LLCs to accumulate funds for investments, but I have always dealt with immediate family members and close associates, not the “public.” I am not an expert on securities laws, I just know enough to be dangerous.

Of course you should also realize that any particular asset may be held directly by an IRA as opposed to owning the asset through an LLC. Depending on the complexity of the transaction and the volume of activity, direct ownership by the IRA or IRAs may be sufficient to meet your needs.

I apologize for the delay in answering your questions. If I can do anything for you, please let me know. Have a great day!

H. Quincy Long’s Entity Investments in Your IRA White Paper

Would it be a prohibited transaction if I only owned 25% of the entity???