By Robert A. Green, CPA and managing member of Green NFH, LLC

Alert! Many traders may be triggering IRS excise-tax penalties for prohibited transactions including self-dealing, and/or UBIT taxes, by using their IRAs and other retirement funds to finance their trading activities and alternative investments in problematic ways. One example of this type of trouble may be the IRA-Owned LLC or trust trading account. In many cases, traders also risk losing tax-exempt status on their retirement plans. This content is a serious warning to stay clear of trouble, not just a technical discussion of quirky rules.

Traders are increasingly tapping into their IRA and other retirement funds to finance their trading and investment plans. This trend has been growing since the 2008 financial crisis when many taxable accounts melted down, and proliferating rapidly this year.

The good

For the past several years, GreenTraderTax has offered ways to tap into retirement funds without triggering tax problems. We recap these safe strategies below. But first, lets tackle the new inappropriate retirement-plan schemes and structures.

The bad

There are many companies marketing these structures, often with educational content. One popular structure is the Self-Directed IRA-Owned LLC, or in a minor variation, the Custodian IRA-Owned Trust. Vendors want to put your retirement funds to work and generate commissions with more active trading. Educational firms may realize its your only good source of funds for establishing a trading activity, so they recommend these schemes.

While many of these Websites offer good articles about related IRS, DOL and ERISA laws and rulings, take it with a grain of salt. Many vendors make self-serving conclusions, and generally give insufficient consideration to prohibited-transaction and self-dealing rules, which are complex, nuanced and often misunderstood. Attorneys confirm these schemes create substantial risks of tax non-compliance, prohibited-transactions and/or (the wider net of) self-dealing, opening the door to potential trouble from the IRS and DOL.

You should engage your own independent employee-benefits attorney and CPA to help you make the right decisions and to troubleshoot how to handle structural and compliance matters going forward. Unless you are talking about serious money, why bother with all this potential trouble and costs (including legal fees) if it probably wont work anyway?

And, the ugly

Scheme vendors put too much stock in their 1996 tax court ruling Swanson v. Commissioner (Note 1). They utilize the ruling to sell their scheme Self-Directed IRA-Owned LLC with Checkbook Control.

How do these schemes work? Working with your IRA administrator or a new intermediary custodian, you arrange for your IRA to own 100% of a newly formed single-member LLC. You then open an LLC trading margin account with the broker of your choice.

You pay trading expenses through an LLC bank account or the LLC trading account with check writing privileges and debit card. Thats LLC Checkbook Control. The intermediary custodian has control of the LLC interest itself, but not checkbook control in the LLC.

In a minor variation, the Custodian IRA-Owned Trust opens a trust trading margin account rather than an LLC account. The purpose is basically the same. They have checkbook control on the trust level. Both the LLC and trust are disregarded entities.

Many traders abuse that checkbook control by loading up expenses that are otherwise non-deductible on their tax returns. Only investment expenses that directly relate to the IRAs own trading (Section 212) are payable from the retirement account, not business expenses (Section 162) such as education and home-office expenses which benefit the trader personally.

Its fishy

What does this tell you so far? Youve gone through a lot of trouble to navigate around restrictions to open a margin account for the benefit of your IRA with your online broker. The brokers compliance department said no to a margin account for your IRA. The broker doesnt want to be associated with or responsible for these schemes in any way, so it refers outside vendors. The rules are strict: IRAs may have cash accounts, not margin accounts and the IRA administrator is supposed to have checkbook control. Doesnt this scheme sound fishy so far?

Note: A few brokers do allow IRAs to have margin accounts but for very limited purposes where the risk of loss cannot exceed the assets in the account (such as covered calls).

Swanson vs. Commission is no swan song

Many attorneys think both the IRS and the tax court mishandled the Swanson ruling. The Swanson court ruled there wasnt a prohibited transaction with a disqualified person when the IRA acquired 100% interests in two newly formed corporations (a key point that is often glossed over these were corporations, not LLCs). But it did not consider whether there might be a prohibited transaction after that point going forward. In particular, the Swanson court did not address self-dealing rules. Swanson likely triggered self-dealing rules in his role as IRA beneficiary and fiduciary versus his personal interest in the Swanson LLC and Swanson C-Corp operating business. Self-dealing is generally the Achilles heel of these structures.

The IRS missed another big elephant in the room the IRA-owned corporations received income, but it is not clear that they actually did anything to add value. If they did add value, who performed the services the IRA owner? That is considered a disguised contribution. If they did not add value and the transfers were gratuitous, that looks like not only a disguised contribution but potential tax fraud. These issues were never explored by the IRS or the court.

Some vendors tell the most of the story

QuestIRA.com (Note 2) states the Swanson case is not clear case law precedent. According to the site, Some people, perhaps through ignorance of the rules, appear to be abusing Swanson-type entities. For example, in IRS Notice 2004-8 on abusive Roth transactions the IRS states that it is aware of situations where taxpayers are using a Roth IRA-owned corporation which deals with a pre-existing business owned by the same taxpayer to shift otherwise taxable income into the Roth IRA. (I.e. disguised contribution or tax fraud.)

QuestIRA goes on to say the Swanson court skipped over IRC Section 408(a)(2), which requires that the custodian of an IRA be a bank or other qualified institution. Attorney Richard Matta of Groom Law Group (Note 3) points out that the IRS views a single-member LLC as a disregarded entity, which means in the eyes of the IRS the LLC does not exist. Matta says if the LLC does not exist but check-writing authority is now in the hands of the IRA owner, a strong argument can be made that the IRA assets are no longer properly custodied. While some may argue to the contrary, supporting authority beyond the near-useless Swanson case is weak to non-existent.

In other words, the fact the Swanson court did not rule against Swanson (on very different facts) is not precedent and offers no comfort. The IRS failed to raise the real issues and the court could only rule on the questions before it. Dont count on the IRS to get it wrong the next time.

Why set up a disregarded entity like a SMLLC or trust?

One popular reason is for traders to give their IRA access to an otherwise forbidden margin account, since an IRA generally may only open a cash account. Day traders need pattern day trader (PDT) rights with 4:1 intraday leverage, versus 2:1 leverage for regular margin Reg T accounts. Cash accounts are 1:1, which means no leverage. The bigger the buying power, the more risk you can take on your limited funds. A related reason is that in order to move money quickly, you need checkbook control asking a bank custodian to transfer funds simply takes too long for traders.

On the other hand, the IRA owner doesnt want to move non-taxable IRA assets into a taxable entity. A SMLLC or revocable trust doesnt file a tax return and pay entity level tax; all activity is reported inside the IRA anyway, effectively back to stage 1. (The corporations in Swanson had special tax status so they avoided tax in a different way.)

Margin interest triggers UBIT

Paying margin interest expense to a broker on securities purchased on margin overnight triggers UBIT in a retirement account. Basically, this means you owe regular taxes in your retirement plan related to unrelated business taxable income (UBTI). Margin interest expense opens that trap door. (UBIT is beyond the scope of this article.)

Do personal guarantees trigger UBIT or self-dealing?

What happens when an individual needs to personally guarantee an IRA-Owned LLC or trust margin account? Brokers typically dont open margin accounts without some kind of guarantee. In two advisory opinions, DOL indicated that personal guarantees may constitute a form of self-dealing. Can it also trigger UBIT? Probably not since its not actual borrowing.

Our problems with the Swanson court

I think the Swanson court didnt show how his IRA-Owned SMLLC structure and related transactions benefited Swanson for the purposes of assessing self-dealing. Its not the job of the court to raise issues that the IRS missed, only to address the questions before it.

As the owner of the C-Corp operating business, Swanson benefited personally by diverting and deferring taxable business income in his related-party-operating company to his IRA-Owned SMLLC. The transaction between his IRA-Owned SMLLC and operating business were probably not negotiated at arms length and the payments to the IRA through the SMLLC conduit could be deemed excessive IRA contributions subject to another excise tax.

The owners management services for the SMLLC were not pro-bono; he was compensated through other means like the taxable income diversion and deferral tactic discussed earlier. The Swanson court discusses the fiduciary owner not acting in his own interest, but I think he did act in his own interest. Certainly, enough to trigger the wider self-dealing rules, even if not the narrower non-fiduciary prohibited transaction rules.

Distinction between a regular prohibited transaction and fiduciary self-dealing

As noted, there are two types of prohibited transactions, those involving specific transactions between an IRA and a disqualified person, which I will call a regular prohibited transaction, and those involving fiduciary conflicts, including self-dealing. Certain linear family attribution rules (parent, child, grandchild, but not brother, sister, uncle and aunt) apply to regular prohibited transactions. (There are also attribution rules for corporate entities.) Regular prohibited transactions are subject to these linear attribution rules.

Conversely, self-dealing is not linear and is much wider in interpretation. Even if your LLC invests in a company in which you own less than 10% of the equity, while thats less than the regular prohibited transaction threshold, it still can be viewed as self-dealing if theres a conflict of interest and you are enriched in one role versus the IRA. Enrichment does not necessarily mean a direct transfer of money any indirect benefit can involve self-dealing.

Too good to be true?

If these too-good-to-be-true structures help you tax and business wise, its probably likely the IRS could argue self-dealing and maybe a regular prohibited transaction, too.

A different example: If your IRA lends money to your brothers business, the IRS could argue self-dealing based on your conflict of interest as a family member and fiduciary role for your IRA. How is that loan really in the best interests of your IRA? Its more about family generosity and planning.

Dont rely on being lucky with IRS exams

Swanson got lucky in tax court, but the process cost him plenty. Attorneys argue Swanson doesnt set proper precedent, yet too many IRA-alchemist vendors claim their solutions work because Swanson won in tax court.

Listen to an attorney in the know

Self-Directed IRA Myths (2009) written by respected employee-benefits attorney Richard Matta is excellent. You should also watch his 2012 video on the same subject. (Note 3.) (Mr. Matta will be a panelist in future Webinars and also reviewed this content.)

Mr. Matta pulls no punches in criticizing the Swanson court: Several of these concepts derive from Swanson v. Commissioner, 106 T.C. 76 (1996), cited by at least one IRA custodian as a landmark decision around which an entire industry has been built but which, in the opinion of the author, was much ado about nothing. The IRS raised the wrong arguments and failed to raise the right ones, and the tax court appears to have arrived at the right answer only by accident, via a nearly incomprehensible analysis [O]ne key holding of the court was not a holding at all, and is also inconsistent with later authorities. Swanson is a weak foundation on which to rest a multi-billion dollar industry.

Mr. Matta advises the banking and brokerage associations and financial institutions about these rules and its probably one reason why they wont touch these structures with a 10-foot pole. The cottage industry selling these continues to fly under the radar.

So, just what can you do that does pass muster?

While the above strategies raise as many questions as they promise to put to bed, there are other strategies you can pursue with IRAs and retirement plans that are on safer ground.

These strategies dont generate UBIT, and they generally dont trigger penalties for prohibited transactions or self-dealing:

Take an early withdrawal subject to regular taxes, plus a 10% excise tax penalty on Form 5329 if you are under age 59 in an IRA and age 55 in a qualified plan. There are some exceptions to the taxes and penalties. (Learn RMD rules which are beyond the scope of this content.)

Trade your IRA in a cash account. There may be higher commissions and more restrictions but you can still actively trade the account in securities. You may have trouble opening a futures or forex account. You cant get lower Section 1256 60/40 tax rates on futures through an IRA, anyway.

Consider a Roth IRA conversion, especially in a year when youre subject to lower marginal tax rates or have a large net operating loss (NOL) to soak up the Roth conversion income. Then trade your Roth IRA for life without new taxes being owed.

Set up a trading business with an Individual 401(k) plan. Rollover your IRA and other retirement assets to the Individual plan. Borrow up to $50,000 but no more than 50% of plan assets from this qualified plan to finance your taxable trading business or for any other personal use.

Rollovers as Business Start-Ups (ROBS) may pass muster with the IRS. While some IRAs got closing letters from the IRS saying okay, there are critical open prohibited transaction questions that have not yet been resolved, Matta says.

ROBS is structured as follows: You form a new C-Corp, then rollover retirement funds into a new C-Corp employee retirement plan account in your name, invest those retirement plan funds in your C-Corp stock, and then the C-Corp can operate or invest in a pass-through trading business. ROBS has many strict requirements, pros and cons, and related compliance costs. C-Corps have a lower tax rate (34%) than the Obama-era tax rates on upper-income taxpayers starting in 2013 (44% with Medicare taxes on unearned income included).

If the C-Corp just trades itself, watch out for personal service holding company rules. The C-Corp may be able to invest in a trading business LLC. Stay tuned as we look into it more.

ROBS seems to make more sense than some of the above self-directed IRA-Owned LLC or trust solutions. ROBS only allows a C-Corp, not a disregarded entity or pass-through entity like an LLC or trust. That means the C-Corp owes taxes on income and the IRA owns that value, too. A C-Corp paying taxes is sort of like UBIT taxes owed in the short term. Also, an ROBS structure involving an operating business can deduct salaries to lower the double tax hit.

Bottom Line

Dont take everything on the Internet at face value. Dig deeper to read the fine print. Are these more aggressive IRA and retirement-plan schemes really worth it? You need an independent attorney to monitor the plan, structure, transactions and the law each year. Thats serious money and there are no cutting corners with these solutions and compliance. (Ask the promoter of the IRA scheme if they will pay the costs of defending an IRS audit, as well as any resulting adverse tax consequences.)

If you are talking about big bucks, engage an employee-benefits attorney experienced in this area. For small potatoes, just skip it!

Notes & References:

mmctv.granicus.com/MediaPlayer.php?view_id=3&clip_id=808

5. IRS Notice 2004-8. Abusive Roth IRA Transactions

6. The Dos and Donts of IRA Investing — Journal of Accountancy April 2000 SELF-DEALING, OR ENGAGING IN A PROHIBITED transaction, can taint any IRA transaction. Transactions must be made at arms length and not involve the.

The following article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.