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Estate Planning Challenges of Self-Directed IRAs

Posted by attorney Warren Baker

Properly planning for the passing of retirement accounts at death can result in huge tax (and other) benefits for a client and their beneficiaries. "Self-directed" IRAs present specific challenges because of the "non-traditional" assets (e.g. real estate) that they typically hold. As I have described in prior articles, the use of so-called "self-directed IRA" structures has exploded in popularity in recent years. The basic purpose of these structures is to invest some (or all) of an IRA account holder's retirement assets into "alternative" investments, i.e. almost anything other than stock market-based investments. By far the most popular self-directed IRA investment category is real estate. These structures are also used to invest into: loans, privately-held businesses, precious metals, etc. In order to facilitate a real estate investment, the IRA account holder must establish a self-directed IRA and then choose one of two methods of investing the IRA's funds. The first method involves instructing the IRA custodian to purchase the real estate directly using the IRA's assets. The second method requires the IRA to purchase 100% ownership in a newly-formed Limited Liability Company (LLC) and subsequently have the LLC purchase the real estate. In either case, these structures present specific estate planning challenges (in addition to other tax/legal issues discussed in other articles in this series). IRA Beneficiary Designation Forms / Required Minimum Distributions: When establishing a new IRA, whether self-directed or not, the IRA custodian will require the IRA account holder to list his or her primary and secondary beneficiaries. Often, the account holder will list his or her spouse, if applicable, as the primary beneficiary and his or her children as secondary beneficiaries. One benefit of this strategy is that the account holder's spouse can "roll" the IRA into his or her own name upon the account holder's death, which is generally the best tax result. However, there can be compelling estate planning reasons for listing a specific trust as the beneficiary of an IRA, but very careful planning must occur in order to ensure that the Required Minimum Distribution (RMD) rules apply in a tax-advantageous manner. The basic idea behind the RMD rules is that the federal government forces an IRA holder (or his or her beneficiary) to gradually withdraw the funds out of their retirement account beginning at a certain point in time in the future. For pre-tax IRAs (e.g. a traditional, SEP), the RMDs must start by the year following the year in which the IRA account holder turns 70 1/2 years old. For Roth IRAs, the RMDs are not triggered at age 70 1/2 , but rather they generally start when the IRA is inherited by anyone other than the original IRA account holder's spouse. Particular RMD problems occur if one (or more) of the beneficiaries of an IRA (whether pre-tax or Roth) are the account holder's estate or another entity that does not have a measurable life expectancy (e.g. a charity). For example, if a trust is named as the beneficiary of the IRA, but the trust is not structured in a way that eliminates "non-individual" beneficiaries, the IRA will be required to distribute all of its assets over the 5-year period following the account holder's death. This result greatly reduces the time available for the IRA to grow tax-free, so the application of "the 5-year rule" should almost always be avoided. In a self-directed IRA context, the RMD rules can cause particular difficulties. Assuming the IRA consists of pre-tax funds, the account holder must begin taking RMDs on a yearly basis starting at age 70 1/2 . In other words, the RMD rules apply to self-directed IRAs the same way as any other IRA. If the IRA's assets consist of real estate, privately-held business interests, or other "illiquid" assets, it is possible for the account holder to be required to take a distribution, but the IRA to have no cash. In these situations, the IRA account holder is left with the following options: (1) take his or her RMD from a different IRA of the same tax character (assuming the distribution is sufficient to cover the RMD for all of the account holder's IRAs); (2) have the self-directed IRA distribute an illiquid asset directly to the account holder, which will likely result in a large income tax bill but no cash [e.g. a $200,000 piece of real estate being distributed out of a pre-tax IRA will result in a $56,000 tax bill (assuming 28% tax bracket), but no cash to actually pay the tax]; or (3) face the daunting 50% excise tax for failing to take the RMD. This same "lack of liquidity" problem can occur if the account holder of the self-directed IRA passes away and the beneficiaries are forced to take an RMD, particularly if the "5-year rule" is triggered. Fortunately, the RMD amount is determined based on the value of the account holder's IRA (or IRAs) on December 31 of the year prior to when the RMD must be distributed. Thus, even if the IRA holds "illiquid" assets, an account holder will have an entire calendar year to sell some (or all) of the IRA's assets to comply with the RMD rules. Prohibited Transactions / Post-Death Operation of the IRA: The biggest legal/tax issue of owning and operating a self-directed IRA is the risk of a "prohibited transaction." At its core, the prohibited transaction rules are designed to limit the interactions between an IRA and a "disqualified person." The disqualified people include the IRA account holder, certain members of the account holder's family, business entities controlled by the account holder (and/or his or her family), and certain people connected to those business entities. The task of avoiding a prohibited transaction is a serious matter because the violation of these rules results in the IRA losing its tax-exempt status (i.e. the IRA is treated as fully distributed to the account holder on January 1 of the year in which the prohibited transaction occurred). See my "Part 3" article for more information on prohibited transactions. Often, the account holder who sets up the self-directed IRA is very familiar with the legal framework within which he or she must operate. However, when the account holder passes away, the risk of a prohibited transaction often increases due to the beneficiary's lack of understanding of the self-directed IRA structure. For example, imagine a self-directed IRA that owns 100% of a LLC. The LLC has several assets, including a checking account, savings account, and real estate holdings. Upon the account holder's death, if a disqualified person (e.g. the surviving spouse) does not understand the IRA legal restrictions and financially interacts with the LLC (e.g. borrows money from the checking account), a prohibited transaction could occur. At first blush, assets held by a self-directed IRA (or IRA-owned LLC) might be difficult to distinguish from other assets held by the deceased IRA account holder. For example, the decedent might own several pieces of real estate and/or LLCs personally. Thus, special care must be taken to avoid prohibited transactions following the account holder's death.

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