by Guest Contributor Attorney John Hyre – www.Iralawyer.com
Quick Synopsis
An engineer from Phoenix made a living doing “Phase I” and similar types of environmental impact reports for purchasers of commercial properties. When the 2008 crash came, his business declined. He started flipping properties and did quite well with it in very short order.
Pursuant to the “advice” of a CheckBook LLC promotor, the promotor set up an IRA-owned LLC for the Engineer. The “advice” and “customization” were typical, or, in a word, somewhere between “awful” to “non-existent”. The operating agreement was almost certainly a template with no customization to meet the client’s specific needs. The Engineer was the sole manager of the LLC. Worse yet, Engineer received no effective advice on how to property use the LLC without destroying his IRA (which is quite common). Consequently, he entered into deals between himself and his IRA that were clearly prohibited. As a result, his $230,000 IRA was destroyed, the funds distributed, and heavy taxes & penalties levied as a result.
Lessons: Avoid Checkbook LLC promotors. If you think an LLC for your IRA or 401k might make sense, contact a qualified tax attorney. When consulting with counsel, be sure to accomplish three tasks:
- Determine whether you really need an IRA-owned LLC;
- IF the answer to #1 is yes, customize the LLC to your particular circumstances & strategy – this is not the time to “cheap out” with a mere template, which is what the vast majority of checkbook LLC promotors sell; and
- Learn the rules that apply to self-directing an IRA, especially the Prohibited Transaction rules. Make sure to analyze those rules in the context of the specific types of transactions you intend to complete with your IRA or IRA-owned LLC.
Other implications of the case:
- Engineer made about $126k off of 9 real property flips – nice way to start! He reported the flips as short-term capital gains, which are exempt from social security/self-employment taxes. This means that the IRS did not try to argue that 9 flips in a year made Engineer a “dealer”. Had the IRS made & won such an argument, the income would have been subject to self-employment taxes on top of regular income taxes.
- Engineer could not deduct travel expenses because he failed to document the business purpose of each trip.
- Engineer was not able to deduct attorney’s fees spent investigating the purchase of a portfolio of notes. The court implied that he missed a subtle way to get those fees deducted, probably due to not being represented by a tax lawyer in court. Any decent tax attorney would have caught this issue.
- Home office expenses need to be deducted on Schedule C, they cannot be added to the cost of investment properties. Note: His home office expense was rent paid to his girlfriend, the IRS evidently did not object to that.
- Engineer was penalized for taking improper deductions for his 2009 self-prepared tax return. A CPA completed Engineer’s return for 2010 and no penalties were levied for the deductions disallowed in that year. Having a good CPA often pays.
Detailed Discussion
- Engineer Niemann from Phoenix made a living doing economic impact surveys for commercial real estate (e.g. – Phase I reports). The RE crash caused his business to drop dramatically, so he started flipping RE. He did 9 deals his second year (2009), 8 of which made a profit, for net income of $126,000.
- Niemann represented himself in court. Such cases tend to go poorly for the taxpayer and often set poor precedents for the rest of us. It’s hard to tell how the case would have gone had good counsel been involved, maybe it would have helped, maybe not. The trend is that tax counsel makes a difference, including settling bad cases before they get to court.
- Niemann had 3 entities, which the Tax Court referred to as a “tangle”.
- Dependable Project Services, LLC
- Founded for Niemann’s services business in 2003, later used to hold mineral rights
- 2008 and 2009 are years at issue, claimed some of this LLC’s deductions on Schedule C.
- Real Estate Rabbit, LLC (The “Checkbook” LLC)
- A “check book IRA” LLC
- Niemann’s IRA was the sole member of the LLC
- Neiman was the LLC’s manager
- The LLC was used mainly for flipping real estate, also held mineral rights and loans
- The Court’s language in re checkbook LLC’s is worth quoting at length. I submit that as the Tax Court starts to address “checkbook LLC’s” with greater frequency, we shall see more such language & that the court shall have developed a distaste for them, or at least for the poorly drafted & misused ones.
- “His reporting went most awry after he attended seminars advertising the use of a self-directed “checkbook LLC.” [Niemann] explained that what that meant to him was simply the process of writing checks inside of an LLC that is inside of a tax-advantaged IRA. This information was sold to anyone who attended these seminars.”
- “Niemann, who we found to be a very smart man though not trained in law, realized as trial neared that Magic was not actually a multimember LLC. This led him to then concede that he had engaged in numerous “prohibited transactions” with his IRA.”
- “For example, Niemann arranged for Rabbit the entity that he had tucked into his IRA to transfer one property to himself and another to Magic, which he wholly owned. This meant that Niemann had terminated his IRA. And this termination is with extreme prejudice – the IRA’s assets are deemed distributed. See secs. 72(t), 408(e)(2)(B). And what “deemed distributed” means to Niemann is actually “added to his taxable income” about $230,000 in extra income according to the notice of deficiency for the 2009 tax year.” (bold mine)
- This sort of result is absolutely typical with most “checkbook” LLC promotors. They often have no idea what they are doing and charge quite a bit to structure a tax disaster, see my comments under “Quick Synopsis” on page 1 for some key pointers in dealing with IRA-owned LLC’s. They can be very useful – if done right.
- Magic, LLC
- Was supposed to be a multi-member LLC
- Vendor never made it a “multi-member” LLC – typical slop from promotors, seminars, and especially LLC pushers out of Nevada and Utah. I doubt that making this LLC multi-member would have solved any of the problems addressed by this case – but the fact that the promotor botched it and Niemann did not catch the error are unsurprising.
- The court found that Niemann was the sole owner and manager of the LLC.
By John Hyre, Attorney, Accountant, & Real Estate Investor
