Self Directed IRA + LLC = Checkbook IRA

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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Yes. Some day you may actually retire. That may be the furthest thing from your mind as you deal with the day-to-day operations of your business. You've probably also had the thought that growing your business may be your best retirement plan. While that may be true, it's important to set aside some personal retirement savings separate from the business, and doing so correctly can save you thousands in taxes.

In 1974, Congress passed the legislation that created Independent Retirement Accounts (IRA). An IRA owner can deduct contributions on their current tax returns, deferring taxes until retirement, when (presumably), they will be taxed at a lower rate because their income is lower. Perhaps even more importantly, you have the use of those funds you would be paying in taxes, so you gain the additional returns on the re-investment of those funds.

While open to anyone, IRAs have been used extensively by small business owners and self-employed individuals who don't have access to traditional corporate 401(k) plans. There are currently over 45 million IRA holders in the U.S., with over $4 trillion in assets. Almost half of that is invested in mutual funds.

What most IRA holders don't realize, though, is that securities are just one of the many investment choices available to them. Less than 4% of those funds are held in non-traditional assets other than securities, bonds, etc. In fact, the IRS doesn't even provide a list of what you can invest in, only what you can't. Here's the list:

1. Life insurance
2. Collectibles (art, jewelry, etc.)

That's it. Pretty much anything else that constitutes an investment is fair game:

• Real estate
• Private equity
• Private lending
• Tax liens
• Anything else that qualifies as an investment by IRS standards

Note that it must actually qualify as a capital investment that pays dividends or royalties or is subject to capital gains tax, i.e., simply buying merchandise and reselling it doesn't qualify.

Self Directed IRA

An IRA requires a qualified custodian to manage the funds and ensure that all expenditures are qualified investments. Securities brokers typically offer these services to their clients at very low fees, making their money on the trading fees. However, they will generally only act as a custodian for the type of investments they offer.

A "Self Directed IRA" is a bit of a misnomer. In fact, all IRAs are "self-directed" in that you decide what investments to make. It's really the custodian that makes the difference. Custodians that specialize in self-directed IRAs allow you to invest not only in securities, but any eligible investment. They typically charge both maintenance fees and transactional fees for each disbursement, which can add up quickly if you're doing a lot of transactions.

Checkbook IRA

The checkbook IRA, or "truly self directed IRA," offers a solution for investors who want flexibility without getting nickel-and-dimed with transaction fees. The way it works is that a new legal entity — a Limited Liability Company (LLC) — is formed, with the IRA itself as the sole member (owner), and the IRA account holder as the Manager. The LLC becomes the sole investment of the IRA, and the IRA holder has checkbook control over the LLC. So, for example, expenses to renovate an investment property can be paid immediately, as needed, rather than having to be approved and disbursed by the custodian.

The LLC is still subject to the same eligibility rules regarding investments and transactions. It simply shifts the responsibility to the IRA holder, rather than the custodian. For example, one thing you have to particularly watch out for is "self-dealing," or prohibited transactions. IRC 4975(c)(1) prohibits transactions between the IRA and you individually, as well as your spouse and descendants, or any transaction that directly or indirectly benefits them. For example, your IRA can't buy property you currently own from you. You also can't provide free labor to renovate an investment property.

So how can small business owners take advantage of this vehicle?

For one thing, through your IRA, you can invest in any business in which you do not hold controlling interest. So if you have a business with two other partners (or one partner and some minority investors), you could use your IRA to provide additional capital to your business.

Secondly, if you are already engaged in eligible investing, such as real estate, private lending or angel investing, you can conduct a portion of your business through your IRA LLC, thereby deferring taxes on those investments until retirement and retaining what you would be paying in taxes now as part of your available investment funds.

Finally, this vehicle may offer an attractive option for "friend and family" investors, or even angel investors, to put money into your company on a tax-deferred basis.

Learning More

If you decide to explore truly self directed IRAs, be prepared that your attorney and your CPA may not be much help. Unless they're already familiar with this structure, it will require a great deal of research on their part. It's best to find a firm that specializes in setting up IRA LLCs and already has the proper documents and service providers to do it right.

While this option may only be appropriate for a few people, if you're one of those few, it could potentially net you thousands of dollars in tax savings and additional investment gains.

This is a guest post by Scott "Social Media" Allen, a 25-year veteran technology entrepreneur, executive and consultant.