21 Common Self-Directed IRA LLC Mistakes

1Forming a Member-Managed IRA LLC

There are two types of Arizona LLCs: member-managed and manager-managed. In a member-managed LLC the members run the company. In a manager-managed LLC the members elect one or more managers to run it.

The only member of a typical IRA LLC is the IRA custodian, for the benefit of your IRA account. If the LLC is member-managed, the custodian is the one running the company — which defeats the entire reason you formed the LLC. You wanted checkbook control. Member-managed means the custodian has the checkbook.

A single-member IRA LLC must be manager-managed so that the IRA owner (or another person the IRA owner selects) can be elected as manager. The manager is the person with so-called checkbook control — the person who signs the contracts, signs the checks and decides how the LLC's money is invested.

2Naming the IRA Owner as a Member of the LLC

This is the single most common formation error I see in do-it-yourself IRA LLCs, and it is a fatal one.

If 100% of the money going into the LLC is coming from your IRA, then the only member of the LLC must be the custodian for the benefit of (FBO) your IRA account — for example, "Acme Trust Company, Custodian FBO John Smith IRA #12345." Not you. Not you and the IRA. Just the custodian.

If you contribute no personal money but take a membership interest anyway, that transfer of value from the IRA to you is a prohibited transaction and the IRA is disqualified. The one exception: if you personally contribute X% of the capital at the time of formation, you may own X% of the membership interests — but that structure raises its own ongoing prohibited transaction problems and should never be done without counsel.

3Paying the LLC's Formation Costs with Personal Money

It feels harmless. The filing fee is due, the IRA custodian takes a week to cut a check, so you pay it out of your checking account and figure you will sort it out later.

You just made a loan to, or paid an expense of, an entity owned by your IRA. Neither the IRA owner nor any disqualified person may pay an expense of the IRA LLC, extend credit to it or guarantee its debts. There is no de minimis exception in the statute. The IRS has never announced a dollar threshold below which it will look the other way.

4No Operating Agreement Signed by the Custodian — or a Generic One Off the Internet

Arizona law does not require the members of an LLC to sign an operating agreement. That is exactly why so many IRA LLCs do not have one, and why so many of the ones that do have a 4-page form downloaded from a website that has never heard of IRC Section 4975.

An IRA LLC operating agreement has to do several things a generic form does not do. It must name the manager and define the manager's authority and duties. It must limit the custodian's voting rights so that the manager actually has control. It should prohibit the LLC from engaging in prohibited transactions and from acquiring assets an IRA may not own. And most custodians will not fund the LLC until their compliance department has reviewed and approved it.

The operating agreement is also your best evidence, years later, that the LLC was a real entity operated for the exclusive benefit of the IRA.

5Signing the Purchase Contract Before the IRA LLC Exists

Homer Simpson finds the perfect rental house. He wants his IRA to own it. He signs the purchase contract in his own name on Monday and calls me on Tuesday to form the IRA LLC.

If Homer were forming an ordinary LLC, this would be a non-event — he would assign the contract to the LLC, or buy in his own name and deed the property to the LLC after closing. Neither option works here. Any transaction between Homer and his IRA LLC is a prohibited transaction, and that includes assigning him a contract to the LLC or deeding the LLC property he bought. It makes no difference that Homer paid nothing for the contract and made no profit.

6Taking Title to the Asset in the Wrong Name

The LLC is formed correctly, the money is wired correctly, and then the title company prepares a deed to "John Smith" or to "John Smith IRA" because that is the name on the wire. Or the promissory note names you as the lender. Or the brokerage account is opened in your personal name.

Every asset the IRA LLC buys must be titled in the exact legal name of the LLC. Sloppy titling is how the IRS argues, five years later, that you — not your IRA — owned the asset all along.

7Never Reading the Prohibited Transaction Rules

If you do not know what a prohibited transaction is, then you are relying on pure luck that you will not accidentally commit one. Luck is not an asset protection plan.

Generally, a prohibited transaction is any improper use of the IRA by the IRA owner, the IRA owner's beneficiary or any disqualified person. Here are the classic examples, drawn from IRC Section 4975 and the IRS publications:

• Selling, exchanging or leasing property between the IRA LLC and a disqualified person.
• Lending money or extending credit between the IRA LLC and a disqualified person — in either direction.
• Furnishing goods, services or facilities between the IRA LLC and a disqualified person.
• Transferring IRA LLC income or assets to, or allowing their use by or for the benefit of, a disqualified person.
• Any act by a fiduciary that uses IRA LLC income or assets for his or her own interest.
• A fiduciary receiving consideration for his or her own account from any party dealing with the IRA LLC in a transaction involving IRA LLC income or assets.
• Borrowing money from the IRA.
• Using the IRA as security for a loan.
• Receiving unreasonable compensation for managing the IRA.
• Buying property for personal use, present or future, with IRA funds.

8Not Knowing Who the Disqualified Persons Are

You cannot avoid transactions with disqualified persons if you do not know who they are. Here is the list.

Two traps hide in that table. First, your son-in-law and daughter-in-law are disqualified persons (spouses of lineal descendants) but your own brother is not. That surprises almost everybody. Second, the right-hand column is not a green light — a transaction with a non-disqualified person can still be a prohibited transaction if it is really a way to benefit you indirectly.

9Personally Guaranteeing a Loan to the IRA LLC

This one has a Tax Court opinion with a name on it, and the name is not a happy one for the taxpayers involved.

In Peek v. Commissioner, 140 T.C. 216 (2013), two taxpayers used self-directed IRAs to fund an entity that bought a business. The lender wanted personal guarantees, so they signed them. Nothing else went wrong. They made no money personally, took no distributions and did nothing else improper.

The Tax Court held that the personal guarantee was an indirect extension of credit between a disqualified person and the IRA — a prohibited transaction under IRC Section 4975(c)(1)(B). Both IRAs were disqualified. Worse, the court held the prohibited transaction was a continuing one for as long as the guarantee remained outstanding, so the taxpayers could not argue the statute of limitations had run. The Tenth Circuit affirmed.

10Using or Occupying the IRA LLC's Property

Homer's IRA LLC owns a single-family home. Homer, as manager, leases it to his son Bart at a fully market rent. Bart pays on time every month. The IRA makes money.

It is still a prohibited transaction and the IRA is still disqualified. Bart is a lineal descendant. The rent being fair does not save it — the statute prohibits the use of IRA assets by a disqualified person, full stop.

The same is true of the vacation condo your IRA LLC owns that you stay in for one weekend a year, the office space your IRA LLC leases to your own business, the storage unit where you keep a few personal boxes, and the truck the IRA LLC owns that you drive on weekends.

11Money or Property Flowing to a Disqualified Person

Two real-world examples that people are shocked to learn are prohibited transactions:

Homer, as manager of his IRA LLC, pays his son $20 out of the LLC's bank account for mowing the lawn at the LLC's rental property. Twenty dollars. Prohibited transaction. The whole IRA is disqualified.

Homer's IRA LLC sells its real estate at a nice profit. Marge, Homer's wife, is a licensed real estate agent working for the listing broker, and she is paid a share of the commission. Prohibited transaction. The whole IRA is disqualified.

12Paying Yourself a Salary or Management Fee

You are the manager. You do the work. It seems obvious that the LLC should pay you something for it. It is not obvious — it is prohibited, and there is a court of appeals decision that says so.

In Ellis v. Commissioner, affirmed by the Eighth Circuit in 2015, a taxpayer used his IRA to fund an entity that operated a used car business, and the entity paid him a salary as its general manager. The court held that paying compensation to the IRA owner was a use of the IRA's assets for his own benefit under IRC Section 4975(c)(1)(D) and (E). The IRA was disqualified and the entire balance was a taxable distribution.

13Sweat Equity — Doing the Work Yourself

The related and even more common version of Mistake 12: your IRA LLC buys a fixer-upper and you spend your weekends painting it, replacing the flooring and fixing the roof. You are not paid a dime, so you assume it is fine. Free labor helps the IRA, right?

It is furnishing services between a disqualified person and the plan, which is prohibited under IRC Section 4975(c)(1)(C). The IRS position is that even uncompensated services from the IRA owner are prohibited, because you are contributing value to the IRA outside the contribution rules.

14Investing in a Business You or Your Family Control

Your IRA LLC does not have to transact with you personally to blow up. It is enough for it to transact with an entity that counts as a disqualified person.

Under IRC Section 4975(e)(2)(G), a corporation, partnership, trust or estate is a disqualified person if 50% or more of it is owned, directly or indirectly, by disqualified persons. So if you and your spouse own 60% of an operating company, your IRA LLC cannot lend that company money, buy its assets, buy real estate from it or lease space to it.

The trap: ownership percentages change. An investment that was perfectly clean when the IRA LLC made it becomes a prohibited transaction the day your family's ownership of the other entity crosses 50%.

15Storing Gold, Silver or Coins at Home or in Your Safe Deposit Box

An entire industry has been built on selling "home storage IRA" and "checkbook IRA gold" arrangements. The Tax Court has now looked at one, and it did not go well for the taxpayer.

In McNulty v. Commissioner, 157 T.C. No. 10 (2021), a taxpayer's IRA owned an LLC, the LLC bought American Eagle coins, and she — as manager — kept the coins in a safe at her home. She argued the LLC owned the coins, not her.

The Tax Court disagreed. IRC Section 408(m) carves certain coins and bullion out of the collectibles prohibition, but only when they are in the physical possession of the IRA trustee. Physical possession by the IRA owner — even through an LLC she managed — was a taxable distribution of the coins. The court also observed that an owner with unfettered personal control of IRA assets has effectively received them.

16Buying an Asset an IRA Is Not Allowed to Own

Self-directed does not mean unlimited. Some assets are simply off the table no matter how the transaction is structured:

• Collectibles under IRC Section 408(m) — artworks, rugs, antiques, metals, gems, stamps, coins, alcoholic beverages and other tangible personal property the IRS designates. Certain U.S. and state-issued coins and qualifying bullion are excepted, but only if held by the trustee, as Mistake 15 explains.
• Life insurance contracts on the IRA owner's life, under IRC Section 408(a)(3).
• S corporation stock. An IRA is not a permitted S corporation shareholder under IRC Section 1361(b)(1)(B). If your IRA LLC buys S corp shares, the corporation's S election terminates — which will make you very unpopular with the other shareholders.

17Using Recourse Debt, and Ignoring UDFI and Form 990-T

There are two separate mistakes buried in leveraged IRA investments, and people usually make both.

The first is the loan itself. As Mistake 9 explains, any borrowing must be non-recourse, with no guarantee from a disqualified person. Using a conventional recourse mortgage is a prohibited transaction.

The second is a tax nobody sees coming. When an IRA owns debt-financed property, the portion of the income and gain attributable to the borrowed money is unrelated debt-financed income (UDFI), a form of unrelated business taxable income. It is taxed at trust income tax rates, which reach the top bracket very quickly. If the IRA has more than $1,000 of gross UBTI in a year, a Form 990-T must be filed and the tax paid from the IRA's funds. The same applies if the IRA LLC holds an interest in an operating business taxed as a partnership.

The special exception that lets qualified plans avoid UDFI on real property does not apply to IRAs. Many IRA owners discover this the year they sell a leveraged property.

18Not Reporting the LLC's Annual Fair Market Value to the Custodian

Your custodian is required to report the value of your IRA to the IRS every year on Form 5498. Once your IRA's only asset is a membership interest in an LLC that owns real estate or private investments, the custodian has no way to determine that value. It has to ask you.

IRA owners routinely ignore that request, or report the same number year after year, or report the original amount invested. That creates two problems: the custodian may resign or restrict the account, and an unsupported valuation undermines any later distribution, Roth conversion or required minimum distribution calculation.

19No Plan for Required Minimum Distributions from an Illiquid IRA

Traditional IRA owners must begin taking required minimum distributions at age 73 (age 75 for those born in 1960 or later). Roth IRAs have no RMDs during the owner's lifetime.

Here is the problem with a traditional IRA LLC that owns a rental house: you cannot distribute a bathroom. If the IRA has no cash and the LLC's only asset is real estate, you are facing a fire sale in December, a partial in-kind distribution requiring an appraisal, or a penalty for failing to take the RMD. And you cannot solve it by writing a personal check into the IRA — that is a contribution, subject to the annual limits.

20Commingling — No Separate LLC Bank Account

The LLC needs its own bank account, in the LLC's name, using the LLC's own EIN, funded only by the custodian and used only for the LLC's business. Every dollar in and every dollar out passes through that account.

What goes wrong: rent checks get deposited into a personal account "temporarily." A repair gets paid with a personal credit card and reimbursed later. A second IRA's money or personal money gets mixed into the same account. Each of those is a prohibited transaction risk and, separately, a gift to any plaintiff's lawyer who wants to pierce the LLC's veil.

21No Books, No Insurance, No Maintenance of the LLC

Three chronic failures that all share the same cause — treating the LLC as a formality rather than a company.

No bookkeeping

Set up QuickBooks or comparable accounting software the week the LLC is formed and enter every item of income and expense as it occurs. Bookkeeping that is put off for a year is bookkeeping that never gets done correctly. Good books are what you need to support the annual valuation, to prepare any required tax return, and to defend the LLC if someone tries to pierce its veil and reach the IRA's assets.

No insurance

If the IRA LLC owns real estate or other valuable property, the LLC itself must be the named insured on the policy. If the house burns down and the policy names you individually, the carrier can deny the claim — and your IRA absorbs the entire loss. Talk to two or three commercial insurance agents about policy types, coverage limits and liability coverage before the LLC closes on any property.

No LLC maintenance

The LLC must keep a statutory agent and a current known place of business on file with the Arizona Corporation Commission, and its records must be kept current when a manager or address changes. An LLC that has been administratively dissolved is not much of a liability shield.