An engineer, Niemann, 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. He completed 9 deals in his 2nd year of 2009, 8 of which made a profit, for net income of $126,000
Pursuant to the “advice” of a Check Book LLC promotor, the promoter set up an IRA-owned LLC for the Engineer. The promoter provided typical “advice” and “customization” on the LLC, or, in a word, somewhere between “awful” to “non-existent”. The operating agreement for the LLC 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 properly use the LLC without destroying his IRA (which is quite common). Consequently, he entered into deals between himself and his IRA that
The first LLC was his Engineering firm Dependable Project Services. This was his existing LLC that he had put together in 2003 for his environmental studies and he later used this to hold mineral rights.
The second LLC was a new one created for his IRA, Real Estate Rabbit, LLC, which gave him “Checkbook Control” of the company and thus his IRA. Niemans IRA was the sole member of this LLC and he was also the manager of the LLC.
The third LLC, Magic LLC was for his real estate investing. It was supposed to be a multi-member LLC, but the promoter that put this company together never took the time to make it a “multi-member” LLC. This is typical from promoters and seminars that push LLC’s especially LLC’s from Nevada and Utah.
So his first mistake was managing his assets and his taxes via promoter, rather than working with a local professional that would take the time to learn his business, help him set it up correctly for his business, and show him how to operate it correctly. His second mistake was doing his own taxes, and making many mistakes. His third was representing himself in tax court.
Travel Expenses: The IRS attacked travel expenses of $8,000 in 2009 and $16,000 in 2010 that were claimed as expenses incurred because of the properties. Because they were round numbers, they were a bright red flag for the IRS auditor as they scream “I made them up!”. Documentation on the expenses was not complete. While he did log the expenses, meals, entertainment, and travel need to be documented with time, place, amount and the business purpose for each transaction. Nieman failed to describe the business purpose. The expenses may have been legitimate and he might have been able to reconstruct the business purposes to provide the needed records, but he failed to do so, so the travel expenses were all disallowed.
Note: Be sure to write the business purpose for all meetings on the receipts and then scan the receipts into a folder that is backed up to multiple devices so that you have then should you ever need to prove the expense and the reason to the IRS.
Attorney’s Fees: One of the LLC’s paid $8,000 to an attorney to evaluate the collectability of a large portfolio of student loans that was for sale for $2M with a face value of $3M. The attorney ultimately advised against the acquisition. The IRS successfully argued that the fees were nondeductible.
To deduct legal fees as an expense under Code Section 162, Niemann needed to have enough activity to qualify as a “trade or business”. He did not have sufficient “continuity” or “regularity” to have a “trade or business” of buying distressed notes. He made 2 loans to realtors and had not bought or held any other notes. He was not even close to having a “trade or business”, at least as far as buying notes was concerned. If Nieman had hired a competent attorney rather than representing himself, he might have turned to case law that could have reversed this ruling, but he didn’t so we will never know.
Short-Term Capital Gains on Flips: Niemann reported $126,000 of short-term capital gains in 2009 based on the profits from his flipping activities – not bad for his second year in the business, and his first year selling!
Note: The IRS apparently did not attempt to argue that buying/selling nine properties in one year constituted a “dealer” activity. Therefore, the $126k was not subject to social security/self-employment taxes of around $19,000. This is the upshot of not having enough activity to constitute a “trade or business” – one is less likely to have enough activity to be a “dealer” and can therefore avoid SS/SE taxes on the income by reporting the sales of Schedule D instead of Schedule C of Form 1040. And because he took title and then sold the properties he was more able to claim the short-term capital gains. However if he had used Assignments, it would have been much harder to report as cpaital gains., since they very much resemble services, which are taxed as ordinary income and subject to self-employment/social security taxes.
Home Office Expenses: He claimed $29,000 of home office expenses that he capitalized to properties, meaning he added them to the cost basis of the properties. The court held that these amounts were the cost of doing business and could not be capitalized, as they were not costs of acquiring property. The Court stated that these costs should have been reported on Schedule C. They were presumably added to Schedule C via court order.
The Checkbook LLC: The court had quite a bit to say about checkbook LLCs worth reprinting here:
- “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 the trial neared that Magic (his real estate company) was not actually a multi member 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.”
Lessons to Learn Avoice Checkbook LLC promoters. 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 these 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 promoters 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.
Please note this article is summarized from the original written by John Hyre. To read the complete article in its original form, please click here.
John Hyre is a Tax Attorney, IRA and 401k specialist and real estate investor from Ohio. He speaks and teaches regularly on planning your business structure and your IRAs or 401ks to protect your assets from those who might want to sue you as well as the tax collector. He will be joining us in October for the monthly meeting on the Tuesday the 10th and a full day workshop on Saturday the 21st. Click the dates to get more details.