There’s something that most “successful” Self-Directed IRA investors do that can spin them out of control and get them into trouble.

I say “successful” in quotation marks because I’m talking about the particular kind of Self-Directed IRA success that is sexy enough to be frequently written about.

What is this dirty deed that leads to massive profits and the potential implosion the very same Self-Directed IRA that got those profits?

Entrepreneurship.

Bad Entrepreneur!

Yep. Entrepreneurship is so powerful that it seems to be the source of all aggressive wealth creation. So where’s the danger?

Let me explain. Some of the most [initially] profitable Self-Directed IRA stories sounds something like this…

Joe, a Self-Directed IRA investor, knows how to work real estate deals into profits. So he buys and sells real estate in his Self-Directed IRA. Sometimes he involves bank financing. Sometimes he involves private financing and partnering.

But one thing is for sure: Once Joe purchases a property, the work has just begun. He has a system. He only buys properties that meet a certain criteria. After the closing, he usually has repairs and/or remodeling work done.

And his system works. He’ll put $30k or $40k of his Self-Directed IRA money into a deal and get $80k to $100k out, often less than a year or two later.

First, applaud Joe for being a successful entrepreneur.

Did you catch that? Joe is being an entrepreneur rather than an investor. This is because his deals have his active involvement rather than the passive placement of his money.

The Pinless Grenade

Unbeknownst to Joe, he’s no longer in control of his financial outcome. His choice to try to sneak business activity inside his IRA gives the IRS an open invitation to tax the hell out of him.

How much?

Well, the IRS can declare Joe’s IRA deals to be a “trade or business” in which they’ll apply the UBTI tax. Also known as the most aggressive tax schedule in the United States. It ramps up to 35% federal tax after only $10,000 of profit.

Will the IRS make this move? When?

That’s unknown, and Joe is no longer in control of his financial outcome.

Terrible Success

All kinds of strategies fit into this same category. I have a friend who has done over 100 deals inside his Self-Directed IRA, producing a return-on-investment of over 9,000%.

And he’s hiding under a rock. He won’t returns the calls of the newspaper and magazine reporters who want him to share his strategies with the world. He rarely teaches investing seminars, and when he does he only invites people who he has personally met and known for at least 6 months. He essentially lives a life of fear because he knows the day his Self-Directed IRA gets audited is the day he gives up at least $1,200,000 plus late penalties and interest to the IRS.

Enjoyable, Controlled Success

Do you know how to do deals that turn pennies into thousands? Thousands into millions?

Fantastic.

Don’t ever consider not pursuing massive profits, and don’t ever lock away your talents and skills to be unused.

Just take a few minutes to educate yourself about the best way to structure your deals to keep you in control.

More info coming in Part Two of this post soon  :-)

In case you haven’t heard through the grapevine, my new book, UNLIMITED INVESTING With a Self-Directed IRA LLC or Solo 401(k): Break Free From Wall Street To Build Real Wealth With Alternative Investments, will be available soon.

I’ve joined forces with Phoebe Chongchua to write the book, and it’s almost through the editing process. If you are unsure what to invest in right now, then this book is for you. Inflation or deflation? Real estate or gold? Own assets domestically or internationally? These questions are thoroughly examined and answered through 12 real-life investor case studies – successes and failures. We expect the book to be available in May, but you can pre-order it now. Use the code “realwealth4″.

*** This is Part 3 of a series about the dangers of letting an administrator act as custodian. Make sure you read Part 1 and Part 2 first to make sense of this post. ***

The illegitimate custodian test

Ask “Who should the check be payable to for the rollover contribution or transfer?”

Ask “If my IRA buys real estate and rents it out, to whom should the tenant make the rent checks payable?”

Ask “If my IRA owns real estate that needs repairs, who issues and signs the check to the repairmen?”

These questions will tell you who is actually serving as custodian. For instance, if you live in TX and unregulated company Dotrust is marketing its self-directed IRA services to you, the answer to one or more of the questions above will probably be something like Dotrust of Texas, Inc. If this is the case, ask to see its bank or trust charter – if it is an illegitimate custodian it won’t have one, and it will insist that another bank is technically the custodian. It not only matters who’s the custodian on the paperwork is; but it also matters who is acting as custodian as uncovered by the answers to the 3 questions above.

Why would somebody operate an illegitimate custodian company?

First of all, if it’s a franchise operation, the franchisee might not even know that he or she is part of an illegitimate IRA custodian scheme. Secondly, there can be a lot of profit to be made in an illegitimate IRA custodian scheme. The company can earn interest off of your IRA funds, and it may pass only some (or even none) of that interest earned on to you. It may also be able to earn higher interest rates when it collectively has custody of hundreds of millions of dollars in funds.

Surprised?

You may be thinking “This sounds like a company I’ve run into. But it promotes and and advertises and has been in the business for decades… it can’t be illegitimate, can it????”

Many high-profile schemes have been shut down. The private annuity trust scheme was promoted for over a decade before the IRS shut it down. Additionally, being in business for decades doesn’t guarantee that business is legitimate. Look at Bernie Madoff.

Madoff may be a harsh comparison. Those involved in an illegitimate IRA custodian scheme may not be knowingly harming anyone. They may even be attorneys or CPAs. They may believe they’ve merely created a loophole for themselves with the “stepped transaction” arrangement. They may be good people. But the bottom line is that there are significant risks you take in using their services, and you will pay the consequences if uncovered by the authorities. In my opinion, it never makes sense to use an illegitimate custodian because there are dozens of regulated/legitimate self-directed IRA custodians out there. There should be a balance between risk and reward. There is significant risk of using an unregulated/illegitimate custodian, and it offers no unique reward that isn’t offered by other self-directed IRA custodians.

Confused? If you have a self-directed IRA or are thinking of opening one at a custodian company, perform the illegitimate custodian test as described above.

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*** This is Part 2 of a series about the dangers of letting an administrator act as custodian. Make sure you read Part 1 first to make sense of this post. ***

Signs that your custodian may not really be a custodian

1. They sometimes call themselves an administrator. “Administrator” is an accurate label for any company who provides record keeping services. Being an “administrator” doesn’t require any regulation. These types of companies may expand their services to include asset custody without actually registering as a bank or trust company.
2. Their name contains the word “trust” attached to other letters or words. A legitimate custodian usually has the word “bank” or “trust” as a separate word included in its name. In most states, the word “trust” is a restricted word for naming companies – just like the word “bank”. This means that you can’t start a company called “ABC Bank” unless it’s registered as a bank. You also can’t start a company called “XYZ Trust Company” without being a registered trust company. An illegitimate custodian might get around this by calling themselves Trustus rather than Trust Us, Dotrust rather than Do Trust, or Safetrust rather than Safe Trust. You see, if trust is attached to another word instead of used as a separate word, then it sneakily gets around the naming restrictions.
3. They have dozens of offices all around the country. Expanding to dozens of cities across the country can get expensive for a regulated custodian. The self-directed IRA custodian business isn’t nearly as profitable as the securities business, and most legitimate custodians must operate only one or two offices in order to be able offer their services for reasonable and competitive fees.
4. They sell franchises. Franchises can be a powerful and leveraged way to build a brand, but for the IRA custodian business it is nearly impossible to expand a legitimate custodian business through franchising. If a legitimate custodian had 40 offices across the country, its overhead would be so high that its fees would be much higher than the next most expensive competitor and its services would have nothing to offer to justify the higher fees. In reality, it appears that only illegitimate custodians are able to run franchise operations, and this is made possible by not having to deal with the regulatory costs of having dozens of audited and regulated offices.
5. They hire a real bank or trust company to be the custodian, but then they fulfill custodial duties themselves. In the legal world, there is a concept known as “stepped transactions” or the use of a “strawperson”. This is basically where a step is added to a transaction to include a person or company, and this inclusion is only involved to circumvent a law. For instance a self-directed IRA can’t buy or sell assets to or from its accountholder or its family members. So let’s imagine a guy named Joe wants to sell his personal residence to his IRA – which would normally be a prohibited transaction. In an attempt to get around this prohibition, he sells his home to his friend Randy, who then sells the house to Joe’s IRA. This would easily be deemed a “stepped transaction” because Randy did not really want to buy the house; he was just trying to disconnect the real parties from transacting (Joe and his IRA) directly so that it would appear to not break any laws. This same concept can be seen with IRA custodians. An administrator may want to serve as a custodian without being a bank or trust company. So it hires a bank to serve as custodian on the paperwork. Then it gets the bank to outsource custody-related tasks (holding and controlling assets) right back to it. In this scenario, the bank is a “strawperson” and the arrangement is similar to a “stepped transaction”. To understand the legal ramification of what’s really going on, you must remove the step/strawperson. In this scenario, what’s really happening is that a non-custodian is serving as the custodian, and it is illegitimate.
6. They are opposed to the “checkbook control” IRA LLC strategy. Illegitimate custodians primarily profit by earning interest on the funds of others (like a bank) without registering themselves as a bank or trust company. In an IRA LLC structure, most of the IRA funds are invested into an LLC where the IRA/LLC accountholder puts them at any bank of their choosing – where the LLC will earn the interest on the funds. This undermines the primary goal for the illegitimate custodian (earning interest on your funds) so it usually discourages (or even disallows) you to use the IRA LLC strategy.

Coming up in Part 3 of this series: How to tell if your custodian is compliant using the illegitimate custodian test.

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