I work in the field of Self Directed IRAs & 401(k)s. Based on the phone calls and emails we receive, by far the most discussed topic is checkbook control. Some people want it; others don’t. Some service providers support it; others discourage it.
What is it?
What most people are referring to when they say checkbook control is an investment structure that is formed as follows:
- A person opens an IRA account at a self directed custodian and transfers other retirement account funds into it.
- The accountholder has a Special Purpose LLC created and names themselves as LLC manager.
- The accountholder directs their custodian to invest some or all of the IRA funds into the newly created LLC.
- The LLC further invests its funds, often into real estate, private companies, or mortgage notes. The LLC is owned by the IRA, but managed by the IRA accountholder. Because the manager is the authorized signor on all LLC accounts, this is known as checkbook control.
The legitimacy of this structure was verified in a tax court decision.
Why would somebody WANT checkbook control?
- Eliminate transaction based custodian fees
- No delay for custodian to process the transaction
- Remove custodian’s prohibition on certain legally allowable investments
- Invest in stock market with margin
- Invest in foreign assets with more ease
Why would somebody NOT want checkbook control?
Here’s where the confusion and disagreement occurs. The argument against checkbook control is based on compliance, mostly with prohibited transactions, which in a nutshell are “self dealing” transactions. Self dealing means the accountholder causing the retirement account to buy, sell, or otherwise enter into a transaction with a disqualified person. This category of people includes the accountholder, most of his relatives, and anyone who provides services to the retirement account. So the argument goes like this:
“Prohibited transactions are costly. Without a custodian overseeing your transactions, you are at higher risk of doing a prohibited transaction and paying large tax penalties as a consequence.”
I always do my best to maintain an objective, balanced viewpoint. In light of the above argument, I formed the opinion that it’s good for some people to have checkbook control and risky for others. Therefore, whether checkbook control is appropriate is dependent on the circumstances of the accountholder. I operated under this thinking for over a year…
Then I learned more about the actual matter at hand.
… and have come to a completely different conclusion. Here are the newly discovered facts:
- A custodian cannot advise you on whether a proposed transaction is compliant. It is a legal matter, and only an attorney can give you legal information that you can act and rely upon.
- A custodian will not allow you to open an account unless you hold them harmless for their guidance and actions relating to prohibited transactions and legal compliance.
- In every retirement account, the person solely responsible for prohibited transaction compliance is the decision maker (aka fiduciary – the one who has discretion over how plan assets are invested). A custodian is not a fiduciary. You make the decision, they only follow through with them.
- In the event of a prohibited transaction in a self directed account, the accountholder will suffer the consequences regardless of whether they had checkbook control.
Okay, so all in all, #4 is what’s important. The idea here is that transacting without checkbook control does not take you off the hook in terms of PTs.
It is easy to know if there is PT risk
Determining whether a proposed transaction is actually a PT is hard. But determining whether something might be a PT is easy. Here’s the 3 step process:
- Make a list of disqualified persons. This list should include your spouse, ancestors, lineal descendants (children, grandchildren, etc), and spouses of lineal descendants. Also include anyone who provides services to your retirement plan.
- If a proposed transaction involves (or is expected to involve in the future) a person on the DQP list in any way, stop. It might be a PT. Either don’t do the transaction or get help before proceeding.
- Seriously, don’t proceed without help.
It’s important to note that “involves in any way” (from #2 above) includes involvement of an LLC, trust, corporation or any other entity that has a DQP as part or whole owner, director, officer, employee, etc. PTs also include any scheme that intends to use plan assets to benefit a DQP even if indirectly.
If you can’t follow that 3 step process, you shouldn’t have a self directed account regardless of checkbook control because the risks are the same. If you are at risk of paying absolutely no attention to PT rules, then a custodian’s “we’ll keep you safe” vow doesn’t jive with their account terms and conditions, and you’ll be paying the price of your naivety if they overlook a PT.
Again, it’s easy to determine PT risk. If there’s a potential PT, only an attorney can give you definitive, binding advice. Your risk is absolutely identical with or without checkbook control: It’s your risk and your responsibility.
Are there any other reasons to want to transact at the custodial level?
The only other possible benefit of transacting at the custodial level is bookkeeping. If you can’t balance a checkbook or put bank statements, contracts, and settlements statements in a file folder… then you will have problems keeping your LLC’s books. Then again, if you don’t understand basic recordkeeping, you shouldn’t be a self directed investor yet, now should you?
What about FDIC insurace?
I’ve noticed FDIC insurance is a frequent component of this topic as well. IRAs have $250,000 of coverage while regular bank accounts have $100,000 of coverage. This should be of no consequence:
- With free checking, why not open multiple bank accounts for LLC cash reserves of over $100,000?
- When’s the last time you used your FDIC insurance coverage?
- It only kicks in during a banking disaster. If there’s a banking disaster, U.S. Dollars may become entirely worthless. Here, the FDIC might as well be giving you Monopoly money.
- The currency is already declining; you shouldn’t have more than $100,000 wasting away from currency debasement anyways.
What about extra tax returns?
Checkbook control makes use of a single member LLC which the IRS disregards for tax purposes. In other words, there is no tax return required. If your IRA or LLC were to invest into a multiple member LLC partnership, a 1065 partnership return needs to be filed, but this is the case with or without checkbook control. Checkbook control creates no unique additional filing requirements.
Back to the big picture for risk of PT noncompliance:
If you pay no attention to PT rules and you transact at the custodial level, you are at high risk.
If you pay no attention to PT rules and you transact with checkbook control, you are at high risk.
If you follow the simple 3 step PT risk determination process described above and you transact at the custodial level, you are at low risk.
If you follow the simple 3 step PT risk determination process described above with checkbook control, you are at low risk.
If you do a PT at the custodial level, you pay the consequences.
If you do a PT with checkbook control, you pay the consequences.
You see, when you really break it down, there is actually no substance to the anti-checkbook-control argument.
But I’ve heard that the government is about to prohibit checkbook control?!
I dare you to find an official written source of this claim. I’ll give you a hint, your best chance is in the magazines you look at while waiting in line at the supermarket.
If you think that government prohibition of checkbook control is actually likely, consider that 401(k) plans (in fact all qualified plans) have never had a custodian requirement in the first place. That’s 27 years of checkbook control with no sign of change. Really think about this for a second. The government allows you to prepare your own tax return. You can lie and cheat on it if you are stupid enough. Outlawing checkbook control of retirement accounts is on par with outlawing self prepared tax returns.
So, get the facts and make your own choice. If you still think it’s best to transact at the custodial level, then that’s fine. Hey, millions of people still think it’s best to invest mostly in mutual funds and the world still turns.
Don’t get too tripped up on account structuring. Get the facts, make your decision and move on to the fun part: finding and making the investments.