Can an IRA Invest in an LLC? Here’s How It Works

An Individual Retirement Account (IRA) can invest in a Limited Liability Company (LLC), offering a pathway to diversify a retirement portfolio beyond traditional stocks and bonds. This strategy allows individuals to gain more direct control over their retirement savings and access a wider range of asset classes. However, this approach involves navigating specific regulations and understanding complex tax implications. Adherence to Internal Revenue Service (IRS) rules is required to maintain the IRA’s tax-advantaged status.

Establishing a Self-Directed IRA

Investing an IRA directly into an LLC necessitates a self-directed IRA (SDIRA), which differs significantly from a traditional IRA. Unlike standard IRAs, which limit investments to publicly traded assets, an SDIRA permits a broader spectrum of alternative investments. This includes real estate, private equity, precious metals, and private business entities such as LLCs. The distinction lies in expanded investment choices and increased control over investment decisions.

Establishing an SDIRA begins with selecting a specialized custodian that handles alternative assets, as most conventional financial institutions do not offer self-directed options. These custodians are responsible for holding assets, processing transactions, and ensuring IRS compliance. When choosing an SDIRA custodian, evaluate their experience with alternative investments, their fee structure, and their commitment to regulatory compliance. The custodian’s expertise in managing non-traditional assets is important for compliance.

After selecting a custodian, the account setup process typically requires completing an application and providing identification documents. Once the SDIRA account is established, funds can be transferred or rolled over from existing retirement accounts, such as a 401(k), another IRA, or a 403(b). A direct rollover from a 401(k) to an SDIRA avoids immediate taxation, while an indirect rollover involves receiving a check and depositing it within 60 days to prevent penalties. The custodian facilitates these transfers, ensuring funds are properly moved into the new self-directed account.

Understanding Prohibited Transactions

Investing an IRA in an LLC requires understanding “prohibited transactions” and “disqualified persons” as defined by ERISA and the Internal Revenue Code. A prohibited transaction is any direct or indirect transaction between an IRA and a disqualified person, or self-dealing or conflicts of interest. These rules prevent individuals from personally benefiting from their tax-advantaged retirement funds outside of prescribed distributions. Examples include lending money to oneself, purchasing property for personal use, or providing services to the IRA for compensation.

A “disqualified person” includes the IRA owner, their spouse, their lineal ascendants (parents, grandparents) and descendants (children, grandchildren), and the spouses of those descendants. Entities in which the IRA owner or other disqualified persons hold a 50% or greater interest are also considered disqualified. If an IRA invests in an LLC, the LLC and its assets cannot be used for the direct or indirect benefit of these individuals or related entities.

Common pitfalls include using the LLC’s assets for personal gain, such as living in a property owned by the LLC, or having a disqualified person perform services for the LLC and receive compensation. For instance, if an SDIRA invests in an LLC that owns real estate, the IRA owner cannot personally use the property as a residence or vacation home, nor can their disqualified family members. The IRA owner cannot be compensated for managing the LLC or its investments.

The consequences of engaging in a prohibited transaction are significant. If an IRA owner or beneficiary participates in a prohibited transaction, the IRA immediately loses its tax-deferred status as of the first day of the year in which the transaction occurred. The entire fair market value of the IRA’s assets is then considered a taxable distribution to the owner, subject to ordinary income tax. If the owner is under age 59½, an additional 10% early distribution penalty may also apply. Disqualified persons involved in the transaction may face an initial excise tax of 15% of the amount involved, with a potential 100% additional tax if the transaction is not corrected promptly.

Tax Considerations for IRA LLC Investments

An IRA is a tax-advantaged account, but certain income generated by an LLC in which it invests can be subject to Unrelated Business Taxable Income (UBTI) and Unrelated Business Income Tax (UBIT). UBTI is income derived from a trade or business regularly carried on by a tax-exempt entity, referring to the IRA’s investment in the LLC. If an IRA-owned LLC generates UBTI above a certain threshold, typically around $1,000, the IRA itself becomes liable for UBIT.

UBTI typically arises when an IRA invests in an LLC that conducts an active trade or business, such as operating a retail store or a manufacturing plant. This income is distinct from passive investment income like interest, dividends, and most rents from real property, which are generally exempt from UBTI. For example, if an IRA-owned LLC actively buys and sells properties with significant development, this could trigger UBTI, whereas simply collecting rent from a long-term rental property typically would not.

Another common scenario triggering UBTI is when an LLC uses debt financing to acquire or improve income-producing property. This is known as Unrelated Debt-Financed Income (UDFI). The portion of income from such a property attributable to the debt is subject to UBIT, even if the underlying activity would otherwise generate passive income. For instance, if an LLC purchases a rental property with a loan, a percentage of the net rental income and any capital gains from its sale, proportionate to the debt used, could be subject to UBIT.

The IRA is generally required to file IRS Form 990-T, “Exempt Organization Business Income Tax Return,” if its gross UBTI exceeds $1,000 in a tax year. This form reports the UBTI and calculates the tax due, which is paid at trust tax rates. These rates can be progressive, reaching higher percentages at relatively low income thresholds. The responsibility for filing Form 990-T typically falls on the IRA custodian, though the IRA owner often needs to provide necessary information and ensure compliance.

Making the LLC Investment

After establishing and funding the self-directed IRA, and understanding prohibited transactions and potential tax implications like UBTI, the LLC investment process can proceed. The SDIRA custodian plays a central role, as the IRA, through its custodian, must be the legal owner of the LLC interest. All investment directions and funding must be routed through the custodian to maintain compliance.

The investor identifies the LLC investment opportunity, conducting their own due diligence on the business plan, financial projections, and overall viability of the venture. Once satisfied, the investor provides detailed investment direction to their SDIRA custodian. This direction typically includes the LLC’s name, the investment amount, and instructions on how funds are to be transferred.

The custodian will require specific documentation to facilitate the investment. This typically includes a copy of the LLC’s operating agreement, which outlines the management structure and member rights, and a subscription agreement or purchase agreement. These documents must clearly indicate that the SDIRA, not the individual IRA owner, is the investor and the legal entity acquiring the ownership interest in the LLC. The custodian will verify these details to ensure the transaction aligns with IRS regulations.

Upon approval of the documentation, the custodian will transfer investment funds directly from the SDIRA account to the LLC in exchange for the ownership interest. This direct transfer prevents funds from being considered a taxable distribution to the IRA owner. The LLC interest is then held within the SDIRA account by the custodian, becoming an asset of the retirement plan.

Ongoing administration involves the custodian receiving any distributions from the LLC directly into the SDIRA. The custodian is also responsible for holding the LLC interest, ensuring proper record-keeping, and handling any annual valuations or reporting for the IRA. The IRA owner retains responsibility for monitoring the investment’s performance and ensuring continued compliance with all IRS rules, especially regarding prohibited transactions and UBTI, throughout the investment’s life.