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The ‘open opportunity’ IRA

By Barbara Whelehan ·
Tuesday, June 15, 2010
Posted: 2 pm ET

I recently received an article called "The Year of the Roth" by Terry Coxon of Casey Research that cites all the pros of doing a Roth conversion. But toward the end it gets into a discussion about something called an "open opportunity IRA" that lets you cut your tax bill by a huge margin.

Here's how it works: The IRA owns a single asset -- a limited liability company -- that enables you to invest in real estate, tax liens, private placements, equipment leasing and foreign real estate, among other things. So far, this sounds like a self-directed IRA, and some custodians structure this as an LLC that gives you checkbook control of your investment.

Here's the part that grabbed me:

"Using a limited liability company to hold IRA investments also enables you to reduce the tax cost of a Roth conversion by adapting a valuation strategy commonly used in estate planning.

"A now well established and conventional estate-planning strategy is to put assets into an LLC having features that suppress the fair market value of ownership shares in the LLC. Such features often include restrictions on transferring shares, restrictions on distributions and a requirement for a supermajority, or even unanimity, to dissolve the LLC. Achieving a discount of 35 percent (the value of the shares vs. the value of the assets inside the LLC) is common, which reduces the related gift or estate tax by 35 percent."

Coxon concludes that you can apply that strategy to a Roth conversion, "since it is the fair market value of the assets being transferred to the Roth -- the shares in the LLC -- that gets taxed. The result can be a big cut in the tax cost of making the conversion."

Is it a scam?

I asked Certified Financial Planner Michael Kitces, director of research at Pinnacle Advisory Group in Columbia, Md., if this was a scam.  He says no. But the strategy Coxon describes, while possible, is "very aggressive," Kitces told me via e-mail.

"The IRS has been fighting many of these types of valuation discounts VERY hard in the estate tax world, and would likely fight them here as well," Kitces says. The upshot: The discount may be disqualified by the IRS, or you just may end up losing money defending your position.

Kitces says the discounting strategy is iffy when the LLC is owned by 1) the IRA and 2) the IRA owner. In his words:

"The discounting for the LLC occurs typically through multiple owners. So you create an LLC. Your IRA owns 49 percent of it. You personally own 51 percent of the LLC. Now your IRA owns a minority share. You can also put restrictions on the salability of the LLC and the transferability of the LLC. The combination of minority non-controlling interest, with restrictions on salability and transferability, reduces its value. ... 'Ideally,' an unrelated third party would own the majority controlling share; of course, most people don't like that in the real world, because then they REALLY CAN'T CONTROL how the LLC is invested. The reflection of those fears -- when they're really applicable -- is WHY there are such minority discounts. The unfortunate reality is that many taxpayers try to have their cake and eat it too -- get the discount for minority and lack of control, but not 'really' give up control -- and that's where the problems tend to arise."

Here's what I get out of it: The open opportunity IRA sounds like an open invitation to get into trouble with the IRS.

Have you opened a self-directed IRA of any sort? Share your experience.

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