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True self-directed IRAs are increasingly popular among IRA owners. But the rules can be complicated and delicate. Two recent court cases show that the risks of investing through self-directed IRAs can be additional taxes and penalties when all the rules are not followed.
Many IRA custodians say they offer self-directed IRAs. In fact, most IRA custodians limit the investments that can be held in their IRAs. Investments are generally limited to publicly traded stocks, bonds, mutual funds, exchange traded funds, and a few other investments.
A true self-directed IRA can be invested in any investment that an IRA can legally own. The tax code prohibits IRAs from holding life insurance and collectibles. Any other investment is allowed unless it violates the prohibited transaction rules, which generally allow debts or personal transactions between an IRA owner and the IRA. The true self-directed IRA can own real estate, mortgages, small business interests, hedge funds, and more.
One of the downsides of a true self-directed IRA is that it can cost more. The IRA custodian is likely to charge a fee for each transaction, plus an annual fee. In addition, the assets must be valued annually, and the custodian is likely to receive a commission for having the assets valued or valued. Another potential drawback is that the custodian must own and control the assets of the IRA.
IRA owners sometimes create problems when trying to take shortcuts or save a fee.
In one case, the taxpayer had a SEP-IRA. The custodian was a national bank. The taxpayer established a limited liability company (LLC) in Nevada of which he was the sole owner and managing member. He opened a commercial checking account for the LLC with the same bank that was the custodian of the IRA.
On two occasions, the taxpayer requested distributions from the SEP-IRA, directing the custodian bank to deposit the distributions into the LLC’s checking account.
Distributions have been used to make real estate loans to third parties. The loans were fully documented and secured by real estate. Over time, the loans were repaid with interest. The taxpayer deposited the payments into the SEP-IRA.
The custodian bank sent the taxpayer a Form 1099-R for each of the distributions declaring them as taxable distributions.
The taxpayer did not report the distributions in his gross income. The IRS imposed taxes on the distributions plus the 10% penalty for distributions taken before age 59 and a half. The taxpayer argued that he did not receive any distributions since the money had passed directly from the IRA custodian to the LLC’s checking account.
The Tax Court ruled in favor of the IRS.
The taxpayer used the standard depositary withdrawal request form when requesting the transactions and did not invoke any of the exceptions to the taxation of distributions. He also checked the box indicating that he was taking an early distribution.
More importantly, once the distributions were made, the taxpayer had full control of the funds. It does not matter whether the distributions were made to a checking account that was not in the name of the taxpayer. He indicated where distributions were to be made and had full control over the checking account. The taxpayer also made the mistake of owning the LLC instead of making sure the IRA owned the LLC. The IRA custodian had no control or legal authority over the money once it was distributed.
When the money was returned to the SEP-IRA, it was not considered a tax-free rollover because more than 60 days had passed since the distributions.
To invest in mortgages through the SEP-IRA, the taxpayer had to transfer the IRA to a custodian that allowed non-traditional investments such as mortgages. Then he could order the custodian to make the loans or other investments. He might be able to structure the investments so that they are made through an LLC, which in turn grants the mortgages or other investments. But the IRA should own the LLC. The taxpayer took shortcuts, apparently because he didn’t want to change the IRA custodian and wanted to save money on fees. (Ball v. Commissioner, memo TC 2020-152)
In the second case, the taxpayer also created an LLC that apparently belonged to her IRA and of which she was the managing member. She asked the IRA to buy American Eagle gold coins. The taxpayer as a managing member of the LLC took physical possession of the exhibits.
Typically, gold bars and coins (as well as other precious metals) are considered collectibles under the tax code. An IRA is not allowed to own collectibles. But exceptions are allowed for certain types of bullion and coins, with American Eagle coins being one of the exceptions.
The dispute concerned the possibility for the taxpayer to take physical possession of the documents. The tax code states that certain precious metals are not considered collectibles and may belong to an IRA when in the physical possession of the IRA custodian.
The taxpayer argued that the physical possession requirement applies only to bullion and not to coins. The IRS and the Tax Court disagreed. The court ruled that the physical possession requirement clearly applies to both bullion and coins.
As a result, the purchase of the coins by the IRA was treated as a distribution to the taxpayer. She was to include the value of the coins in her gross income for the year in which she took possession of the coins. McNulty v. Commissioner, 157 CT # 10 (20210).
Both of these cases involved variations of a strategy popular among owners of true self-directed IRAs. In this strategy, an LLC is created and a true self-directed IRA purchases all of the stakes in the LLC. The LLC establishes a financial account or a checking account.
Then the LLC can buy or invest in anything the tax code allows. Transactions are carried out using the LLC’s checkbook. This saves transaction fees since the IRA custodian does not complete the transactions.
At least that’s the theory behind the strategy. These cases show certain limitations of the strategy. The LLC must follow all of the IRA’s rules because the IRA is considered to have engaged in any of the transactions that the LLC undertakes and as the owner of all assets that the LLC owns. Further, the cases pave the way for the IRS to argue that the owner of the IRA cannot be the managing member of the LLC and control or take possession of the assets. Owners of true self-directed IRAs should make sure that they follow all the rules and that their documentation is in order. They should also consider having their strategies reviewed by tax advisers who have no interest in promoting IRA strategies using LLCs or other vehicles.