A self-directed IRA offers investors great freedom and control over their investments. But IRA owners must be careful not to overstep their role as director of IRA investments and assume control of the investment itself. A recent Tax Court case illustrates how easily IRA owners can run afoul of the prohibited transaction rules – and how much it can cost them in taxable distributions and tax penalties. The case of McNulty v. Commissioner provides a real-life example of what not to do with your IRA, a single-member LLC, and a tangible investment.
The Set Up
Mrs. McNulty, the Petitioner, paid an online service provider to help her establish a self-directed IRA with a third-party trust company named as the IRA custodian. The service provider also helped the Petitioner form a limited liability company, Green Hill Holdings, LLC, with the Petitioner and her husband appointed as managers of the LLC. The Petitioner funded her IRA with just over $425,000 she transferred from a qualified annuity and a 401(k) plan. She then directed her IRA custodian to transfer cash from her IRA to the LLC’s bank account to purchase sole membership interests in the LLC for her IRA. The IRA owner now had “checkbook control” over her IRA assets. In a series of transactions, she used the money in the LLC’s bank account to purchase American Eagle gold and silver coins from an authorized coin issuer. The invoices from the coin issuer list Green Hill as the purchaser of the coins.
The Tax Court in this case acknowledges that the owner of a self-directed IRA is entitled to direct how her IRA assets are invested and that the IRA is permitted to invest in a single-member LLC. That is not a prohibited transaction per se.
What Not To Do
The problems in this case occurred when the Petitioner took unrestricted physical control over the American Eagle coins purchased by the IRA through the LLC. She directed the coin issuer to ship the coins to the business address of the LLC, which was the Petitioner’s home address. The shipping labels identified the Petitioner individually or the Petitioner and her IRA as the recipient of the shipments. The Petitioner stored the coins in a safe at home, along with coins purchased with funds from her husband’s IRA and coins purchased with non-IRA assets. The Petitioner also failed to provide accurate valuations of the LLC investment to her IRA custodian on two occasions: once omitting the value of the LLC’s bank account balance and once failing to provide the value of certain coins when the issuer failed to provide a value for them.
The IRA custodian did not have any role in the management of the LLC, the purchase of the coins, or the administration of the LLC’s or the IRA’s assets.
The Ruling
The Tax Court ruled that all of the Petitioner’s purchases of the American Eagle coins were taxable distributions equal to the cost of the coins in the year she took possession of them because the coins were stored at her home, rather than with the IRA custodian. She had full control over the coins and could have sold or disposed of them as she wished without the knowledge of the IRA custodian. The Tax Court did not accept the argument that she was acting as the manager of the LLC in keeping possession of the investment, or that the LLC was listed as the purchaser of the coins. The issue of whether the Petitioner commingled IRA assets with non-IRA assets was not addressed. The Tax Court said mere possession of the coins was enough to trigger a deemed distribution.
The Tax Court also upheld the IRS’s assessment of accuracy-related penalties for substantial understatements of taxable income since the Petitioner failed to report the transactions as distributions.
The Law
The Tax Court based its ruling on the requirements of Code section 408. These three provisions seem especially pertinent:
- An IRA must be administered by a qualified IRA trustee or custodian as a fiduciary.
- The trustee/custodian must keep separate and distinct records with information on each IRA.
- If assets require safekeeping, the trustee/custodian must deposit them into an “adequate vault” and keep a permanent record of deposits and withdrawals from the vault.
Based on these statutes, the Court noted that an IRA custodian “is required to be responsible for the management and disposition of property held in a self-directed IRA.” This includes having custody of the assets, maintaining required records, and processing transactions involving IRA assets. The independent oversight of IRA activities by a third-party fiduciary is a key aspect of complying with the requirements of the Code to qualify for the tax benefits of the IRA. In the Court’s words, “personal control over the IRA assets by the IRA owner is against the very nature of an IRA.”
Lessons Learned
While an IRA owner has the right to direct the investment of her IRA assets, and even act as an agent of the IRA custodian, an IRA owner cannot have constructive receipt or unrestricted command over the IRA assets. This ruling makes clear that an IRA owner cannot control an IRA’s assets even if the IRA owner is manager of the LLC that is wholly owned by the IRA. The IRA owner must be careful to not single-handedly control the property held by the IRA without the oversight of a third-party fiduciary.
Take an active role in directing the investment of your IRA but trust your IRA custodian to handle the custody of your investments.