Is the Checkbook IRA Illegal? Must Know Tax Court Ruling: SDIRA, QRP, Solo 401k, Checkbook IRA, IRA-LLC, IRA-Trust, HSA, & ESA
Tax Court Opinion: ANDREW MCNULTY AND DONNA MCNULTY, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
- Watch out for “promoters!”
- Lots of Tax Turkey & Red Herring out there!
- Neither the IRS, nor the Tax Court, appear to be attacking the Checkbook IRA structure.
- The ruling – in its essence – has nothing to do with Checkbook IRAs, but:
- Checkbook IRAs does make it easier for a self-directed investor to intentionally or inadvertently run afoul of the Tax Court rules
- Creates questions for all self-directed retirement accounts, including QRP, holding personal assets
- Creates questions for all arrangements in which person touching assets “wears more than one hat.” This includes QRP & Solo 401k!
- Implications for many SDIRA structures – that don’t involve an IRA-LLC or IRA-Trust – that flunk custody! (For example, certain crypto arrangements)
- QRP (incl. Solo 401k) may have a leg-up on SDIRA (Very nuanced discussion)
- Using a QRP-LLC may undermine whatever “leg-up” a QRP may have over an SDIRA!
- Always create and maintain a clear trail of transactions!
- At all times, the role in which you’re acting – you’re “capacity” – must be unequivocal & unambiguous.
- Never, ever take physical possession!
- Don’t ever touch cash!
- Be extra cautious with fungible assets that have no clear evidence of “title” (e.g., gold, silver, bullion, precious metals)
- Creates uncertainty for crypto assets, especially crypto assets moved to “cold storage.”
- Created questions regarding all personal assets
- The Tax Court left many of the IRS arguments unresolved, so steer clear of any of those!
The Story: The Play-by-Play for Mrs. McNulty’s Checkbook SDIRA
- On August 19, 2015, Mrs. McNulty established an SDIRA.
- On August 24, 2015, Green Hill Holdings, LLC (“Green Hill”) was formed as a single-member LLC that is a disregarded entity for Federal tax purposes and its sole initial member was Mrs. McNulty’s IRA.
- Mr. & Mrs. McNulty were appointed Green Hill’s initial managers and were the managers during 2015 and 2016.
- Mr. & Mrs. McNulty’s personal residence is Green Hill’s principal place of business.
- Note: This is a factor that could work both against and in-favor of the taxpayer.
- Green Hill opened a bank account over which Mr. & Mrs. McNulty had signatory authority.
- The SDIRA purchased membership interests on three occasions during 2015 and 2016 through transfer of the purchase price of the membership interests from the IRA to Green Hill’s bank account.
- Note: Follow-on funding of a previously capitalized were not objected to by the IRS!
- Note: The IRS did no object to the funding of LLC bank account over which the SDIRA account-owner and another disqualified person had sole authority!
- Mrs. McNulty, as the LLC’s manager, had Green Hill use almost all of the funds to purchase American Eagle (“AE”) coins from Miles Franklin, Ltd. (“Miles Franklin”), an authorized coin dealer.
- The invoices from Miles Franklin list Green Hill as the purchaser.
- However, the shipping labels identified Mrs. McNulty individually or along with her IRA as the recipient of the shipments.
- There are in the record no certificates of ownership for the AE coins or any other documentation that establishes legal title.
- The coins were shipped to McNulty’s personal residence and were (a) stored in a safe there (b) along with coins purchased with funds from Mr. McNulty’s IRA and coins purchased by petitioners directly (collectively, non-IRA assets).
- The AE coins purchased with funds from Mrs. McNulty’s IRA, through Green Hill, were labeled as such. Meaning, the McNulty’s labeled the coins purchased with Green Hill funds so as to distinguish them from other coins held in the same safe.
- Green Hill purchased $374,000 worth of coins in 2015 and $37,380 in 2016 (there was one more purchase, in 2016, for $6,746).
- Mrs. McNulty completed a valuation form that she submitted to Kingdom Trust on which she identified herself as Green Hill’s sole owner and represented Green Hill’s value as $347,680 and $388,047 for 2015 and 2016, respectively.
- The IRS issued a notice of deficiency with respect to Mrs. McNulty’s IRA for taxable distributions of $374,000 and $37,380 for 2015 and 2016, respectively.
- IRS determined that they were liable for section 6662(a) and (b)(1) and (2) accuracy-related penalties for both years for underpayments due to substantial understatements of income tax and, alternatively, negligence or disregard of rules or regulations, attributed to their failure to report the distributions.
Mr. McNulty’s Checkbook SDIRA: Quick-and-Dirty
- During 2015 and 2016 Mr. McNulty used funds from his IRA to invest in a condominium and AE coins through an LLC structure.
- He engaged in prohibited transactions under section 4975 with respect to his IRA.
- During 2015 he received taxable IRA distributions of $295,554 and reported $1,595 of the distributions in gross income.
- During 2016 he received taxable distributions of $21,862 and did not report any amount in gross income.
Key Self-Directed IRA Tax Concepts
- IRC 408(a)(2): The trustee is a bank (as defined in subsection (n)) or such other person who demonstrates to the satisfaction of the Secretary that the manner in which such other person will administer the trust will be consistent with the requirements of this section.
- CFR 1.408-2(b)(5)(i): The assets of the trust must not be commingled with other property except in a common trust fund or common investment fund.
- CFR 1.408-2
- CFR 1.408-2(e)(5)(v)(A): Except for investments pooled in a common investment fund in accordance with the provisions of paragraph (e)(5)(vi) of this section and for investments of accounts established under section 408(q) on or after August 1, 2003, the investments of each account will not be commingled with any other property.
- CFR 1.408-2(e)(5)(v)(B): Assets of accounts requiring safekeeping will be deposited in an adequate vault. A permanent record will be kept of assets deposited in or withdrawn from the vault.
Uncle Sam vs The McNulty’s
- IRS argues that Mrs. McNulty should be treated as having possession of the AE coins irrespective of Green Hill’s existence, her status as its manager, and its purported ownership of the coins.
- Petitioners counter that the AE coins were assets of Green Hill and Mrs. McNulty’s physical receipt of them did not constitute taxable distributions from her IRA.
Arguments Raised the McNulty SDIRA Tax Court Case
- Who is Green Hill’s sole member?
- Who owned the AE coins?
- Who held legal title to the AE coins?
- Are AE coins bullion?
- Were the AE coins were commingled with non-IRA assets?
- Who can have physical possession of the AE coins purchased with IRA funds?
Note: These arguments reveal the minutiae that the IRS reviewed and looked to argue it’s case! The IRS is NOT forgiving! Based on all the points argued, we can appreciate all the minute – and apparently inconsequential – details referenced by the Court; seemingly innocuous errors, such as calling herself the “sole owner” on a form submitted to the custodian was a factor in the IRS asserting that the IRA was not the owner of the LLC!
Tax Court’s Analysis and Opinion in the McNulty Case
- A self-directed IRA is permitted to invest in a single-member LLC. Swanson v. Commissioner, 106 T.C. 76 (1996); Ellis v. Commissioner, T.C. Memo. 2013-245, aff’d, 787 F.3d 1213 (8th Cir. 2015).
- However, IRA owners cannot have unfettered command over the IRA assets without tax consequences.
- It is on the basis of Mrs. McNulty’s control over the AE coins that she had taxable IRA distributions.
- Based on the extensive rules governing the fiduciary role of the custodian, as outlined in CFR 1.408-2(e):
- A qualified custodian or trustee is required to be responsible for the management and disposition of property held in a self-directed IRA.
- The presence of such a fiduciary is fundamentally important to the statutory scheme of IRAs, which is intended to encourage retirement savings and to protect those savings for retirement.
- Independent oversight by a third-party fiduciary to track and monitor investment activities is one of the key aspects of the statutory scheme.
- When coins or bullion are in the physical possession of the IRA owner (in whatever capacity the owner may be acting), there is no independent oversight that could prevent the owner from invading her retirement funds.
- This lack of oversight is clearly inconsistent with the statutory scheme.
- Personal control over the IRA assets by the IRA owner is against the very nature of an IRA.
- Mrs. McNulty had complete, unfettered control over the AE coins and was free to use them in any way she chose.
- This is true irrespective of Green Hill’s purported ownership of the AE coins and her status as Green Hill’s manager.
- Once she received the AE coins there were no limitations or restrictions on her use of the coins even though she asserts on brief that she did not use them.
- While an IRA owner may act as a conduit or agent of the IRA custodian, she may do so only as long as she is not in constructive or actual receipt of the IRA assets.
- An owner of a self-directed IRA may not take actual and unfettered possession of the IRA assets.
Takeaways from the McNulty Tax Court Case
- Neither the IRS, nor the Tax Court, appear to be attacking the Checkbook IRA structure.
- Follow-on funding of an IRA-LLC were not objected to by the IRS.
- The Tax Court left many questions unanswered!
Next Level Topics, Based on the McNulty Tax Court Case
- How does this apply to Qualified Retirement Plans (“QRP”)?
- How does this apply to QRP-owned LLCs?!?!
- Checkbook IRA Crypto?
- Non-Checkbook Crypto arrangements that “bind and gag the custodian, and stuff it in the trunk?”
- ATM cash withdrawals to pay the roofer and plumber for IRA-LLC owned real estate projects?
- Other personal property ownership by Checkbook IRA-LLC (e.g., equipment, vehicles, a plunger at the rental property)? Heck, what’s “checkbook control” got to do with this, anyway?! Personal property ownership by non-checkbook SDIRAs would be a problem!
Let’s Talk Tax Turkey & Red Herrings
- Petitioners argue that they researched the LLC structure and reasonably concluded that they could take custody of AE coins purchased through an LLC with IRA funds without tax consequences.
- They stipulated exhibits of three versions of Check Book’s website from three dates during 2015, implying that petitioners’ research included a review of the website at some point during 2015.
- Check Book’s website advertised that taxpayers could purchase AE coins with their IRA funds and obtain physical possession of the coins without any tax consequences.
- Check Book’s website is an advertisement of its products and services, and a reasonable person would recognize it as such and would understand the difference between professional advice and marketing materials for the sale of products or services.
- Petitioners have not provided any evidence that sets forth Check Book’s qualifications to provide professional tax advice.
- Nor was Check Book disinterested. It benefited financially from petitioners’ purchase of its services.