Estimated reading time: 10 minutes
By: H. Quincy Long
Attorney at Law and
CEO of Quest Trust Company
A very popular idea in the self-directed IRA industry is to have what some have termed a “checkbook control” IRA. Basically, this involves the following steps: 1) an IRA is formed with a self-directed IRA custodian; 2) a brand-new LLC or other entity is formed with the IRA owner as the manager or a director and officer; and 3) the IRA custodian is directed to invest the IRA funds in the newly formed entity. Voila! The IRA owner has checkbook control over his or her IRA funds and can enter transactions quickly without anyone looking over their shoulder to see that the rules are being followed or doing any paperwork required by the IRA custodian. Admittedly, this sounds like a wonderful idea from the IRA owner’s perspective, but it is fraught with danger and traps for the unwary, as some taxpayers are now discovering.
Most published Tax Court rulings on this topic have resulted in negative tax consequences for the taxpayers who set up a checkbook IRA. The purveyors of checkbook IRAs will point to a few cases that came down in favor of the taxpayers to ‘prove’ the legitimacy of this technique, and they are correct – to a point. Unfortunately, there is a lot more to the story. The danger is typically not with the initial set-up of the LLC, but what happens after the LLC is funded and the IRA owners begin directing the investments in their position as managers of the LLC. The rules governing IRA investments are somewhat complex, and most IRA owners do not have the knowledge to comply with those rules. An IRA owner considering this type of set-up must have a working knowledge of the prohibited transaction rules, who is a disqualified person to their IRA, the plan asset regulations, the rules regarding Unrelated Business Income and Unrelated Debt-Financed income, and more. If you or your advisor is not familiar with these rules, a checkbook IRA may not be the best idea for you.
Most of the cases in Tax Court rulings deal with prohibited transactions. The effect of doing a prohibited transaction in the IRA for the owner is to disqualify the IRA as of January 1 of the year in which the transaction took place. If that happens, the IRA owner may be subject to premature distribution penalties, income taxes on the distributions that the taxpayer had because of the disqualification of the IRA, and accuracy-related penalties for unreported income that the taxpayer didn’t know he had because he thought his IRA was making the money tax free. Additionally, there are other taxes and penalties due by any other disqualified person who participates or benefits from the prohibited transaction.
Now a new Tax Court ruling has come down with a new, but predictable, attack on the idea of a checkbook IRA. The case of McNulty v. Commissioner involves the purchase and holding of American Eagle coins through a checkbook IRA, which were stored in a safe in the house of the McNultys. Mr. McNulty’s IRA was disqualified and deemed distributed because of certain undisclosed prohibited transactions, but he was appealing the understatement penalties. Mrs. McNulty was not found to have done any prohibited transaction, but she was in receipt of the American Eagle coins, which the Tax Court held was a violation of the Internal Revenue Code section creating IRAs (Section 408).
Generally, IRAs are prohibited from holding certain ‘collectibles’, including coins. To the extent the IRA invests in collectibles, as defined in the statute, they are treated as a taxable distribution equal to the cost of the collectible. Exceptions from the definition of a collectible are made for gold, silver, platinum, and palladium bullion, and for certain gold, silver, or platinum coins issued by the United States or coins issued under the laws of any state. American Eagle coins fit within an exception and were therefore acceptable investments for an IRA. However, the exception for bullion and coins requires them to be “in the physical possession of a trustee” of an IRA. The debate of what “physical possession” means in this context has been debated for some time now. McNulty v. Commissioner has now confirmed that an IRA owner cannot take possession of bullion or permissible coins without triggering a deemed distribution from their IRA.
Before establishing their self-directed IRAs, the McNultys claimed that they researched the idea of owning American Eagle coins through an LLC owned by their IRAs. They contacted a purveyor of checkbook IRAs through an LLC structure, and established Green Hill Holdings, LLC for that purpose. Green Hill is a single-member LLC that is disregarded for federal tax purposes, and its sole initial member was Mrs. McNulty’s IRA. The McNultys were appointed as managers of Green Hill.
The checkbook IRA vendor represented on its website that an LLC owned by an IRA could invest in American Eagle coins and IRA owners could hold the coins at their homes without tax consequences or penalties so long as the coins were ‘titled’ to an LLC. The Tax Court noted that there were no certificates of ownership for the American Eagle coins or any other documentation that establishes legal title. Mrs. McNulty argued that the coins were purchased with funds from Green Hills’ bank account, and the invoices from the coin vendor listed Green Hill as the purchaser. However, the recipient on the shipping labels were either Mrs. McNulty individually or Mrs. McNulty along with Green Hill.
The coins were shipped to the McNultys’ personal residence and stored in a safe, along with coins purchased with Mr. McNulty’s IRA and coins purchased by the McNultys individually. Mrs. McNulty asserted that the coins were labeled separately before being placed in the safe. The Tax Court questioned whether labeling is sufficient to satisfy the Internal Revenue Code’s prohibition against commingling IRA assets “except in a common trust fund or common investment fund.” However, the Court decided that it did not need to resolve the question since Mrs. McNulty’s physical possession of the American Eagle coins was enough to result in taxable distributions.
The IRS argued that Mrs. McNulty should be treated as having possession of the American Eagle coins irrespective of Green Hill’s existence, Mrs. McNulty’s status as Green Hill’s manager, and its purported ownership of the coins. The McNultys countered that the American Eagles coins were assets of Green Hill and Mrs. McNulty’s physical receipt of them did not constitute taxable distributions from her IRA. Despite numerous disagreements between the parties, the Court ultimately decided that it only needed to answer the question of who can have physical possession of the American Eagle coins purchased with IRA funds. Unfortunately for Mrs. McNulty, the Court ruled that she had taxable distributions from her IRA when she received physical possession of the American Eagle coins irrespective of her status as a manager of Green Hill. This is true even though the IRS conceded that Mrs. McNulty did not engage in a prohibited transaction with respect to her IRA, its investment in Green Hill, or the purchase of the American Eagle coins.
The Tax Court cited legal precedents which indicated that the owner of a self-directed IRA is entitled to direct how the investments are invested without forfeiting the tax benefits of an IRA, and that a self-directed IRA is entitled to invest in a single-member LLC. However, the Tax Court ruled that IRA owners cannot have unfettered command over the IRA assets without tax consequences. Mrs. McNulty’s control over the American Eagle coins was the basis for determining that she had taxable IRA distributions.
The Tax Court stated that a qualified custodian or trustee is “fundamentally important to the statutory scheme of IRAs, which is intended to encourage retirement savings and to protect those savings for retirement…Personal control over the IRA assets by the IRA owner is against the very nature of an IRA.” The Court further stated:
“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 custodian, she may only do so 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. It is a basic axiom of tax law that taxpayers have income when they exercise complete dominion over it. Constructive receipt occurs where funds are subject to the taxpayer’s unfettered command, and she is free to enjoy them as she sees fit. Accordingly, the value of the coins is includible in her gross income. Petitioners’ arguments to the contrary would make permissible a situation that is ripe for abuse and that would undermine the fiduciary requirements of Section 408.”
Many checkbook IRA providers will argue that this case is not a big deal, since it only applies to US minted coins and gold, silver, platinum, or palladium bullion, which are required by statute to be “in the physical possession of the trustee.” Of course, if you possess those types of assets in your safe at home this case will be of no comfort to you. Only time and new cases will determine whether this case will be of limited applicability or will be used to expand the ways in which you can lose your IRA.
The problem is that the language used by the Tax Court in this case is very broad. A checkbook control IRA-owned LLC all about getting actual and unfettered access to the IRA’s assets. The perceived benefit is that you escape the oversight of the custodian, who the Tax Court said was “fundamentally important to the statutory scheme of IRAs.” If you are the manager of an LLC owned by your IRA, and your IRA contributes money to that LLC, it’s hard to argue that you don’t have unfettered control over the IRA’s assets. The result in this case did not rely on a violation of the requirement in Section 408(m) that precious metals and coins must be in the physical custody of the trustee or custodian of the IRA. Instead, the issue came down to Mrs. McNulty’s unfettered control over the American Eagle coins. Having such control, according to the Tax Court, is against the very nature of an IRA. You cannot just ignore the statutory scheme of IRAs merely by interposing a disregarded entity between you and the custodian. Mrs. McNulty did not enter a prohibited transaction with her IRA. Her only ‘sin’ was taking possession and control of the IRA’s assets.
It may turn out that this case is limited in its applicability to possession by the IRA owner of permissible coins and bullion in an IRA. For the sake of the thousands of people who have a checkbook IRA I hope so. Regardless of what happens in the future, one thing is certain – checkbook IRAs just got a whole lot riskier, at least until case law limits the applicability of this case.
One other interesting issue in this case bears mentioning. Section 6662(a) and (b)(2) of the Internal Revenue Code imposes an accuracy-related penalty for any portion of an underpayment that is attributable to a substantial understatement of income tax. The Section 6662(a) penalty will not apply where the taxpayers establish that they acted with reasonable cause and in good faith with respect to any understatement. Reasonable reliance on professional advice may constitute reasonable cause. The McNultys argued that they researched the LLC structure and reasonably concluded that they could take custody of the American Eagle coins through an LLC with IRA funds without tax consequences. The parties did not stipulate what research was done by the McNultys but did stipulate three versions of the checkbook IRA provider’s website, as well as screen prints from the website of the IRA custodian. Additionally, Mr. McNulty argued that he did not know that he had engaged in a prohibited transaction when he filed their tax returns.
The Court was unsympathetic. The IRS asserted that the McNulty’s engagement of the checkbook IRA provider to assist in setting up Green Hill did not present a reasonable cause defense. Instead, the McNultys argued in vague terms that they performed research about an IRA investment in American Eagle coins through an LLC structure, without identifying the source or specific results of the research, other than stipulating parts of the checkbook provider’s and the custodian’s websites as exhibits. The Tax Court questioned whether the checkbook provider’s website and/or services could constitute professional advice upon which a reasonable person could rely. The checkbook IRA’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. The McNultys were both employed professionals during the years at issue. The McNultys also did not seek or receive any advice from their CPA who prepared their tax returns for the years in question. The point is that you cannot rely on an advisor who participates in structuring the transaction (i.e., a “promoter”) to avoid penalties. This issue comes up regularly in cases where the IRS is asserting accuracy-related penalties.
It should be noted that this article is not intended to be tax or legal advice. If tax or legal advice is needed, please contact a knowledgeable professional. I have purposely left out the legal references to make it easier to read. No claim is made to materials subject to copyright. This is not intended to be a legal brief, but rather just a summary of an interesting and important case. The McNulty case is titled Andrew McNulty and Donna McNulty vs. Commissioner of Internal Revenue, as was filed in the United States Tax Court on November 18, 2021.