True self-directed IRAs are becoming more popular among IRA owners. But the rules can be complicated and tricky. Two recent court cases show the risks of investing through self-directed IRAs can be extra taxes and penalties when all the rules aren’t 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 generally are limited to publicly-listed stocks, bonds, mutual funds, exchange-traded funds, and a few other investments.
A true self-directed IRA can be invested in any investment an IRA legally can own. The tax code prohibits IRAs from owning life insurance and collectibles. Any other investment is allowed unless it violates the prohibited transaction rules, which generally allow debt or self-dealing 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 fees for every transaction plus an annual fee. In addition, the assets must be valued each year, and the custodian is likely to charge a fee for having assets appraised or valued. Another potential disadvantage is the custodian has to own and control the IRA assets.
IRA owners sometimes create trouble when they try to take shortcuts or save fees.
In one case, the taxpayer had a SEP-IRA. The custodian was a national bank. The taxpayer set up a limited liability company (LLC) in Nevada of which he was sole owner and managing member. He opened a business checking account for the LLC with the same bank that was the IRA custodian.
On two occasions, the taxpayer requested distributions from the SEP-IRA, directing the custodian bank to deposit the distributions in the checking account of the LLC.
The distributions were used to make real estate loans to third parties. The loans were fully documented and secured by the real estate. Over time, the loans were repaid with interest. The taxpayer deposited the payments in the SEP-IRA.
The custodian bank sent the taxpayer a Form 1099-R for each of the distributions reporting them as taxable distributions.
The taxpayer didn’t report the distributions in his gross income. The IRS assessed him for taxes on the distributions plus the 10% penalty for distributions taken before age 59½. The taxpayer argued that he didn’t take distributions since the money went directly from the IRA custodian to the checking account of the LLC.
The Tax Court found in favor of the IRS.
The taxpayer used the standard withdrawal request form of the custodian when requesting the transactions and did not claim any of the exceptions to taxability of the distributions. He also checked the box indicating he was taking an early distribution.
Most importantly, after the distributions were made the taxpayer had full control of the funds. It doesn’t matter that the distributions were made to a checking account that wasn’t in the taxpayer’s name. He directed where the 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 ensuring 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 didn’t qualify as a tax-free rollover, because more than 60 days had passed since the distributions.
To invest in mortgages through the SEP-IRA, the taxpayer needed to move the IRA to a custodian that allowed non-traditional investments such as mortgage loans. Then, he could direct 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 makes the mortgage loans or other investments. But the IRA would have to own the LLC. The taxpayer took some shortcuts, apparently because he didn’t want to switch IRA custodians and wanted to save some money on fees. (Ball v. Commissioner, T.C. Memo 2020-152)
In the second case, the taxpayer also created an LLC that apparently was owned by her IRA and of which she was the managing member. She had the IRA buy American Eagle gold coins. The taxpayer as managing member of the LLC took physical possession of the coins.
Generally, gold bullion and coins (as well as other precious metals) are considered collectibles in the tax code. An IRA isn’t allowed to own collectibles. But exceptions are allowed for certain types of bullion and coins, the American Eagle coins being among the exceptions.
The dispute concerned whether the taxpayer could take physical possession of the coins. The tax code says certain precious metals aren’t considered collectibles and can be owned by an IRA when they are in the physical possession of the IRA custodian.
The taxpayer argued that the physical possession requirement applies only to bullion and not to coins. Both 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 had to include the value of the coins in her gross income for the year she took possession of the coins. McNulty v. Commissioner, 157 T.C. No. 10 (20210).
Both these cases involved variations of a strategy that’s popular among owners of true self-directed IRAs. In this strategy, an LLC is created and a true self-directed IRA buys all the ownership interests in the LLC. The LLC establishes a financial account or checking account.
Then, the LLC can buy or invest in anything the tax code allows. The transactions are conducted using the LLC’s checkbook. This saves transaction fees since the IRA custodian isn’t making the transactions.
At least that’s the theory behind the strategy. These cases show some limits of the strategy. The LLC must follow all the IRA rules, because the IRA is considered to have engaged in any of the transactions the LLC undertakes and to own any assets the LLC owns. In addition, the cases pave the way for the IRS to argue that the IRA owner can’t be the managing member of the LLC and control or take possession of the assets. Owners of true self-directed IRAs need to be sure they’re following all the rules and have their documentation in order. They also should consider having their strategies reviewed by tax advisors who don’t have an interest in promoting IRA strategies using LLCs or other vehicles.