Tax Code Case Study

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Be Careful When Using an IRA to Hold Alternative Investments

Using an IRA to acquire and hold non-traditional investments can be problematic.

Non-traditional investments include things like stock that is not publicly traded, real estate and precious metals. To hold such investments in an IRA, you must set up a so-called self-directed account with an IRA custodian or trustee. You must then carefully arrange for the IRA funds to be used to acquire the investments. If you mess up, the IRA withdrawal can be treated as a taxable distribution to you.

Two U.S. Tax Court decisions addressed attempts by IRA owners to have their accounts invest in non-traditional assets. In one, a taxpayer won and in the other, a taxpayer lost. Here are both stories.

Observation: Well-known financial companies typically won’t let you set up a self-directed IRA. However, some smaller outfits specialize in acting as custodians or trustees for such accounts. You can find them with an Internet search.

Taxpayer Winner: No Taxable Distribution in Wire Transfer

In one decision, the Tax Court concluded that there was no taxable distribution to a self-directed IRA owner who instructed the custodian to wire cash to acquire shares of a private company.

Facts of the Case

The taxpayer’s self-directed IRA already owned shares in a private corporation. When the taxpayer requested that the IRA custodian buy additional shares in the company for $50,000, the custodian refused to acquire the stock directly. So the taxpayer took an indirect route. He instructed the custodian to make a $50,000 wire transfer directly to the corporation, which then issued a certificate for the shares in the name of the IRA for the taxpayer’s benefit.

There was a dispute about how quickly the share certificate was issued and received by the custodian. More than 60 days elapsed between the withdrawal of the funds and receipt of the certificate, the custodian said. Therefore, the custodian exercised an overabundance of caution by reporting the $50,000 withdrawn from the IRA as a taxable distribution by sending to the taxpayer and the IRS a Form 1099-R, “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.”

The taxpayer was audited when he didn’t report the $50,000 as income on his personal income tax return. The IRS claimed that the withdrawal was a taxable distribution. Specifically, the IRS argued that a taxable distribution took place because the stock certificate wasn’t received by the custodian within 60 days after the withdrawal.

Therefore, according to the IRS, the taxpayer failed to accomplish a tax-free rollover of the withdrawn funds. To add insult to injury, the IRS then tacked on a 10% early withdrawal penalty, because the taxpayer was under age 59 1/2. The alleged tax underpayment and penalty added up to $16,246. The taxpayer took his case to court.

The Court’s Conclusion

The Tax Court opined that there was no taxable distribution because the taxpayer never had personal control over the withdrawn funds. No cash, check or wire transfer ever passed through his hands. Instead, he simply acted as a conduit for an IRA investment. The fact that the share certificate wasn’t received within 60 days didn’t matter, because the transactions were never intended to be a rollover.

Even though the taxpayer “pulled all the strings,” the funds from the IRA went straight to the investment and resulted in the stock shares being issued straight to the IRA. Therefore, the taxpayer didn’t owe any tax or penalty on the $50,000. (McGaugh, TC Memo 2016-28)