Page 30 - Investment Advisor March 2022

Cover Story

Beware the Pitfalls of Self-Directed IRAs
Clients who are interested in alternative or nontraditional that the IRA investments never revert directly to the IRA
investment strategies often wish to use their retirement owner, but always back to the IRA itself.
funds for those investments. Of course, the Internal Revenue
Service limits the types of investments that can be made ‘Deemed Distribution’ Treatment
within the traditional IRA structure. For many, a self-directed A recent U.S. Tax Court case, McNulty v. Commissioner,
“checkbook control” IRA can provide a powerful investment illustrates the substantial risks associated with maintaining
tool that allows the account owner to have a greater degree a checkbook control IRA. In this case, the taxpayer used a
of control over retirement investment choices, all while mini- third-party service provider to purchase American Eagle coins
mizing custodian involvement and the red tape associated with the IRA and stored them at home. She first directed her
with traditional self-directed IRAs. IRA custodian to form a single-member LLC (of which she
A recent Tax Court case, however, illustrates the seri- was the managing member) and to transfer her IRA funds to
ous negative tax consequences that can arise when these the LLC’s bank account.
accounts aren’t managed according to the letter of the law. She used the bank account to purchase the coins (using
Advisors should take note — and advise taxpayers who wish records to establish the LLC as the legal purchaser). While
to buy rare coins, real estate or even cryptocurrency about the IRA custodian filed a Form 5498 to report the value of
the risk of potential “deemed distribution” treatment that can the IRA assets, the court found that the custodian had no role
create immediate tax liability. in the management of the LLC, the purchase of the coins or
administration of the LLC/IRA.
Checkbook Control IRAs: The Basics The court found that, under IRC Section 408(a), an IRA
A checkbook control IRA is an IRS-approved retirement must be administered by an IRA trustee that is a bank or IRS-
account structure that allows the account owner to make approved custodian. While the court did recognize the legality of
independent investment decisions. Like self-directed IRA the checkbook control IRA structure, it found that the IRA owner
owners, owners of checkbook control IRAs can invest in cannot have “unfettered control” over IRA assets without nega-
nontraditional assets, such as Bitcoin, precious metals and tive tax consequences. More specifically, the court found that
real estate. the custodian’s role in the self-directed IRA structure included
To form a checkbook control IRA, a self-directed IRA LLC maintaining custody over the assets, maintaining records, and
is established first. The LLC establishes a checking account processing the actual transactions involving the IRA assets.
like any other business entity. However, the LLC is funded The IRA owner, on the other hand, can permissibly act only
using the IRA funds — which are then transferred to the as a conduit or agent for the IRA custodian. Personal control
checking account. With the advice of tax counsel, the IRA over the IRA assets resulted in deemed distribution treatment
owner can become the managing member of the LLC and in this case — because the IRA owner took physical posses-
retain signature authority over the checking account (i.e., sion of the coins in her own home and failed to purchase the
“checkbook control”). coins directly through the IRA.
The checkbook control can allow the IRA owner to act While it’s difficult to know how far the Tax Court will go
more quickly when making an investment. Despite this, the in applying deemed distribution treatment to any particular
owner is prohibited from receiving assets — and any distribu- transaction, it’s always a good idea to exercise caution —
tions must be properly processed through the IRA custodian, and note that Congress and the IRS have been paying close
who is required to report the distribution. attention to self-directed IRAs generally in recent months.
The key to preserving tax-preferred treatment is to ensure —Robert Bloink and William H. Byrnes

28 INVESTMENT ADVISOR MARCH 2022 | ThinkAdvisor.com