Proceed with caution in self-directed IRAs
TAX ALERT |
On Feb. 24, 2016, the U.S. Tax Court released two opinions relating to distributions from self-directed individual retirement accounts (IRAs). In Mark Vandenbosch et ux. v. Commissioner, T.C. Memo. 2016-29, the court ruled that the taxpayer had received a taxable distribution from his IRA when he removed the funds to loan to a business. In Raymond S. McGaugh v. Commissioner, T.C. Memo. 2016-28, the court ruled that the taxpayer merely served as a conduit for the investment made by the IRA and, therefore, no taxable distribution resulted. The following discusses the reasons for the different results.
Self-directed IRAs are popular investment tools that allow individuals to invest in a broader category of investments than what a bank, brokerage or mutual fund company-based IRA would permit. However, these court cases are reminders that IRA account owners must exercise such control with caution and proper appreciation that personal use of the money will cause the amount to be treated as a distribution for tax purposes or in some case deem the entire IRA account to be taxable.
In Vandenbosch, the court ultimately upheld the form of the transaction in which money was distributed from Dr. Vandenbosch’s IRA to his personal account, and then from his personal account to an individual representing the business to which Dr. Vandenbosch wished to loan the money. The taxpayer argued that the transaction was an investment by the IRA and he did not personally have any right to the money, but the court did not overlook that the money was temporarily in the taxpayer’s personal account, and the loan agreement required payments to be sent to Dr. Vandenbosch and not to his IRA.
Contrasted from Vandenbosch is Ancira v. Commissioner, 119 T.C. 135 (2002), in which the individual was determined to be a mere conduit, and no taxable distribution occurred. In Ancira, the individual delivered a check from his IRA to the company in which he wished to invest, but the check was written from the IRA and made payable to the company, and the individual had no personal right to the money, he merely carried the check.
McGaugh, decided on the same day as Vandenbosch, was similar to Ancira, and the taxpayer was determined to not have a right to the money so it was not a taxable distribution. In McGaugh, the IRA custodian wired the money directly to another institution to facilitate the investment and the other institution issued a stock certificate in the name of the IRA. Therefore, although the taxpayer directed his IRA to make that investment, he never had a right to the investment personally since the IRA undertook the transaction as the IRA.
These cases show that taxpayers must be careful with the form of the transactions in their self-directed IRAs. The lines can be blurred because the individual is the IRA beneficiary and has the right to direct the investment while it is in the IRA and in reality, the individual controls the investment and benefits from it. The important distinction is when the individual receives that benefit. In Vandenbosch, although Dr. Vandenbosch had an investment already arranged for the money, he received a benefit when the money was paid to him personally before being invested.
While both of these cases involve the legal issue of whether the individual or the IRA was a party to the transaction, self-directed IRAs can have traps for the unwary even in cases that the IRA is the legal party to the transaction. An individual that self-directs his IRA is a fiduciary to the IRA and, as such, the individual is prohibited from benefiting personally from the investment while it remains in the IRA. Certain investments may violate this prohibition indirectly. For example, an investment by the IRA to a company in which the individual beneficiary is an executive and receives compensation may be viewed as personally benefitting the individual if that investment helps the company which is making current cash payments to the individual. That same investment by the IRA to a company in which the individual does not work would likely be allowed, and in fact, the investment may not increase the amount the individual receives from the company at all. However, the mere chance of an outside benefit is enough to be treated as a violation. A number of other investments could similarly benefit to the individual outside of the IRA. If the individual receives, or has the opportunity to receive, such a personal benefit, the IRS might assert that the transaction constitutes self-dealing and thus a prohibited-transaction; in which case the entire IRA account will be deemed to have been distributed to the individual as of the first day of the year in which the transaction occurred.
Self-directed IRAs can be valuable investment alternatives for individuals. However, taxpayers need to be aware of their role as beneficiary and fiduciary of such an account and have proper appreciation for the rules to avoid being taxed on the investment before a distribution is intended.