Tax Court Addresses Self-Directed IRA
The recent Tax Court opinion in McNulty v. Commissioner, 157 T.C. No. 10 (2021) addressed whether distributions from a purported self-directed IRA were taxable. The Court also took up the question of whether tax penalties were applicable under section 6662(a) and (b)(1). Below is a summary of the facts and the key holdings/points of law. We cover the case – and every other Tax Court case – in our weekly Tax Court in Brief series.
During tax year 2015, Mr. and Mrs. McNulty (the “Petitioners”) decided to establish self-directed IRAs. In particular, the Petitioners wanted to invest in certain assets through LLCs owned by the self-directed IRAs. In August 2015, Mrs. McNulty (1) established a self-directed IRA, naming Kingdom Trust Co. the IRA custodian; and (2) formed Green Hill Holdings, LLC (“Green Hill”), a single-member LLC with Mrs. McNulty’s IRA serving as Green Hill’s sole initial member (and the Petitioners serving as Green Hill’s initial managers).
Mrs. McNulty funded the IRA with direct transfers from two qualified retirement accounts during 2015 and 2016. She also instructed Kingdom Trust to use the IRA funds to purchase membership interests in Green Hill. Then, Mrs. McNulty, as manager, used the Green Hill funds to purchase American Eagle coins, and the coins were received and held by the Petitioners at their personal residence.
On October 30, 2018, the Internal Revenue Service issued to Petitioners a notice of deficiency for 2015 and 2016, determining (1) the Petitioners received distributions from their IRAs, and (2) the Petitioners were liable for Section 6662(a) and (b)(1) and (2) accuracy-related penalties for both years. The Petitioners petitioned the Tax Court and submitted the case for decision without trial under Rule 122.
- Whether Mrs. McNulty received taxable distributions from her IRA; and
- Whether Petitioners were liable for Section 6662(a) penalties.
- McNulty received taxable distributions from her IRA; and
- Petitioners were liable for Section 6662(a) penalties.
Key Points of Law:
- An owner of a self-directed IRA is entitled to direct how her IRA assets are invested without forfeiting the tax benefits of an IRA. McGaugh v. Comm’r, T.C. Memo. 2016-28 , at *9, aff’d, 860 F.3d 1014 (7th Cir. 2017). A self-directed IRA is permitted to invest in a single-member LLC. Swanson v. Comm’r, 106 T.C. 76 (1996); Ellis v. Comm’r, T.C. Memo. 2013-245, aff’d, 787 F.3d 1213 (8th Cir. 2015). However, IRA owners cannot have unfettered command over the IRA assets without tax consequences.
- A qualified custodian is required to maintain custody of IRA assets, maintain required records, and process transactions that involve IRA assets. SeeR.C. § 408(h) and (i); Treas. Reg. § 1.408-2(e)(4), (5)(i)(2), (iii), (vii).
- While an IRA owner may act as a conduit or agent of the IRA custodian, she may do so only as long as she is not in constructive or actual receipt of the IRA assets. See Ancira v. Comm’r, 119 T.C. 135 , 137-140 (2002).
- The Internal Revenue Service imposes an accuracy-related penalty for any portion of an underpayment that is attributable to a substantial understatement of income tax. An understatement is substantial if it exceeds the greater of 10% of the tax required to be shown on the return or $5,000. See R.C. § 6662(a), (b)(2), and (d).
- The Section 6662(a) penalty will not apply to any portion of an underpayment where the taxpayers establish that they acted with reasonable cause and in good faith with respect to that portion. See R.C. § 6664(c)(1).
Insight: McNulty underscores the basic requirements for IRAs under Section 408 of the Internal Revenue Code. In particular, taxpayers should be mindful of the restrictions on IRAs—e.g., owners of self-directed IRAs may not take actual and unfettered possession of IRA assets. Further, the Tax Court notes that, with respect to the reasonable cause defense to accuracy-related penalties, failure to disclose pertinent facts to a taxpayer’s CPA shows a lack of good faith in tax reporting.