The idea that freedom means control over your own destiny s arguably the most defining characteristic of American culture. It is most certainly the basis on which various companies promote “checkbook IRAs.” If you Google that term you will find a gaggle of companies urging people to take full control of their retirement funds, to free themselves from restrictive IRA custodians. The companies promote structures that purport to allow taxpayers maximum freedom over their investment decisions. Freedom equals control.
In Andrew McNulty and Donna McNulty v. Commissioner, 157 T.C. No. 10 (Nov. 18, 2021)(Judge Goeke) we learn that too much control messes up a checkbook IRA. There, Mr. and Ms. McNulty created a checkbook IRA, funded it with transfers from their other retirement accounts, and then used the money to buy gold coins which they stored in their home. The Tax Court said that last bit—storing the physical coins in their home—was too much control and thus the receipt of the coins was a taxable distribution to them. While the taxpayers crossed the line in this case, it may not be altogether clear where that line is. How far can a taxpayer go before they mess up their checkbook IRA? Let’s see what we can learn. Details below the fold.
How Checkbook IRAs Work
A checkbook IRA is a species of those special accounts authorized by §408. The idea behind §408 is to incentivize taxpayers to save for their retirement. Thus the accounts are called Individual Retirement Accounts (IRAs). The incentive is that any earnings in the account remain untaxed until the taxpayer starts taking distributions when they hit retirement age. Once taken, distributions must be reported as gross income governed by the annuity rules in §72. §408(d)(1). Distributions will have a zero basis because the contributions are deductible. Treas. Reg. 1.408-4(a). In addition, taxpayers who take a distribution before age 59.5 must pay a 10% penalty, unless the distribution is for a qualified purpose.
To get this favorable tax treatment, Congress requires taxpayers to give up direct control of the money they contribute into an IRA. Section 408(a) and associated regulations require the IRA to be controlled by a Custodian who holds the IRA assets in a fiduciary capacity. Generally, IRA assets are intangibles such as stocks and bonds. If the Custodian invests IRA money in physical assets, the physical assets must be held in an “adequate vault” and may not be co-mingled with other assets unless all are part of a common trust fund. Treas. Reg. 1.408-2(e)(5)(v)(B); §408(a)(5).
Congress does allow taxpayers to retain some control over how the Custodian invests their retirement funds. That control, however, is subject to (a) applicable statutory limitations, both in §408 and other statutes (e.g. §4975), and (b) contractual limitations created by the chosen custodian. Custodians can be banks or investment companies such as J.P Morgan, Vanguard, Fidelity, or the like.
This is where “checkbook IRAs” come into play. Taxpayers who chafe at the contractual limitations created by traditional custodians are encouraged to create IRA accounts that are nominally held by very permissive custodians—the ones kind of like your dream chaperone when you were in high school. Unlike traditional Custodians these passive Custodians are basically mere conduits. They take responsibility only for holding and administering the assets in the IRA per the direction of the taxpayer. They explicitly disclaim any duty to evaluate the investment choices or bear any responsibility for investment performance or police taxpayer compliance with statutory restrictions.
The checkbook part works like this. The taxpayer funds the IRA and directs the IRA to invest funds to become the sole owner of a single-member LLC that the taxpayer has created. The LLC’s operating agreement names the taxpayer as the manager. This structure expands the taxpayer’s control over investments to the full extent permitted by statute. No more Custodial limitations. Here’s the pitch from Checkbook IRA LLC, which says it started this concept:
You open bank accounts wherever you wish as manager. Manage the assets, including rentals. Take Control! You’ll eliminate transaction fees by using the LLC. Now you can react with lightning speed. The Instant Control has made it very popular with Real Estate investors, Trust Deeds and Note buyers and Tax Lien investing. Once your LLC is funded you can bypass transaction fees and only pay a small Annual Custodial Fee.
While the LLC frees the taxpayer from any custodial restrictions on investments—especially useful if you have drunk the crypto—the taxpayer is still subject to the statutory rules for IRAs. And the fundamental statutory rule is that a taxpayer must not have too much control. Earlier this year we learned one lesson about control when the taxpayer withdraw funds from their IRA, made a profitable loan, then after the loan was repaid tried to put the principal and interest back into the IRA. That did not work. See Lesson From The Tax Court: Too Much Control Over IRA Distribution Makes It Income, TaxProf Blog (Jan. 11, 2021).
Today’s lesson is similar but involves the purchase and holding of physical assets. Let’s take a look.
For many years Mr. and Ms. McNulty built traditional retirement accounts, both IRAs and the employment-related 401(k) accounts. In 2015, they were lured into the fabled freedom of a checkbook IRA. Mr. McNulty ran into his own problems with statutorily prohibited transactions. This lesson focuses on Ms. McNulty’s problems with buying gold coins.
Relying on the advice and services of Checkbook IRA LLC, Ms. McNulty followed the playbook. She first created an IRA account using the passive Custodian Kingdom Trust. She then formed Green Hill LLC whose articles of incorporation specifically stated its election to be treated as a disregarded entity for federal tax purposes. Its sole member was Ms. McNulty’s IRA and the McNultys were named as managers. Green Hill opened a checking account.
In 2015 Ms. McNulty directed two existing retirement accounts to transfer a total of $378k into the Kingdom Trust IRA and she then directed the IRA to purchase membership units in Green Hill, depositing the money into Green Hill’s checking account, over which she had complete management control. She then used her “checkbook” powers to have Green Hill invest $374k in gold coins from Miles Franklin, Ltd. The coins were shipped to the McNultys’ home (which was also listed as Green Hill’s principal place of business). The McNulty’s carefully labeled the Green Hill coins and put them in their home safe, where they snuggled up to a bunch of other coins, some bought with Mr. McNulty’s IRA money and some bought with non-IRA money. Aside from that self-labeling, there was nothing to distinguish the coins. In 2016 Ms. McNulty did the same little dance but to a softer tune of $48,000, and that year she bought a mix of gold and silver coins.
At the end of each tax year, Miles Franklin gave Ms. McNulty a valuation of her gold and silver coins. She dutifully reported the gold coinage value to Kingdom Trust which, in turn, dutifully reported the values to the IRS. Sure, in 2015 Ms. McNulty forgot to include the Green Hill bank account balance as part of her IRA’s valuation and in 2016 she forgot to tell Kingdom Trust about the silver coins. But let’s keep our focus on those gold coins sitting in her home safe.
On audit, the IRS decided that the receipt of the gold coins represented a distribution of the IRA equal to their purchase price. Its basic reasoning was “hey, they are sitting in your home safe!” Ms. McNulty responded that “oh, but they did not belong to me. They belonged to my IRA through Green Hill, a separate legal entity!”
Lesson: Don't Keep Your IRA Assets At Home
In Tax Court, Ms. McNulty continued to protest that the coins were not, legally, hers. They just happened to be sitting in the safe in her house. More importantly, she had not actually used them. They were just sitting there. Thus, she had not received any benefit from that. She argued there could be no distribution until she used them.
Judge Goeke cut right to the chase: “Mrs. McNulty had complete, unfettered control over the [coins] and was free to use them in any way she chose. This is true irrespective of Green Hill’s purported owenership of the [coins] and her status as Green Hill’s manager.” Op. at 14. He then reviewed the law establishing the proposition that when an IRA owner comes into either actual or constructive possession of IRA assets, that possession constitutes a distribution.
What is possession important? Because, Judge Goeke writes, “it is a basic axiom of tax law that taxpayers have income when they exercise complete dominion over it.” Op. at 15. He then cites to Commissioner v. Glenshaw Glass, 348 U.S. 426 (1955), that hoary classic every tax student in every law school has read. Ms. McNulty's "I did not use them" defense proved too much. One could make the same argument about a cash distribution that the taxpayer simply stashes under the mattress.
Comment: Where’s the Line?
Ok. So Ms. McNulty crossed the line by having the coins shipped to her, in her name, and then putting them in her home safe with zero indication that they belonged to anyone else except her own Sharpie note. That is all we need to know to resolve this particular case. Lesson learned: don’t stick your IRA coinage in your home safe! And that is how legal lines get formed, on a case-by-case basis. Judge Goeke has no reason to consider what other facts might lead to a different result.
But I’m a law professor so I’m compulsively consigned to contemplate the possibilities.
Here's one question I think is interesting to contemplate. What if the coins had been shipped to “Green Hill” at the address of the bank where Green Hill had its account and had been placed in a safety deposit box in the bank?
On the one hand, that would not seem to change the result if one focuses on Judge Goeke’s “unfettered control” test. Ms. McNulty could still walk into the bank and take the coins and no one would say boo about it. Oh, sure, the passive Custodian, Kingdom Trust, would have the theoretical ability to object. But that is true for the coins stored at home as well. And as a practical matter, would Kingdom Trust even care what Ms. McNulty does? Hasn’t it absolved itself of any duties other than holding legal title and following Ms. McNulty’s directions on what to do with the IRA assets?
On the other hand, does the “unfettered control” test prove too much? If it applies to coins in the safe deposit box at the bank, it would also seem to apply to any dollars in Green Hill’s bank account. After all, Ms. McNulty had “unfettered control” over those dollars. Yet I do not think unfettered access to dollars in an IRA account takes those dollars out of the IRA shelter until they are actually distributed. So perhaps if she had kept the coins in safe-deposit box, that would not cross the line into actual or constructive possession? It would make the coins look much more like the intangible dollars held in the bank for two reasons. First, it would objectively identify them as belonging to Green Hill (much more than a Sharpie note taped to the coins in the home safe). Second, it would avoid the co-mingling problem.
I welcome comments on where readers might think the line is drawn. As taxation of retirement accounts is not my area, I may be overlooking something quite fundamental and I welcome the opportunity to learn.
Bryan Camp is the George H Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return to TaxProf Blog each Monday for a new Lesson From The Tax Court.