Checkbook IRA, or Checkbook LLC?

A recent case has shed light on one of the riskiest retirement plan strategies offered by promoters.

In McNulty v. Commissioner (157 T.C. 10), a U.S. Tax Court provided clarity to the scheme of using self-directed IRAs for personal investments. Although the rules are strict, they had become lax and were unenforced in recent years. The McNulty case brings the requirements back into line and serves as a warning of what may come.

If you have a checkbook IRA or LLC, you may want to speak with your lawyer immediately.

The Facts of the Case

The facts in McNulty are fairly common. Promoters of the scheme have been attending investment conferences for years.

In August 2015, Donna McNulty purchased services from Check Book IRA, LLC (Check Book), through its website. Those services included assistance in establishing a self-directed IRA and forming an LLC. She would transfer IRA funds to the LLC though purchases of membership interests. Then American Eagle (AE) gold coins would be purchased using IRA funds.

During 2015, Check Book’s website advertised that an LLC owned by an IRA could invest in AE coins, and IRA owners could hold the coins at their homes without tax consequences or penalties so long as the coins were “titled” to an LLC.

So, McNulty used Check Book to set up Green Hill Holdings, LLC (Green Hill) to own the coins. Green Hill was then owned by her IRA.

Why Problems Arose

There were a few problems with this. First, an IRA trust must be administrated by an independent trustee, not the beneficiary of the retirement assets. The trustee is responsible for storing the coins in an adequate vault. In this case, McNulty, following the promoter’s advice, took personal possession of the coins herself and held them in her own safe at home.

McNulty and the IRS made numerous arguments and counterarguments as to why the whole chain of events was either appropriate or amiss. The court could have decided the case on a number of issues, but it chose just one.

The Tax Court noted that an owner of a self-directed IRA is entitled to direct how IRA assets are invested without forfeiting the tax benefits of an IRA and that a self-directed IRA is permitted to invest in a single-member LLC. However, IRA owners cannot have unfettered command over the IRA assets without tax consequences. The Tax Court stated that based on McNulty’s control over the American Eagle coins, she had taxable IRA distributions.

A qualified custodian or trustee is required to be responsible for the management and disposition of property held in a self-directed IRA. A custodian is required to maintain custody of the IRA assets, maintain the required records, and process transactions that involve IRA assets. The presence of such a fiduciary is fundamentally important to the statutory scheme of IRAs, which is intended to encourage retirement saving and to protect those savings for retirement.

The Tax Court emphasized that independent oversight by a third-party fiduciary to track and monitor investment activities is one of the key aspects of the statutory scheme; that when coins or bullion are in the physical possession of the IRA owner (in whatever capacity the owner may be acting), there is no independent oversight and was clearly inconsistent with the statutory scheme; and that personal control over the IRA assets by the IRA owner was against the very nature of an IRA.

The Tax Court concluded McNulty had complete, unfettered control over the American Eagle coins; that she was free to use them in any way she chose; and that this was true irrespective of Green Hill’s purported ownership of the American Eagle coins and her status as Green Hill’s manager. Once McNulty received the American Eagle coins, there were no limitations or restrictions on her use of the coins, even though she asserted she did not use them.

Although an IRA owner may act as a conduit or agent of the IRA assets, an owner of a self-directed IRA may not take actual and unfettered possession of the IRA assets. It is a basic axiom of tax law that taxpayers have income when they exercise complete dominion over it. Constructive receipt occurs where funds are subject to the taxpayer’s unfettered command, and she is free to enjoy them as she sees fit.

The Tax Court concluded that McNulty’s possession of the American Eagle coins was a taxable distribution. Accordingly, the value of the coins was includible in her gross income. The Tax Court noted that the McNultys’ arguments to the contrary would make permissible a situation that was ripe for abuse and would undermine the fiduciary requirements of the act. McNulty took position of the American Eagle coins and had complete control over them. Accordingly, she had taxable distributions from her IRA in excess of $300,000, a painful financial mistake.

More Limitations Coming?

We have long warned about the risks of the checkbook scheme. In my 2015 book “Finance Your Own Business,” the hazards were enumerated, with the conclusion being “The safer course is to stay away from Checkbook IRAs.”

Interestingly, some promoters claim that the McNulty case is limited to situations in which gold coins were taken into personal possession. But that narrow view misreads the whole case. (Indeed, if they argue otherwise, ask for a legal opinion letter on the viability of the Checkbook LLC.)

Remember when we said the court chose just one issue as a discussion point? The court mentioned numerous prohibited transactions (rule violations) and problems with the Checkbook scheme. But it focused on just the physical possession of the coins in this specific case.

The court may be doing everyone else using a Checkbook IRA a huge flavor. The court may be signaling that future limitations on the scheme are coming. The court may be giving everyone a head’s up that it’s time to change your Checkbook IRA structure.

Be sure to talk to your own attorney about this. But here is a scenario to consider. Let’s say you are the manager of the LLC that controls your IRA investments. As such, you have management control over your IRA assets. You are keenly aware that the court in the McNulty case started: “Personal control over the IRA assets by the IRA owner is against the very nature of an IRA.”

So, to clean things up, you need to step aside as manager of the Checkbook LLC. You appoint your CPA or attorney or other fiduciary as the manager so that you no longer have any personal control over your retirement assets.

If the IRS ever questions you later about such a move, you tell the truth. You had initially been led to believe that the Checkbook IRA scheme was acceptable. But then you learned of the McNulty case, and in an attempt to follow IRS guidance you appointed a new, non-related fiduciary to serve as the LLC manager overseeing your personal IRA investments. You have made a “good faith” effort to be compliant with their rules in light of new information. Instead of doing nothing and by taking prompt corrective action, you are in a much better position to ask for forgiveness.

The McNulty case is not the only challenge to the Checkbook LLC. Proposed legislation in Congress also seeks to crack down on IRA abuses. Talk to your professionals now to stay ahead of what is coming.