Taxpayer Escapes Penalty Where Self-Directed IRA Funds Went Straight to Investment

(Parker Tax Publishing February 2016)

No distribution from a self-directed IRA occurred where the IRA's custodian, at the request of the IRA's owner, issued a wire transfer directly to a corporation to obtain the corporation's stock for the IRA, and more than 60 days thereafter, that corporation issued the stock in the name of the IRA. The court determined that the owner, at most, acted as a conduit for the transfer and that the 60-day rollover requirement did not apply. McGaugh v. Comm'r, T.C. Memo. 2016-28.

Background

Since 2002, Raymond McGaugh has maintained a self-directed individual retirement account (IRA) with custodian Merrill Lynch, and the IRA held 10,000 shares of stock in First Personal Financial Corp. (FPFC). In the summer of 2011, McGaugh requested that Merrill Lynch use funds from his IRA to purchase an additional 7,500 shares of FPFC stock. For unknown reasons, Merrill Lynch refused to purchase the shares directly. McGaugh then requested that Merrill Lynch initiate a wire transfer of $50,000 directly to FPFC. Merrill Lynch complied, and FPFC issued the stock certificate in the name of IRA more than 60 days after the wire transfer.

Because Merrill Lynch received the stock certificate from FPFC more than 60 days after the wire transfer, it believed the transfer to be outside the 60-day limitation period for a qualified rollover transaction under Code Sec. 408(d)(3). Believing the transaction to be subject to the rollover rules, and believing the transfer to be outside the 60-day limit, Merrill Lynch reported the $50,000 transaction as a taxable distribution on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. and refused to treat the FPFC stock as an asset of the IRA.

The IRS issued McGaugh a notice of deficiency for 2011. The IRS determined that the wire transfer issued by Merrill Lynch constituted a distribution from McGaugh's IRA that was includible in his gross income and, because he had not yet reached age 59 1/2, it was an early distribution subject to the 10 percent additional tax of Code Sec. 72(t).

Code Sec. 408(d)(1) provides that any amount paid or distributed out of an IRA is included in gross income by the payee or distributee. Those amounts are subject to a 10 percent additional tax if the taxpayer has not yet attained age 59 1/2 (Code Sec. 72(t)).

An amount will not be treated as a taxable distribution from an IRA if it is a qualified rollover, and a distribution is considered a qualified rollover contribution if the entire amount an individual receives is paid into a qualifying IRA or other eligible retirement plan within 60 days of the distribution.

Self-Directed IRAs

A self-directed IRA is simply an IRA under which the IRA owner has control over the type of investments that will be held in the IRA. Thus, the owner of a self-directed IRA may choose from the complete range of investments permitted for IRAs - including real estate, limited partnerships, mortgages, notes, franchise businesses, etc. - rather than being limited to the typical investments offered by IRA custodians and trustees (stocks, bonds, mutual funds, etc.). This higher degree of flexibility in choosing IRA investments allow for the IRA owner to invest in assets with greater wealth-building potential. However, there are also potential pitfalls with self-directed IRAs. Because of the types of investments taxpayers with self-directed IRAs are able to make, these taxpayers also run a greater risk of running afoul of the prohibited transaction rules.

While self-directed IRAs can hold different types of property, the Code does not require that IRA trustees or custodians must give the owner of a self-directed IRS the option to invest IRA funds in any asset that is not prohibited by statute. IRA trustees and custodians generally have broad latitude to direct or limit the investment of funds in an IRA. Several cases are instructive as to what can happen where a self-directed IRA owner attempts to go around the custodian of a self-directed IRA.

In Ancira v. Comm'r, 119 T.C. 135 (2002), a taxpayer who maintained a self-directed IRA wanted to invest in specific assets. The taxpayer made requests by telephone to the IRA's investment adviser. When the taxpayer requested that his IRA purchase a particular company's stock, the investment adviser informed him that, while the issuing company's stock could be held as an asset of the IRA, the custodian would not purchase the stock because the stock was not publicly traded. Subsequently, the investment adviser determined that the IRA could invest in the issuing company's stock if the custodian issued a check payable to the issuing company and the taxpayer delivered the check to the issuing company. The taxpayer used a "Distribution Request Form" to request a check made payable to the issuing company, and the custodian sent the taxpayer the requested check. The taxpayer forwarded the check to the issuing company, and the issuing company issued a stock certificate which stated that the IRA was the owner of several hundred shares of the issuing company's stock. The IRA custodian held the stock certificates. In that situation, the Tax Court held that there was no IRA distribution to the taxpayer.

In a subsequent case, Dabney v. Comm'r, T.C. Memo. 2014-108, the Tax Court found that, in its role as an IRA trustee, Charles Schwab had the power to prohibit the purchase and holding of real property. And, in fact, Charles Schwab had a policy prohibiting the holding of real estate in an IRA. Thus, where a taxpayer tried to get around this policy by taking a distribution from his self-directed Charles Schwab IRA and buying property, at first titled in his own name and then titled in the name of his self-directed IRA, the taxpayer was taxable on the distribution. The court found that the taxpayer did not act as an agent on behalf of Charles Schwab and that the Charles Schwab IRA could not have purchased the property because of its policy against holding real estate in an IRA.

Tax Court's Analysis

The Tax Court began by noting that neither the Code nor the regulations provide specific guidance on whether or when an amount is considered to have been "paid or distributed out of an individual retirement plan" through the use of the beneficiary as a conduit from the custodian to the investment. The court noted, however, that in Ancira, it addressed a case involving facts similar to McGaugh's. Thus, the Tax Court held that because no cash, check, or wire transfer ever passed through McGaugh's hands, he was therefore not a literal "payee or distributee" of any amount under Code Sec. 408(d)(1) and was thus not subject to the 10 percent penalty tax.

The owner of an IRA, the court stated, is entitled to direct the investment of the funds without forfeiting the tax benefits of an IRA. Even acknowledging that McGaugh pulled all the strings, the court found the funds the IRA released went straight to investment in additional shares and resulted in the shares being issued straight to the IRA. Citing its decision in Ancira, the court said that McGaugh was merely a conduit of the IRA funds and that money received as a mere agent or conduit is not includible in gross income.

The Tax Court rejected the IRS's reliance on its Dabney decision, noting that in the instant case, Merrill Lynch previously permitted FPFC stock as an asset to be held in McGaugh's IRA, and its subsequent correspondence seemed to indicate that if the stock at issue had been received within the 60-day period, it would have been accepted. Further, the court observed, the stock certificate in the instant case bears the name of the IRA as its owner; and it is therefore not like the real property in Dabney that, for more than a year, was titled in the name of the individual taxpayer. The taxpayer in Dabney, the court observed, requested a distribution in order to conduct a real estate transaction not permitted by the IRA, whereas McGaugh directed the IRA to make a permissible investment.

The Tax Court thus concluded that McGaugh did not receive a distribution when Merrill Lynch made the wire transfer to FPFC. Consequently, the court noted, the 60-day limitation on a rollover under Code Sec. 408(d)(3) was not relevant to the instant case, and the timing of the mailing of the shares (i.e., more than 60 days after the wire transfer) did not alter the conclusion that there was no distribution from the IRA to McGaugh.

For a discussion of self-directed individual retirement accounts, see Parker Tax ¶ 134,505.08.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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