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Tax Court Shows Risks in Self-Directed IRAs & Unconventional Investments

Published on: Apr 18 2021
estate planning

A self-directed IRA is a good way to invest your retirement account in non-traditional investments.

But a recent Tax Court decision shows the dangers of taking shortcuts and not setting up and operating the IRA the right way.

In the case, the taxpayer had a SEP-IRA (Simplified Employee Pension Individual Retirement Arrangement).

The custodian was a national bank. The taxpayer set up a limited liability company (LLC) in Nevada, of which he was sole owner and managing member.

He opened a business checking account for the LLC with the same bank that was the IRA custodian.

On two occasions, the taxpayer requested distributions from the SEP-IRA.

He directed the custodian bank to deposit the distributions in the checking account of the LLC. The distributions were used to make real estate loans to third parties.

The loans were fully documented and secured by the real estate. Over time, the loans were repaid with interest.

The taxpayer deposited the payments in the SEP-IRA.

The custodian bank sent the taxpayer a Form 1099-R for each of the distributions reporting them as taxable distributions.

The taxpayer didn’t report the distributions in his gross income. And what happened?

The IRS assessed him for taxes on the distributions plus the 10% penalty for distributions before age 59½.

The Tax Court found in favor of the IRS.

The taxpayer used the standard withdrawal request form of the custodian when requesting the funds from the SEP-IRA and did not claim an exception to the distributions being taxable.

He also checked the box indicating he was taking an early distribution.

In addition, when the distributions were made, the taxpayer had full control of the funds. They no longer were controlled by the custodian.

It doesn’t matter that the distributions were made to a checking account that wasn’t in the taxpayer’s name. He directed where the distributions were to be made.

They were taxable to him, even if the distributions were made to a third party.

When the money was returned to the SEP-IRA, it didn’t qualify as a tax-free rollover, because more than 60 days had passed since the distributions.

What the taxpayer was trying to do was to create a true self-directed IRA, also known as an LLC IRA, so that he could invest the IRA in property other than publicly listed stocks, bonds and mutual funds.

In this case, he wanted to make mortgage loans on real estate.

To do that correctly, he needed to move the SEP-IRA to a custodian that allows non-traditional investments such as mortgage loans.

Then, he could direct the custodian to make the loans or other investments.

He might be able to structure the investments so that they are made in the LLC, which in turn makes the mortgage loans or other investments.

However, he took some shortcuts, apparently because he didn’t want to switch IRA custodians and wanted to save some money on fees.

Details are important when considering the tax effects of transactions.

The effect of the transactions the taxpayer took probably were little different than if he had transferred the SEP-IRA to a custodian of self-directed IRAs and directed the custodian to make the mortgage loans in the IRA’s name.

But, he chose to request a distribution to a non-IRA checking account he controlled.

That difference caused the transactions to be taxable distributions rather than investments by the IRA.

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