Tax Court

Alternative Investments in IRAs – Part II: Be Creative

WARNING:  Do not try the following strategy unless, at least:

  • Your daddy built a big company that exports products
  • You have the nerve to battle the IRS for many years
  • You have creative and careful tax advisors (like me!)
  • You have the money to hire white-shoe lawyers, who probably charge $1,000 per hour, to represent you in Tax Court
  • Preferably, you live within or relocate to be within the geographic boundaries of the Sixth Circuit Court of Appeals (MI, OH, KY or TN)

If you qualify, then read on, oh lucky, wealthy and intrepid taxpayer.

In my last blog, I urged caution when considering the acquisition of alternative investments in IRAs.  I still so urge.  However, the Sixth Circuit’s recent decision in Summa Holdings does inspire one to consider being creative.

Let’s start with the headline, as stated by nationally renowned IRA expert Ed Slott:  “$7,000 in Roth IRA contributions that became $6 million in tax-free gains.”

Do I have your attention?

Next, we consider quick explanations of two important tax-beneficial provisions of the Internal Revenue Code:  Roth IRAs and DISCs (Domestic International Sales Corporations).

A taxpayer may contribute after-tax dollars to a Roth IRA.  The earnings and gains within the Roth are, in most cases, not taxed.  If a taxpayer owns the Roth for at least 5 years and is at least 59 ½ years of age, distributions to the owner of the IRA are not taxed.  Sweet.  Why not put all my after-tax earnings in a Roth?  The limits on contributions to Roth IRAs are low, if your income is below a certain threshold that permits you even to make a Roth IRA contribution.  If you are not at least 50 years of age, then in 2017 you can contribute no more than $5,500.  The limit was $3,500 in 2001, when the Benenson brothers started the series of actions that resulted in the Summa Holdings case.

DISCs were created by Congress to subsidize U.S. exports.  Using DISCs can reduce tax rates on income from exports.  An exporter avoids corporate income tax by paying the DISC “commissions” of up to 4% of gross receipts or 50% of net income from qualified exports.  The DISC pays no tax on its commission income (up to $10,000,000 in a year) and may hold on to the money indefinitely, though the DISC shareholders must pay annual interest on their shares of the deferred tax liability.

Money and other assets in a DISC may exit the DISC as dividends to shareholders.  Individuals treat the dividends as qualified dividends and pay taxes on the dividends at long-term capital gains tax rates.  If an IRA owns the DISC, it must pay tax on its dividends at the high unrelated business income tax rates.

What kind of business operations must the DISC conduct to earn these benefits for its shareholders? None, nothing, nada.

So what did the Benenson brothers do?

  1. In 2001, each contributed $3,500 to his Roth IRA.
  2. Through a series of transactions, their Roth IRAs formed companies that resulted in a DISC.
  3. The DISC contracted with Summa Holdings, owned primarily by a trust for their benefit, to receive export commissions.
  4. The DISC made distributions to the Roths, which paid UBIT and retained the after-tax distributions.
  5. By the end of 2008, the two Roths initially funded with $3,500 each had each accumulated over $3,000,000. Earnings on the non-DISC investments of the Roth will never be taxed to the Roth and distributions will never be taxed to the Roth owners, if distributions don’t occur before age 59 ½.

The IRS came a-calling.  The Revenuers claimed that the “substance-over-form” doctrine applied to negate the transactions and the benefits.  The IRS recast the transaction as dividends from Summa Holdings to its shareholders (the trust and the boys’ parents).  The Tax Court agreed.

The Sixth Circuit disagreed with the IRS and the Tax Court.  The Court stated that the IRS stretched substance-over-form past its limits, which, in the Court’s opinion, are when the taxpayer’s formal characterization of a transaction fails to capture the economic reality and would distort the meaning of the Code.

The Sixth Circuit said that the taxpayers’ transactions fit well within the boundaries of the statutes enacted by Congress.  If Congress wants to change the statute, it can; the IRS cannot change the statute.  The Sixth Circuit pointed out that the whole DISC idea is a form-over-substance arrangement authorized by Congress to promote exports.

So, the taxpayers got a great result.  The general issue is probably not resolved.  Two similar cases are being pursued in two other Federal Circuits. A statute addressing economic substance has been enacted since the taxable years under consideration.  The Sixth Circuit’s apparent narrowing of the ubiquitous substance-over-form doctrine may have much broader reverberations.

In any case, under the right circumstances, being creative, bold and an IRA owner can be quite lucrative.

Ending Note.  On an evening that you have nothing better to do, you might read the Summa Holdings opinion written by Judge Sutton.  One can surmise that any court opinion starting with references to the bat-crazy Roman Emperor Caligula is going to be entertaining.

VKM

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Personal Taxes

Unconventional Investments in IRAs – Part I: Be Careful

I remember when Individual Retirement Accounts (“IRAs”) were first established in 1974.  (Yep, I’m no spring chicken.)  At first, these tax-deferred IRAs were restricted to those workers who were not already covered by a qualified employment-based retirement plan.  In 1981, that restriction was removed.  IRAs became big business. Then Roth IRAs came along in 1997.  The Investment Company Institute reported that at yearend 2015, people had IRAs worth $7.3 trillion.

Many people assume that any income inside an IRA is nontaxable.  Quite a few IRA holders don’t think much about what kind of investment they place in their IRAs.

I could write a book about all the problems you can have, if you are not careful with your IRAs.  I won’t do that; I wrote a book in my last blog.  Let me touch on just a few of the key problems into which one can run.

Excepting general prohibitions on investing retirement funds in life insurance or collectibles, you can invest your IRA funds in a broad spectrum of assets.  Most of the investments in IRAs are publicly-traded stocks, marketable bonds, mutual funds and ETFs.  For the most part, income and gains from those kinds of investments are not taxed currently to either the IRA or the IRA holder.  However, beyond a threshold of $1,000 per year per IRA, IRAs may have to pay tax on income and gains from some kinds of “unconventional” investments, such as hedge funds, private equity funds, publicly traded partnerships, real estate, and closely-held businesses operated as partnerships or limited liability companies treated as partnerships for tax purposes.  This tax is levied on “unrelated business taxable income” (“UBTI”).  The tax is levied also on “unrelated debt-financed income” (“UDFI”) of the IRA.  The IRA must file a Form 990-T and pay tax at rates that quickly reach top individual rates.

Recently, The Wall Street Journal reported that Ms. Fanny Handel, a retiree from Queens, was shocked and dismayed to get a notice from the IRS in 2015 that her IRA owed $92,000 in taxes, penalties and interests.  Her IRA had invested in Kinder Morgan, an energy publicly traded partnership.  Upon a taxable merger, Kinder Morgan generated a lot of income and gain for its limited partners.  Ms. Fanny or her IRA paid the tax, but got a bit of break from the IRS on the penalties and interest.

So, one’s IRA can owe tax, if one has UBTI or UDFI in one’s IRA.  Your problems don’t stop there.   You can’t engage in prohibited transactions (a) with disqualified persons or (b) involving self-dealing.  Just a few examples of prohibited transactions in an IRA include: (1) having your IRA purchase for you a vacation home; (2) selling your own assets to the IRA; (3) taking a salary from an IRA-funded business; and (4) personally working on and/or paying for repairs on a rental property that your IRA owns.  If you do engage in a prohibited transaction, what happens?  The entire IRA loses its tax-favored status as an IRA, and the account is treated as distributing all of its assets to the IRA owner at the fair market value on the first day of the year in which the transaction occurred.  If it’s a traditional IRA, you may have a huge tax bill.  If you are less than 59 ½ years old when this happens, you’ll also owe a 10% early distribution penalty.

Let’s throw in one more complexity – valuing unconventional assets.  This is can be a particularly vexing problem when you reach 70 ½ years of age, the age at which you must begin taking required minimum distributions (“RMDs”) from traditional IRAs. Generally, you calculate the RMD by applying a percentage to the value of your IRA accounts at the beginning of the year of the RMD.  What if you underestimate the value of the unconventional assets (for example, stock in a private company) in your IRA accounts and, thus, don’t distribute enough to satisfy your RMD?  You pay an excise tax equal to 50% of the amount that the RMD exceeds what you paid.

Now, wait a minute, you might say.  Does not the IRA custodian have to keep up with all the particulars of your IRA investments, including valuing your unconventional assets?  Usually, no.  Does not the IRA custodian prepare the IRA Form 990-T for and pay the tax from your IRA? It depends; often not.  When your IRA invests in unconventional assets, you should assume that you are assuming a lot of responsibilities.

The Government Accountability Office released a report in December 2016 and suggested that the IRS give a lot more guidance to and, basically, post big warning signs for IRA holders who are invested in, or are thinking of investing in, unconventional assets.  Good idea.

So, placing unconventional assets in an IRA can cause problems.  On the other hand, placing unconventional assets can create significant wealth.  I’ll discuss a very creative example of this wealth-building in my next blog, Alternative Investments in IRAs – Part II:  Be Creative.

VKM

Click here to read this blog and others on our website at www.hmpc.com