Sonny Corleone’s IRA

I remember him as Sonny Corleone in The Godfather. He is James Caan, and he passed away in July 2022.

I am reading a Tax Court case involving his (more correctly: his estate’s) IRA.

There is a hedge fund involved.

For the most part, we are comfortable with “traditional” investments: money markets, CDs, stocks, bonds, mutual funds holding stocks and bonds and the mutual fund’s updated sibling: an ETF holding stocks and bonds.

Well, there are also nontraditional investments: gold, real estate, cryptocurrency, private equity, hedge funds. I get it: one is seeking additional diversification, low correlation to existing investments, enhanced protection against inflation and so forth.

For the most part, I consider nontraditional investments as more appropriate for wealthier individuals. Most people I know have not accumulated sufficient wealth to need nontraditional assets.

There are also tax traps with nontraditional assets in an IRA. We’ve talked before about gold. This time let’s talk about hedge funds.

James Caan had his cousin (Paul Caan) manage two IRAs at Credit Suisse. Paul wanted to take his career in a different direction, and he transferred management of the IRAs to Michael Margiotta. Margiotta left Credit Suisse in 2004, eventually winding up at UBS.

The wealthy are not like us. Caan, for example, utilized Philpott, Bills, Stoll and Meeks (PBSM) as his business manager. PBSM would:

·       Receive all Caan’s mail

·       Pay his bills

·       Send correspondence

·       Prepare his tax returns

·       Act as liaison with his financial advisors, attorneys, and accountants

I wish.

Caan had 2 IRAs at UBS. One was a regular, traditional, Mayberry-style IRA.

The second one owned a hedge fund.

The tax Code requires the IRA trustee or custodian to file reports every year. You probably have seen them: how much you contributed over the last year, or the balance in the IRA at year-end. Innocuous enough, except possibly for that year-end thing. Think nontraditional asset. How do you put a value on it? It depends, I suppose. It is easy enough to look up the price of gold. What if the asset is trickier: undeveloped land outside Huntsville, Alabama – or a hedge fund?

UBS had Caan sign an agreement for the IRA and its hedge fund.

The Client must furnish to the Custodian in writing the fair market value of each Investment annually by the 15th day of each January, valued as of the preceding December 31st, and within twenty days of any other written request from the Custodian, valued as of the date specified in such request. The Client acknowledges, understands and agrees that a statement that the fair market value is undeterminable, or that cost basis should be used is not acceptable and the Client agrees that the fair market value furnished to the Custodian will be obtained from the issuer of the Investment (which includes the general partner or managing member thereof). The Client acknowledges, understands and agrees that if the issuer is unable or unwilling to provide a fair market value, the Client shall obtain the fair market value from an independent, qualified appraiser and the valuation shall be furnished on the letterhead of the person providing the valuation.

Got it. You have to provide a number by January 15 following year-end. If it is a hassle, you have to obtain (and you pay for) an appraisal.

What if you don’t?

The Client acknowledges, understands and agrees that the Custodian shall rely upon the Client’s continuing attention, and timely performance, of this responsibility. The Client acknowledges, understands and agrees that if the Custodian does not receive a fair market value as of the preceding December 31, the Custodian shall distribute the Investment to the Client and issue an IRS Form 1099–R for the last available value of the Investment.

Isn’t that a peach? Hassle UBS and they will distribute the IRA and send you a 1099-R. Unless that IRA is rolled over correctly, that “distribution” is going to cost you “taxes.”

Let’s start the calendar.

March 2015		UBS contacted the hedge fund for a value.
June 2015		Margiotta left UBS for Merrill Lynch.
August 2015		Striking out, UBS contacted PBSM for a value.
October 2015		Hearing nothing, UBS sent PBSM a letter saying UBS was going to resign as IRA custodian in November.
October 2015		Margiotta had Caan sign paperwork to transfer the IRAs from UBS to Merrill Lynch.
		There was a problem: all the assets were transferred except for the hedge fund.
December 2015		UBS sent PBSM a letter saying that it had distributed the hedge fund to Caan.
January 2016		UBS sent a 1099-R.
March 2016		Caan’s accountant at PBSM sent an e-mail to Merrill Lynch asking why the hedge fund still showed UBS as custodian.
December 2016		Margiotta requested the hedge fund liquidate the investment and send the cash to Merrill Lynch.
November 2017		The IRS sent the computer matching letter wanting tax on the IRA distribution. How did the IRS know about it? Because UBS sent that 1099-R.

The IRS wanted taxes of almost $780 grand, with penalties over $155 grand.

That caught everyone’s attention.

July 2018

Caan requested a private letter ruling from the IRS.

Caan wanted mitigation from an IRA rollover that went awry. This would be a moment for PBSM (or Merrill) to throw itself under the bus: taxpayer relied on us as experts to execute the transaction and was materially injured by our error or negligence….

That is not wanted they requested, though. They requested a waiver of the 60-day requirement for rollover of an IRA distribution.

I get it: accept that UBS correctly issued a 1099 for the distribution but argue that fairness required additional time to transfer the money to Merrill Lynch.

There is a gigantic technical issue, though.

Before that, I have a question: where was PBSM during this timeline? Caan was paying them to open and respond to his mail, including hiring and coordinating experts as needed. Somebody did a lousy job.

The Court wondered the same thing.

Both Margiotta and the PBSM accountant argued they never saw the letters from UBS until litigation started. Neither had known about UBS making a distribution.

Here is the Court:

            We do not find that portion of either witness’ testimony credible.

Explain, please.

We find it highly unlikely that PBSM received all mail from UBS— statements, the Form 1099–R, and other correspondence—except for the key letters (which were addressed to PBSM). Additionally, the March 2016 email between Ms. Cohn and Mr. Margiotta suggests that both of them knew of UBS’s representations that it had distributed the P&A Interest. It seems far more likely that there was simply a lack of communication and coordination between the professionals overseeing Mr. Caan’s affairs, especially given the timing of UBS’s letters, Mr. Margiotta’s move from UBS to Merrill Lynch, and the emails between Mr. Margiotta and Ms. Cohn. If all parties believed that UBS was still the P&A Interest’s custodian, why did no one follow up with UBS when it ceased to mail account statements for the IRAs? And why, if everyone was indeed blindsided by the Form 1099–R, did no one promptly follow up with UBS regarding it? (That followup did not occur until after the IRS issued its Form CP2000.) The Estate has offered no satisfactory explanation to fill these holes in its theory.

I agree with the Court.

I think that PBSM and/or Merrill Lynch should have thrown themselves under the bus.

But I would probably still have lost. Why? Look at this word salad:

        408(d) Tax treatment of distributions.

         (3)  Rollover contribution.

An amount is described in this paragraph as a rollover contribution if it meets the requirements of subparagraphs (A) and (B).

(A)  In general. Paragraph (1) does not apply to any amount paid or distributed out of an individual retirement account or individual retirement annuity to the individual for whose benefit the account or annuity is maintained if-

(i)  the entire amount received (including money and any other property) is paid into an individual retirement account or individual retirement annuity (other than an endowment contract) for the benefit of such individual not later than the 60th day after the day on which he receives the payment or distribution; or

(ii)  the entire amount received (including money and any other property) is paid into an eligible retirement plan for the benefit of such individual not later than the 60th day after the date on which the payment or distribution is received, except that the maximum amount which may be paid into such plan may not exceed the portion of the amount received which is includible in gross income (determined without regard to this paragraph).

I highlighted the phrase “including money and any other property.” There is a case (Lemishow) that read a “same property” requirement into that phrase.

What does that mean in non-gibberish?

It means that if you took cash and property out of UBS, then the same cash and property must go into Merrill Lynch.

Isn’t that what happened?

No.

What came out of UBS?

Well, one thing was that hedge fund that caused this ruckus. UBS said it distributed the hedge fund to Caan. They even issued him a 1099-R for it.

What went into Merrill Lynch?

Margiotta requested the hedge fund sell the investment and send the cash to Merrill Lynch.

Cash went into Merrill Lynch.

What went out was not the same as what went in.

Caan (his estate, actually) was taxable on the hedge fund coming out of the UBS IRA.

Dumb. Unnecessary. Expensive.

Our case this time was Estate of James E. Caan v Commissioner, 161 T.C. No. 6, filed October 18, 2023.

Blowing Up An IRA

I am not a fan of using retirement funds to address day-to-day financial stresses.

That is not to downplay financial stresses; it is instead to point out that using retirement funds too easily can open yet another set of problems.

Those who have followed me for a while know that I disapprove of using retirement funds to start a business: the so-called Rollovers as Business Startups, whose humorous acronym is ROBS. I know that – in a seminar setting – it is possible to mitigate the tax risks that ROBS pose. I do not however practice in a seminar setting. Heck, I am lucky if a client calls in advance to discuss whatever he/she is getting ready to do.

Let me give you a couple of ROBS pitfalls:

(1) You have your IRA buy a fourplex. You spend time cleaning, doing maintenance and repairs and routinely running to Home Depot.

Question: Is there a tax risk here?

(2) You have your IRA buy a business. You have your son and daughter run the business. You work there part-time and draw a paycheck.

Question: Is there a tax risk here?

The answer to both is yes. Consider:

(1) You are buying stuff at Home Depot, stuff that the IRA should have been buying - as the IRA owns the fourplex, not you. If you are over age 50, you can contribute $6,500 to the IRA annually. Say that you have already written that check for the year. You are now overfunding the IRA every time you go to Home Depot. Granted, one trip is not a big deal, but make routine trips – or incur a major repair – and the facts change. That triggers a 6% penalty – every year - until you take the money back out.

(2) There are restrictions on direct and indirect benefits from an IRA. You are receiving a paycheck from an asset the IRA owns. While arguable, I am confident that your paycheck is a prohibited benefit.

I am looking a Tax Court case where the taxpayer had her IRA lend $40,000 to her dad in 2005. A few years went by and she had the IRA lend $60,000 to a friend.

In 2013 she changed IRA custodians. The new custodian saw those two loans, and she had problems. Perhaps the custodian could not transfer the promissory notes. Perhaps there were no notes. Perhaps the custodian realized that a loan to one’s dad is not allowed. This part of the case is not clear.

COMMENT: It is possible to have an IRA lend money. I have a client who does so on a regular basis. Think however of acting like a bank, with due diligence, promissory notes, periodic interest and lending to nonrelated independent third-parties.

The IRS saw easy money:

(1)  There was a taxable distribution in 2013;

(2)  … and a 10% penalty for early distribution;

(3)  … and the “substantial understatement” penalty because the tax numbers changed enough to rise to the level of “substantial.”

How do you think it turned out for our tax protagonist?

Go back to the dates.

She loaned money to her dad in 2005.

Let’s glance over IRC Section 408(e)(2)

 (2)  Loss of exemption of account where employee engages in prohibited transaction.

(A)  In general. If, during any taxable year of the individual for whose benefit any individual retirement account is established, that individual or his beneficiary engages in any transaction prohibited by section 4975 with respect to such account, such account ceases to be an individual retirement account as of the first day of such taxable year.

The loan was a prohibited transaction. She blew up her IRA as of January 1, 2005. This means that she should have reported ALL of her IRA as taxable income in 2005, of which we can be quite sure she did not.

Can the IRS assess taxes for 2005?

Nope. Too many years have gone by. The standard statute of limitations for assessments is three years.

So, the IRS will tag her in 2013, right?

Nope, they cannot. For one thing, the prohibited transaction did not occur in 2013, and the IRS is not allowed to time-travel just because it serves their purpose.

But there is a bigger reason. Read the last part of Sec 408(e)(2) again.

There was no IRA in 2013. There could be no distribution, no 10% penalty, none of that, as “that” would require the existence of an IRA.

And there was no IRA.

The name of the case for the home gamers is Marks v Commissioner.