Checkbook Control and the McNulty Case
When I use the term “checkbook control”, I’m referring to the arrangement in the self-directed IRA investing world in which an accountholder has set up an IRA-owned entity, typically an LLC, and they are the manager and have checkbook direction over the funds in their IRA that were invested into the LLC. I have been discussing a Tax Court case known as “McNulty” with knowledgeable, educated individuals in the field, and I want to share with you what I believe are the current best practices involving checkbook control and some things that may need to be adjusted in your existing IRA-owned entity to better comply with how the IRS is interpreting the rules.
Let me give you an overview of the facts in the McNulty case. Mr. & Mrs. McNulty formed two separate IRA-owned LLCs and then used those LLCs to make various investments. The Tax Court case focused on investments made by Mrs. McNulty, specifically ones in which her IRA purchased a safe and then gold coins to be stored in the safe. The safe containing the coins was kept in the McNulty’s primary residence. The IRS determined that the way in which she handled the money and did these transactions was a violation of the rules governing IRAs and that each time Mrs. McNulty spent money from the IRA to buy coins of which she physically took possession, it constituted a distribution as of January 1st of that year. Essentially, Mrs. McNulty destroyed her entire IRA.
The key language used by the Court was that Mrs. McNulty had “unfettered access and control” over the assets in the IRA, which is really what most people say they want when they are asking for checkbook control. They want to make the day-to-day decisions and sign checks so they can immediately pounce on a deal.
In the years since IRA-owned entities became a thing, there has been an ongoing debate about who should be the manager of an IRA-owned LLC. Certain custodians that I am affiliated with have made the decision that the accountholder should not be the manager of an IRA-owned LLC based upon a careful reading of sections of the Tax Code, specifically 26 U.S.C. 4975. Instead, the manager should be an independent, non-disqualified, disinterested third party.
The manager is the person responsible for the day-to-day operations and actions of the LLC. The manager supervises the LLC’s activities, the hiring and termination of the LLC’s employees and independent contractors, and ultimately calls all the shots for what happens in the company. This is true whether the LLC is a small, single-member LLC with only a couple of assets in it or if it is a $50 million company. The manager is the person ultimately in charge.
One of the things the manager has the authority to do is deal with the banking institutions with which the LLC has accounts. That means the manager has the ability to go to the bank and deposit and withdraw funds, meaning the manager pretty much has “unfettered access and control” of the LLC assets. That was the problem in the McNulty case. Mrs. McNulty had unfettered access and control of the assets bought with the money in her IRA-owned LLC. That is a huge problem in the eyes of the IRS. The best way to avoid that is for someone other than the accountholder to be the manager of the LLC.
An important practice taught to me early in law school was that when you read a court decision, always look at the legal precedents cited within the case to better understand where the court is coming from and the basis for their opinion. When we do that with the McNulty case, we find an important case cited, Ancira v. Commissioner, which was decided in 2002 (119TC135). This case held that no taxable distribution from an IRA occurred when the IRA accountholder personally received and had possession of a check that he could not negotiate. The check was made payable to the IRA but was in the hands of the accountholder.
This is an important case to think about when looking at what the court meant in McNulty when it talked about “unfettered access and control”. It’s clear that if you choose to remain the manager of your IRA-owned entity and receive payments, wires, ACH deposits, checks, money orders, etc., that are directly payable to the IRA entity and not to you personally or in your title as manager, then your receipt and possession of those negotiable instruments is not a distribution of the assets. It remains to be seen what arguments may come as to the ability to go to the bank and withdraw cash.
In McNulty, the court further emphasized that point by talking about another case, McGaugh v. Commissioner, and how the accountholder held in his possession a stock certificate issued in the name of the IRA. The court stated that the IRA accountholder could not realize any personal benefits from the possession of that stock certificate and did not have constructive receipt of the IRA asset because the stock certificate, being a financial instrument, was titled in the name of the IRA.
I want to clarify one thing. The McNulty case applies to IRA-owned LLCs. It does not apply to solo 401(k)s. A solo 401(k) is a retirement plan adopted by a self-employed individual or an individual who owns an entity being taxed as a corporation. That individual is required to be the trustee of their 401(k). This is completely different from my warnings about being the trustee of your IRA-owned trust. There is a significant distinction between the two.
For those of you who have solo 401(k)s wherein you handle the checkbook, this McNulty case is not bad information. It is instructive, however, to make sure you are being very diligent and accurate regarding all the investments you make with your solo 401(k). You must keep track of the amount of contributions that go into any Roth component vs. a traditional component, the amount of the employer match going into the traditional component, and the investment results of the Roth and traditional funds together.
From these cases, we can see that dealing with financial instruments is permissible for an IRA accountholder when their IRA owns an LLC. Please remember, however, that the facts in each case depend upon the circumstances of each case. Making a decision based upon just this information would be unwise and imprudent. It’s important to consult with your own legal counsel when you have a question about IRA-owned entities, how those entities should be operated, and who should be managing them.
Jeffery S. Watson is an attorney who has had an active trial and hearing practice for more than 25 years. As a contingent fee trial lawyer, he has a unique perspective on investing and wealth protection. He has tried over 20 civil jury trials and has handled thousands of contested hearings. Jeff has changed the law in Ohio four times via litigation. Read more of his viewpoints at WatsonInvested.com.