No IRA Distribution Although Custodian Refused Taking Stock
The Seventh Circuit, in McGaugh,1 held that a taxpayer-initiated wire transfer of funds from the taxpayer's self-directed individual retirement account (IRA) to purchase stock to be held in an IRA, which the IRA custodian refused to purchase directly, was not a taxable distribution of funds from the IRA to the taxpayer.
Raymond McGaugh had an IRA with Merrill Lynch. In the summer of 2011, McGaugh requested that Merrill Lynch use money from the IRA to purchase shares of stock in a privately held corporation. For a reason that was not clear from the record, Merrill Lynch refused to purchase those shares on McGaugh's behalf. So McGaugh called Merrill Lynch and initiated a wire transfer of funds from his IRA directly to the private corporation.
In November 2011, the private corporation issued a stock certificate titled "Raymond McGaugh IRA FBO Raymond McGaugh" which it mailed to Merrill Lynch. Merrill Lynch claimed that it received the stock certificate in early 2012. After receiving the stock certificate, Merrill Lynch did not retain it, believing McGaugh's transaction to have impermissibly exceeded the 60-day window applicable to rollovers of IRA assets under Section 408(d)(3). Rather, Merrill Lynch attempted to send the stock certificate to McGaugh twice in February 2012, but the U.S. Postal Service returned it both times. McGaugh claims it was returned because the stock certificate was mailed to an incorrect address.
On the second occasion, it was marked as "refused." Merrill Lynch then sent the stock certificate to McGaugh a third time by Federal Express, and it was not returned. The stock certificate was never deposited into McGaugh's IRA. At trial, the location of the stock certificate was disputed. The IRS contended that McGaugh possessed it, although McGaugh denied that allegation.
Merrill Lynch characterized the wire transfer as a taxable distribution and issued a Form 1099-R. McGaugh claimed he never received the Form 1099-R. On 3/17/2014, the IRS issued a notice of deficiency, which indicated that McGaugh had failed to report a $50,000 distribution for the tax year 2011. Accordingly, the IRS assessed McGaugh tax due in the amount of $13,538 and a substantial-tax-understatement penalty of $2,708.
McGaugh then filed suit, contending that this was an error. The Tax Court agreed, holding on summary judgment that McGaugh did not take a taxable distribution from his IRA in 2011. The IRS appealed that decision of the Tax Court to the Seventh Circuit Court of Appeals.
The court stated that the issue in this case was whether McGaugh made a taxable withdrawal from his retirement account under Section 408(d)(1) which provides that IRA distributions are generally subject to income tax. Though McGaugh never physically received any cash or other assets from his IRA during the 2011 tax year, the IRS nevertheless asserts that McGaugh took such a distribution because he constructively received the IRA proceeds.
Pursuant to the doctrine of constructive receipt, a person receives income "not only when paid in hand but also when the economic value is within the taxpayer's control."2 Reg. 1.451-2(a) provides that the doctrine of constructive receipt occurs where income "is credited to an individual's account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions."
The court found that a review of the record revealed no evidence that McGaugh was in constructive receipt of assets from his IRA. First, the court stated that it was clear that McGaugh did not constructively receive the stock since the stock certificate was never in his physical possession during the 2011 tax year. In addition, the court found that there was no evidence that McGaugh had any control over the stock certificate or the rights associated with them that could give rise to a finding of constructive receipt. Furthermore, the court stated that the stock certificate was issued in the name of "Raymond McGaugh IRA FBO Raymond McGaugh" rather than in McGaugh's own name. Also, the court noted that when McGaugh requested a replacement share certificate, the private corporation refused to issue one without first receiving indemnification from Merrill Lynch.
The IRS's primary argument was that McGaugh constructively received funds from his IRA when he directed Merrill Lynch to wire the funds at his discretion to the private corporation. The IRS argued that a person cannot circumvent the rules on taxable income simply by directing a distribution to a third party. However, the court stated that this rule is not implicated in this case. The court noted that McGaugh did not direct a distribution to a third party but rather he bought stock, which is a permissible IRA transaction.
The court also noted that there was no indication that McGaugh orchestrated the purchase for the benefit of the private corporation or for any reason other than because he wished to purchase stock in the corporation to be held in his IRA. Thus, the court found that there was no evidence that McGaugh constructively received funds, either in ordering Merrill Lynch to wire funds to the private corporation, or in any other respect. Accordingly, the court held that McGaugh did not have actual or constructive receipt of any assets from his IRA during the 2011 tax year and so did not take a distribution from his IRA during that time.
While Mr. McGaugh was able to persuade the Tax Court and the Seventh Circuit regarding the merits of his position, he would have avoided the grief and professional fees incurred as a result of the litigation had he simply transferred a portion of his IRA to another custodian that permits investment in nonpublicly traded stocks. Although there is certainly no prohibition on an IRA holding stock in a private company, this case illustrates the practical problems involved when attempting to do so with a major wire-house custodian.
1 860 F.3d 1014 119 AFTR2d 2017-2359 (CA-7, 2017).
2 Fletcher, 562 F.3d 839 103 AFTR2d 2009-1674 (CA-7, 2009).
Frank Baldino is an estates and trusts attorney who helps people throughout the greater Washington, DC area protect assets for their families and future generations through careful estate tax planning. For more information, contact Frank at 301-657-0175 or firstname.lastname@example.org.
This article originally appeared in the December 2017 edition of Estate Planning, a monthly periodical directed to estate planning professionals that offers readers the newest and most innovative strategies for saving taxes, building wealth, and managing assets.