ZEMS BLOG

Originally published on Unrestricted.com.

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It's not often you see the term “Roth IRA” trending online, but in 2021, tech investor Peter Thiel made headlines for his $5 billion tax-free Roth IRA piggy bank. How did he do it? The answer is alternative investments. He has used a self-directed IRA to invest in early-stage technology companies several times. Is it a loophole? maybe. But it happened, it attracted attention, and the structure of the IRA could come under greater scrutiny.

“Thale took a retirement account worth less than $2,000 in 1999 and turned it into a $5 billion windfall.” – ProPublica (2021)

Let's take a look at six common risks associated with self-directed IRAs and checkbooks, how they apply in the context of Bitcoin, and why there may be more regulation in the future. But first, we need to define our terminology and differentiate between IRA structures.

Different IRA structures

Different IRA structures can behave in a “every square is a rectangle, but not all rectangles are squares” manner. IRAs can be traditional (pre-tax) or Roth (after-tax) regardless of the custody relationship/structure. All IRAs are custodial. A trustee, in the context of IRAs, is a licensed financial institution that oversees and manages the IRA.

Brokerage and bank IRAs

Brokerage and bank IRAs are the most well-known and common types. Brokerage and bank IRA accounts allow investors to invest in stocks, bonds, ETFs, mutual funds, and other securities, as well as banking products (CDs, deposit accounts, etc.). Examples include the Fidelity, TD Ameritrade, or Charles Schwab IRA model. The Unchained IRA is the closest to this structure in this hierarchy.

Self-Directed IRA (SDIRA)

A Self-Directed IRA is a custodial IRA in which the custodian allows expanded investment options outside of or in addition to typical brokerage and banking assets (stocks, bonds, CDs, etc.). Self-directed IRA account holders can invest in non-traditional assets such as real estate, businesses, private loans, tax liens, precious metals, and digital assets. Although the IRS does not have a specific list of permitted investments, it certainly has a few that are not permitted (collectibles, life insurance, certain financial derivatives, S-Corps, etc.).

IRA Checkbook

Checkbook IRAs are a subset of self-directed IRAs. The term “checkbook IRA” is not a standard, but typically refers to a self-directed IRA that gives the account owner control over investments through a checking account, usually through an LLC channel. The account holder can then make investments with the IRA funds simply by writing a check (“checkbook control”). And with the added freedom of additional investment options comes additional responsibility for management, as well as legal ambiguity about whether the structure still qualifies as a tax-advantaged IRA.

Self-directed IRA without a checkbook

A subset of a self-directed IRA in which the custodian approves transactions before investments are made. Investors must wait for the custodian to review each potential investment and formally accept ownership of the underlying asset. They were commonly used in real estate and private equity investments and began to regain popularity once additional legal uncertainties regarding checkbook IRA accounts arose in late 2021 (discussed in Section 4 below).

Risks to Watch for When Using a Self-Directed IRA or Checkbook

1. Liquidity

Unfortunately, many self-directed assets lack liquidity, which makes selling them quickly difficult. Examples include real estate, private companies, precious metals, etc. If cash is ever needed for distribution or internal expenses, selling an asset quickly could be a problem (leading to other problems, i.e. accidentally mixing up funds). Self-directed IRA owners should conduct thorough due diligence on asset liquidity before committing to an investment strategy.

2. Legal composition and structure

When forming a Checkbook IRA, a self-directed IRA LLC is created first. Next, the LLC creates a checking account like any other business entity. Next, the LLC is funded by sending the IRA funds to the checking account.

With the proper legal structure, an IRA owner can become the sole managing member of the LLC and have signing authority over the checking account. However, an inappropriate legal structure, registration, or ownership can cause serious problems for the tax-advantaged status of an IRA. Many checkbook IRA facilitators are competent, but mistakes can always lead to problems and potential disqualification/loss of the entire IRA.

3. Incorrect transactions

Within a checkbook IRA, owners can fund investments quickly and freely, but this comes with the responsibility of properly following the rules and self-reporting transactions.

At the end of each year, the LLC owner will need to provide full transaction details to their IRA custodian and provide fair market valuation (FMV) information. Without monitoring every transaction you make, your trustee will likely misreport your investment income. Always make sure the trustee has accurate information to avoid accidentally breaking the law.

4. “Deemed distribution” treatment.

Clients looking to purchase precious metals, real estate, or digital assets should be aware of the risks of a “supposed distributions” transaction. A recent U.S. Tax Court case, McNulty v. Commissioner, illustrates the significant risks of maintaining an IRA checkbook. In the McNulty case, a taxpayer used her checkbook IRA LLC to purchase gold from a precious metals dealer. She stored the LLC's gold at home in her personal safe. The court ruled that her “unrestricted control” of the LLC’s gold without third-party oversight resulted in a taxable distribution from her IRA.

It is impossible to know how far the Tax Court will go in applying the “deemed distribution” treatment to any particular transaction or investment within a checkbook IRA. For checkbook IRA owners who hold bitcoin keys in an unregulated structure, there is a risk that the McNulty ruling could result in the entire IRA being subject to tax. Furthermore, since alternative investments were recently (2015) added to IRS Publication 590, it is entirely possible that the IRS and Congress will apply greater scrutiny to checkbook IRA accounts in the future. Read more about the McNulty case and its implications.

5. Prohibited transactions

All self-directed IRA owners are prohibited from commingling personal assets with IRA assets or using any personal funds to improve IRA assets. One of the most common pitfalls of self-directed account owners is “self-dealing.” For example, if you use your IRA to buy real estate, you are not allowed to use the property yourself — not even a little. You can't live there, stay there, or rent office space for yourself there. You're not even allowed to make your own repairs or save “the sweat equity.”

It's not just the IRA owner who can't engage in any “self-dealing,” but spouses, children, and grandchildren as well. They are considered incompetent individuals, and the penalties are harsh. These are strict rules and can lead to huge tax problems if violated. I don't intend to crush any dreams, but investing your 401k/IRA in an Airbnb vacation home with a lake view and keeping you or your family there even once is a bad idea. It is not permissible to buy a house for rent and rent it to family members as well. For more fun, check out the IRS list of prohibited transactions here.

Here are some examples of how the prohibited transaction rules apply to digital asset investors:

Merging personal portfolios with IRA portfolios
Leverage without a non-recourse loan
Invest in some collectible NFTs1

6. Financing

Funding within a self-directed IRA is also more complex for several reasons:

A non-recourse loan and a larger down payment are usually required to purchase any property.
Unexpected costs and fees can quickly pile up and affect any profits.
Active IRA-owned businesses can face the problem of UBIT (Unrelated Business Income Tax). This also affects the overlap of Bitcoin mining within the IRA.
Any income and expenses should remain within the IRA structure and never commingle with personal funds. For example, when a water heater breaks (real estate) or salaries have to be paid (businesses), the IRA itself must pay for those services from the IRA's own funds. IRA account holders may be tempted to temporarily shuffle funds as they search for short-term liquidity to meet their cash needs.

What does this mean for Bitcoin IRAs?

The self-directed IRA space has many potential risks if not managed properly. The IRS and Congress have paid particular attention to how these structures are used and abused. Combine this with their interest in regulating digital assets, and the landscape appears ripe for further scrutiny. However, Bitcoin IRAs need a unique approach that mitigates these risks.

An unrestricted IRA is not a checkbook IRA

If you're looking to keep actual bitcoin in your IRA, you should consider an Unchained IRA. It's not an “IRA checkbook” where transactions must be self-reported, and Unchained uses its key in a cooperative custody setup to track flows in and out of IRA coffers. This visibility mechanism allows the custodian to effectively monitor the IRA, thus allowing users to remain compliant with current IRA rules and regulations.

No self-reporting is required, and the non-checkbook structure helps mitigate the risks of potential risks (McNulty, misreporting of transactions, etc.). If Bitcoin rises in value as many investors hope and expect, properly holding the coins in an IRA structure is extremely important.

This article is provided for educational purposes only and should not be relied upon as tax advice. Unchained makes no representations regarding the tax consequences of any structure described herein, and all such questions should be directed to an attorney or CPA of your choice. Jesse Gilger was an Unchained employee at the time of writing this post, but now works at Unchained's label Sound Advisory.

1 Although not technically part of the prohibited transaction rules (Section 4975 of the Internal Revenue Code), holding holdings in an IRA is separately prohibited under Section 408(m).