It has become popular to shift IRA holdings from standard investments, such as stocks and bonds, to alternative, non-traditional IRA assets that offer a higher return. Some investors have turned to real estate, hedge funds and cryptocurrency to diversify their retirement holdings; however, these high-performing investments are on the IRS’s radar and bring strict compliance rules. The deceased actor, James Caan, who played Sonny Corleone in The Godfather, ran afoul of these rules and as a result, his estate incurred a significant tax liability on a failed rollover.
Sequence of Events is Key
In Estate of James Caan v. Commissioner, the deceased actor held two IRAs with the global investment bank UBS. Both IRAs were governed by a custodial agreement between Caan and UBS. One of the IRAs held a partnership interest in the P&A Multi-Sector Fund, LLP, a hedge fund. Under the agreement, it was Caan’s responsibility to provide UBS with the P&A Interest’s year end fair market value every year. When Caan failed to do this for tax year 2015, UBS notified Caan that it had distributed the P&A Interest to him, and it then issued a Form 1099-R. On the form, UBS misvalued the P&A Interest at $1,910,903, which was its 2013 FMV.
Caan’s wealth management advisor at USB had resigned from the company and joined Merrill Lynch. This advisor convinced Caan to move the assets to Merril Lynch, then liquidated the P&A Interest and contributed the cash proceeds to Caan’s other IRA which also was at Merrill Lynch. The liquidation and cash transfer did not occur until almost a year after UBS notified Caan that it had distributed the P&A Interest.
On his 2015 income tax return, Caan reported an IRA distribution but claimed that it was nontaxable as a rollover contribution. The IRS disagreed and issued a notice of deficiency. Caan then requested a private letter ruling to waive the 60-day period for rollover contributions, but the IRS declined to rule saying the distribution was taxable. Caan died in 2022 before the issue was resolved, so his estate took over the case.
Tax Court Agrees with IRS
The Tax Court agreed with the IRS that the distribution was taxable, and the 60-day rollover period could not be waived because Caan should have contributed the P&A Interest to the second IRA, not the cash proceeds. The Court explained that Caan did not contribute the P&A Interest in a manner that would qualify as a nontaxable rollover contribution because he “changed the character of the property when he liquidated the P&A Interest.” Therefore, the IRS did not abuse its discretion in denying the waiver. The Court then fixed the value of the P&A Interest at the time of the distribution at $1,548,010, leaving Caan’s estate with a hefty tax bill.
In deciding the case, the Tax Court also held that it had the jurisdiction to review whether denial of the rollover waiver was an abuse of IRS discretion, an issue of “first impression,” meaning that the Court had not ruled on it before.
Takeaways
Investing in non-traditional IRA assets can bring higher rates of return, help you hedge against inflation and represent a smart diversification of your investment portfolio; however, because IRAs are tax-preferred, they come with strict requirements that are closely scrutinized by the IRS. A 2020 report issued by the Government Accountability Office (GAO) urged the IRS to boost its review of these IRAs based on the complex tax rules in four compliance areas: (1) barred investments, (2) prohibited transactions, (3) unrelated business income and (4) fair market value. GAO also noted that IRS needs to provide taxpayers with more information on how to comply.
A key takeaway from this case is that you cannot change the character of an investment when rolling over an asset from one IRA to another. Here, the partnership interest was liquidated into cash proceeds as part of the rollover transaction. As the Tax Court warned, “This case is a quintessential example of the pitfalls of holding nontraditional, non-publicly traded assets in an IRA. Failure to follow the labyrinth of rules surrounding these assets can mean forfeiting their tax-advantaged status.”