Self-help stock purchase not IRA distribution

The Seventh Circuit held that a taxpayer-initiated wire transfer of funds from the taxpayer’s self-directed individual retirement account (IRA) to purchase stock to hold in the IRA, which the IRA custodian would not purchase directly, was not a taxable distribution of funds from the IRA.

Background

Raymond McGaugh opened an IRA with Merrill Lynch in 2002. In 2011, he asked Merrill Lynch to use money from that IRA to purchase 7,500 shares of stock issued by First Personal Financial Corporation (FPFC), a privately held company. For unknown reasons, Merrill Lynch refused to purchase those shares on McGaugh’s behalf. McGaugh then initiated a wire transfer of $50,000 from his IRA directly to FPFC on Oct. 7, 2011, to buy the shares.

On Nov. 28, 2011, FPFC issued a stock certificate titled “Raymond McGaugh IRA FBO Raymond McGaugh,” which it mailed to Merrill Lynch. After receiving the certificate, Merrill Lynch, believing McGaugh’s transaction to have impermissibly exceeded the 60-day window applicable to rollovers of IRA assets under Sec. 408(d)(3), tried to mail the certificate to McGaugh. The Post Office returned the certificate twice to Merrill Lynch as undeliverable, but the third time the company sent out the certificate (this time by FedEx), it did not return. McGaugh, however, claimed he never received it.

Merrill Lynch characterized the wire transfer as a taxable early distribution and issued a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., to McGaugh, which he also claimed he never received. McGaugh did not report the distribution on his return for 2011. Based on the Form 1099-R, the IRS determined that he had received a taxable distribution from his IRA and in 2014 sent him a notice of deficiency listing a $13,538 tax deficiency and an accuracy-related penalty of $2,708.

McGaugh filed suit in the Tax Court to challenge the IRS’s determination. The Tax Court held he did not take a taxable distribution from his IRA in 2011. The IRS appealed the decision to the Seventh Circuit.

Seventh Circuit’s opinion

The Seventh Circuit affirmed the Tax Court’s holding that McGaugh had not taken a taxable distribution from his IRA because he had not constructively received funds from it. The court looked at whether McGaugh had constructively received the stock when he received the certificate or when he directed Merrill Lynch to wire the funds to purchase the stock to FPFC.

Regs. Sec. 1.451-2(a) provides that a taxpayer constructively receives income when 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 Seventh Circuit has held that under the constructive-receipt doctrine, a taxpayer receives income “not only when paid in hand but also when the economic value is within the taxpayer’s control” (Fletcher, 562 F.3d 839, 843 (7th Cir. 2009)).

The Seventh Circuit first addressed the IRS’s contention that McGaugh had constructively received the stock when he received the stock certificate. As had the Tax Court, the Seventh Circuit noted that FPFC issued the shares not in McGaugh’s name but in the name of his IRA. Thus, McGaugh did not have any control over the shares or the rights associated with them that could give rise to a finding of constructive receipt.

The Seventh Circuit then considered the IRS’s argument that McGaugh constructively received funds from his IRA when he directed Merrill Lynch to wire them at his discretion to FPFC. The IRS made this argument based on the general principle that a party cannot circumvent the rules on taxable income simply by directing a distribution to a third party. However, the court found that this principle was not implicated in this case. According to the court, McGaugh did not direct a distribution to a third party; instead, he simply bought stock, which “is a prototypical, permissible IRA transaction.” The court further noted that a finding of constructive receipt was not appropriate because there was no indication that McGaugh purchased the stock to benefit FPFC or for any reason other than his wish to obtain the stock to hold in his IRA.

Reflections

In Ancira, 119 T.C. 135 (2002), the Tax Court was even more lenient, allowing the taxpayer to receive a check made out to a non-public-issuing company and then send the check to the company to make the stock purchase. However, if the taxpayer were to receive a check made out to him or her from an IRA, deposit the money, and then use the funds to purchase stock issued in the name of the IRA, it is likely that the taxpayer would be held to have constructively received the funds distributed because there was no restriction on how the taxpayer could use the funds.

McGaugh, T.C. Memo. 2016-28