Editor: Mark Heroux, J.D.
Many investors may be eager to explore alternative investments to diversify their portfolios. One approach is by using a self-directed individual retirement account (IRA). While this approach allows IRA owners to invest in a variety of nontraditional asset classes, the inherent flexibility of self-directed IRAs may also pose serious tax risks as retirement savers venture into the alternative investment space. Some of these alternative investments seek to provide a return on capital by investing in entities that hold specific types of collectibles, such as classic cars and art. This item explores how certain tax provisions may affect potential investors planning to indirectly invest in collectibles.
Most traditional IRAs set up through large financial services companies have a standard menu of investment options including stocks, mutual funds, and bonds. Should individuals want to invest outside those prescribed options, they must take matters into their own hands.
When individuals want to use pretax dollars to invest in assets that are not offered in a traditional IRA plan, they must establish a self-directed IRA. Companies that specialize in such offerings will act as a custodian of a self-directed IRA. Once the self-directed IRA is established, the owner funds it and selects the investments.
Sec. 408(m)(2) prohibits individuals from directly investing in items defined as “collectibles.” Pursuant to Sec. 408(m)(2), collectibles include:
- Any work of art;
- Any rug or antique;
- Any metal or gem;
- Any stamp or coin;
- Any alcoholic beverage; or
- Any other tangible personal property specified by the IRS for purposes of this subsection.
It is important to note that the broad category of tangible personal property is not defined by the Code or the regulations.
While the Code prohibits IRA investments in these collectibles, Sec. 408(m)(3) carves out an exception for certain coins and bullion that may be held in a self-directed IRA. Secs. 408(m)(3)(A) and (B) require that these items must meet certain metallurgical specifications and must be held in trust for the account.
The penalties for investing in prohibited collectibles are severe. Upon acquisition of the collectible, the IRA owner is deemed to have received a distribution equal to the cost of the collectible (Sec. 408(m)(1)). Additional penalties may apply for early withdrawal, depending on the age of the account holder. Overall, these transactions can result in significant penalties and require careful vetting by tax professionals.
Plan asset rules
The Department of Labor (DOL) has promulgated rules that expand the potential application of penalties for direct investments in prohibited collectibles by treating certain assets of an investment entity in which the self-directed IRA invests as assets owned by the self-directed IRA. The plan asset rules, also known as lookthrough rules, determine when an underlying asset of the investment entity would be treated as an asset that is directly owned by the self-directed IRA. These lookthrough rules apply to a plan benefit investor such as a self-directed IRA (see 29 C.F.R. §2510.3-101(f)(2)(ii); see also Sec. 4975(e)(1)(B)). As a result, the self-directed IRA’s owner should consider the underlying assets of the investment entity when making investments.
Generally, the self-directed IRA will be considered a plan benefit investor in two scenarios. First, if the self-directed IRA owns greater than 25% of an investment entity that is not a publicly offered security or a mutual fund, the underlying assets of the investment entity are deemed plan assets owned by the plan (29 C.F.R. §2510.3-101(a)(2)). Similarly, if the self-directed IRA owns 100% of an operating company, the lookthrough rules apply. An operating company is defined as “an entity that is primarily engaged, directly … in the production or sale of a product or service other than the investment of capital” (29 C.F.R. §2510.3-101(c)(1)).
If either scenario is present and the self-directed IRA is considered a plan benefit investor, the lookthrough rule will apply, and the underlying assets of the investment entity or operating company would be deemed as owned directly by the self-directed IRA. There are certain exceptions to these rules, but they are beyond the scope of this analysis.
These rules are consistent with IRS guidance regarding exchange-traded funds (ETFs) backed by precious metal. In Legal Advice Issued to Program Managers Memorandum 2008-01809, the IRS Chief Counsel’s Office states:
"[I]nvestors in a physically backed metal ETF' are considered to own undivided beneficial interests in the underlying physical metal. If a trustee of a 'physically backed metal ETF' treated as a trust sells some of the metal held by the trust, the investors are treated as having sold the metal."
Taken together, these rules demonstrate that the IRS and DOL are willing to impute the ownership of underlying assets to the entities that indirectly invest in those assets. This practice can have grave consequences for investors using self-directed IRAs to make alternative investments.
Collectibles held in alternative investment partnerships
This section explores examples of investments where an underlying asset is a prohibited collectible and illustrates potential problems that may occur without proper tax planning.
Classic cars: Using the self-directed IRA to invest in an investment entity that holds classic cars as assets may trigger the lookthrough rules and could pose issues for certain self-directed IRA investors. These types of investment entities offer an equity stake in a company whose underlying business is the purchase, ownership, and sale of classic cars. Whether a classic car would be considered a prohibited collectible per Sec. 408(m) is unclear, but taking a conservative approach, it likely would be. The pitfall of this investment is that the classic car is imputed to the self-directed IRA, likely resulting in the loss of the tax advantages of the self-directed IRA, plus penalties. Nevertheless, the existence of these investment funds indicates taxpayers’ appetites for alternative investments.
Fine art: Another type of alternative investment is art funds. Like classic car funds, these funds allow individuals to invest indirectly in works of fine art. While some of these funds may use limited liability companies to hold each individual piece of art, potential self-directed IRA investors looking to emulate this investment strategy must proceed with caution. Here, potential investors face similar challenges as those posed in the classic-car example; however, unlike classic cars, art is directly identified as a collectible in Sec. 408(m)(2)(A). As such, a potential investor seeking to invest in art using a self-directed IRA would be wise to speak with a tax professional, given the potential negative tax results and penalties.
Challenging investment environment
The imputation of underlying assets to a self-directed IRA creates serious challenges for tax-advantaged alternative investments. However, with proper planning and tax advice, a potential investor can stay abreast of all the current changes in this evolving landscape. An additional consideration is the application of the prohibited-transaction rules under Sec. 4795, not specifically discussed here, but which would also be relevant when considering a self-directed IRA.
Mark Heroux, J.D., is a tax principal in the Tax Advocacy and Controversy Services practice at Baker Tilly US, LLP in Chicago. Contributors are members of or associated with Baker Tilly US, LLP. For additional information about these items, contact Mr. Heroux at email@example.com.