Despite a recent downturn due to rough markets, interest in holding cryptocurrency in self-directed IRAs has grown considerably. A self-directed IRA, while not specifically defined by the tax code, refers to accounts established under Section 408 for which the account owner, or beneficiary, makes the investment decisions in lieu of a traditional discretionary investment adviser.
One subtype is the checkbook IRA, for which an individual establishes and serves as the manager of a limited liability company owned by the IRA. Funds are transferred to the LLC, and then the beneficiary can invest in alternative assets such as business interests, real property, and cryptocurrency, subject to Section 408 rules and regulations, and Section 4975’s prohibited transaction rules.
Assuming the checkbook IRA trustee is qualified, and all formalities of setting up the LLC are followed, questions arise as to what to do with cryptocurrency once it’s purchased by the checkbook LLC. Outside the IRA context, crypto enthusiasts have many options.
On proof-of-stake blockchains such as ethereum, one may stake holdings to a smart contract, the purpose of which is to help secure the network in exchange for a block reward. One may use crypto as collateral for loans of other crypto through decentralized finance protocols such as the Aave platform.
There are different ways in which to hold cryptocurrency. While some elect to maintain purchases on the exchanges where they bought the coins, it’s better to take custody of one’s own cryptocurrency by using a “cold” or hardware wallet—essentially a specialized USB drive designed to hold the private keys to one’s coins. A private key is a string of alphanumeric digital characters, which, when paired with a public key, allows cryptocurrency transfers from one address to another.
Impact of McNulty
This best practice—holding one’s own private keys—presents a problem in light of McNulty v. Commissioner of Internal Revenue. In McNulty, the appellants—owners of a checkbook IRA that purchased gold and silver coins—took physical possession of the coins and stored them in a home safe. The IRS ruled that taking physical possession in this manner constituted taxable distributions from the IRA to the beneficiaries.
In ruling for the IRS, the US Tax Court noted that the plain language of Section 408 prohibits actual or constructive receipt and unfettered control over plan assets. The court noted that a plan’s trustee must exercise independent oversight of plan assets, which facilitates its responsibility to report the fair-market value of the assets and track distributions.
The court rejected the appellants’ argument that Section 408(m), which specifically requires that qualified precious metals be stored with a qualified custodian, excused their taking physical possession of the coins. In light of this decision and the plain language of Section 4975(c)(1)(D)—prohibiting transfers to a disqualified person, including the plan beneficiary—holding one’s private keys on a hardware wallet over which one has control likely would produce a result similar to that in McNulty.
The private key is what’s recognized as the essential piece of data that signifies ownership of a given coin, or part thereof. Possessing the private key doesn’t move the cryptocurrency in the same manner that one may move a tangible asset. It does, however, distinguish the holder (whether or not that person is the rightful owner) as the one able to change the state of the blockchain on which the coin or token lives.
The IRS likely would be more than happy to follow the crypto industry’s conventions for what constitutes possession and probably would disqualify a plan for which the cryptocurrency owner self-custodies the private keys. This is unfortunate, given the risks that cryptocurrency owners face—as we’ve seen in the FTX debacle, when someone else holds the private keys to “your” cryptocurrency.
Surprisingly, the plain language of Section 4975(c)(1)(F)—prohibiting receipt of consideration generated by plan assets “for his [the disqualified person’s] own personal account”—is a closer question. One may have a third-party custodian maintain the address to which block rewards are paid. If this is the case, the checkbook IRA beneficiary might be able to produce income with their cryptocurrency for the account of the LLC rather than in their personal account.
This is analogous to commercial property that generates rents that are retained in the LLC’s accounts. This arrangement again assumes, however, that the private keys are custodied by a qualified third party and not by the beneficiary.
Exactly who receives the benefit of the use of LLC cryptocurrency is also a central consideration in the borrowing and lending context. If one were to borrow against one’s crypto in the DeFi context described above (thereby leveraging the position), the proceeds could be further invested, provided again that custody remains with a qualified third party. It’s clear from Section 408(e)(4) that the beneficiary may not receive the crypto proceeds of the loan, but it’s possible that the LLC could. This is again analogous to real estate transactions in which the LLC borrows (if it can, without the personal guarantee of the beneficiary) to purchase property.
It remains to be seen whether the IRS will consider these custody, staking, and lending issues as they pertain to cryptocurrency. It would be helpful if companies that provide crypto custody services, such as Gemini Trust Co. and Coinbase Global Inc., considered whether they may qualify as trustees under Section 408(a)(2)—or perhaps as downstream custodians under IRC Section 408(h)—permitting them to hold checkbook LLCs’ cryptocurrency, and even offer the types of ancillary services mentioned above.
Until there is further clarity, caution is best in how one holds and uses cryptocurrency within a checkbook IRA.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Ari Good is a blockchain lawyer focused on tax, securities, and financial regulatory issues in the cryptocurrency community.
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