Despite a recent downturn due to tough markets, interest in holding cryptocurrency in self-directed IRAs has increased. grown considerably. A self-directed IRA, while not specifically defined by the tax code, refers to accounts established under Section 408 so the account holder, or beneficiary, makes investment decisions instead of a traditional discretionary investment adviser.
A subtype is the checkbook IRA, for which an individual establishes and serves as manager of an IRA-owned limited liability company. Funds are transferred to the LLC, and the beneficiary can then invest in alternative assets, such as business interests, real estate, and cryptocurrency, subject to Section 408 rules and regulations, and Section 4975 prohibited transaction rules.
Assuming the IRA checkbook trustee is qualified and all the formalities are followed to establish the LLC, questions arise about what to do with the cryptocurrency once the checkbook LLC buys it. Outside of the IRA context, cryptocurrency enthusiasts have plenty of options.
On proof-of-stake blockchains such as ethereum, one can stake shares in a smart contract, the purpose of which is to help protect the network in exchange for a block reward. One can use cryptocurrencies as collateral for loans of other cryptocurrencies through decentralized finance protocols like the Aave platform.
There are different ways to hold cryptocurrency. While some choose to keep purchases on the exchanges where they bought the coins, it is better to take custody of the cryptocurrency itself by using a "cold" or hardware wallet, essentially a specialized USB drive designed to store the private keys of one's coins A private key is a string of alphanumeric digital characters that, when combined with a public key, enables the transfer of cryptocurrency from one address to another.
Impact of McNulty
This best practice, keeping one's own private keys, presents a problem in light of McNulty v. Commissioner of Internal Revenue. In McNulty, the appellants, owners of an IRA checking book that bought gold and silver coins, took physical possession of the coins and kept them in a 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 of and unrestricted control over plan assets. The court noted that a plan trustee must exercise independent oversight of plan assets, which eases their responsibility to report the fair market value of assets and keep track of distributions.
The court rejected appellants' contention that Section 408(m), which specifically requires that qualified precious metals be stored with a qualified custodian, excused physical possession of the coins. In light of this decision and the plain language of Section 4975(c)(1)(D), which prohibits transfers to a disqualified person, including the plan beneficiary, from maintaining private keys in a hardware wallet on which that one has control would probably produce a result similar to that of McNulty.
The private key is what is recognized as the essential data that signifies the ownership of a given currency, or part of it. Owning the private key does not move cryptocurrency in the same way that one might move a tangible asset. However, it distinguishes the holder (whether that person is the rightful owner) as the one who can change the state of the blockchain on which the coin or token lives.
The IRS would probably be more than happy to follow cryptocurrency industry conventions for what constitutes possession and would likely disqualify a plan where the owner of the cryptocurrency has custody of the private keys. This is unfortunate, given the risks cryptocurrency owners face, as we have seen in the FTX debacle, when someone else has the private keys to "their" cryptocurrency.
Who benefits?
Surprisingly, the simple language of Section 4975(c)(1)(F)โprohibition of receiving the consideration generated by the assets of the plan โfor its [the disqualified personโs] own personal accountโโis a closer question. One can have a third-party custodian hold the address to which the block rewards are paid. If this is the case, the IRA checkbook beneficiary could generate income with their cryptocurrency for the LLC's account instead of their personal account.
This is analogous to commercial property that generates income that is held in the LLC's accounts. However, this arrangement again assumes that the private keys are held by a qualified third party and not by the beneficiary.
Exactly who receives the benefit from the use of LLC cryptocurrency is also a central consideration in the context of lending and lending. If one were to borrow against one's crypto in the DeFi context described above (thus leveraging the position), the proceeds could be further invested, as long as custody remains with a qualified third party. It is clear from Section 408(e)(4) that the beneficiary may not receive the crypto proceeds from the loan, but the LLC may. This is again analogous to real estate transactions where the LLC borrows (if able, without the beneficiary's personal guarantee) to purchase property.
It remains to be seen if the IRS will consider these custody, stake and lending issues when it comes to cryptocurrency. It would be helpful for companies that provide crypto custodian services, such as Gemini Trust Co. and Coinbase Global Inc., to consider whether they can qualify as trustees under Section 408(a)(2), or perhaps as intermediate custodians under Section 408 of the IRC. (h)โallowing them to hold the cryptocurrency of the checkbook LLCs, and even offer the types of ancillary services mentioned above.
Until there is more clarity, it is best to exercise caution in how one holds and uses cryptocurrency within an IRA checkbook.
This article does not necessarily reflect the views of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
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good ari is a blockchain attorney focused on financial, securities, and tax regulation issues in the cryptocurrency community.
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