For most assets IRAs invest in, providing the annual valuation doesn’t matter because most of the $4 to $5 trillion of those accounts is invested in publically traded investments. For the 3% of that amount invested in self-directed IRAs however, it matters a great deal. You receive a request from your IRA provider every year and you probably don’t realize that for the self-directed account this has become a hot button for the IRS. They are sitting up and paying attention to the fact that with hard-to-value assets there is a wealth of taxes to either be reaped or avoided.
Case in point, “Berks vs Commissioner of Internal Revenue”. This is about a situation that is played out every year when the IRA holder is asked to provide a value for their IRA asset. This particular instance involved an investment in notes where the borrower either defaulted or the collateral did not adequately secure the debt resulting in the notes being worth zero. The IRA provider, over a period of several years, requested that the IRA holders, the Berks, provide an annual valuation. The Berks referred these queries to the investment provider who allegedly in turn called the provider and only told them that “the notes are worth zero”. No documentation supporting this assertion was provided. The Berks requested that the assets be valued at zero and that the Provider terminate their accounts. In accordance with the Provider’s policy, the assets were distributed from the IRA holder’s account to the IRA holder at the currently recorded book value of the asset. In other words the IRA holder received a 1099-R (form for reporting distributions from pension plans) for the full amount of the account using the original face value of the notes.
The Berks had the means to fight this, however, and took the case to tax court challenging the valuation of the IRA at the time of distribution. This is where this case becomes interesting. The IRS did not see this situation the same way as the Berks did. Not only would the IRS not accept the opinion of the Berks that the IRA was worth zero, they penalized them 20% of the account value for their “negligence” in failing to make a reasonable attempt to comply with tax laws, maintain adequate books and records or to substantiate items properly. They were also cited with the intentional “disregard” for rules and regulations. They surely did not see this coming.
As is usual in tax cases, the burden of proof falls on the taxpayer. The Berks’ tax return claimed the IRA distributions were not taxable and therefore they paid no taxes on the reported distribution. They blamed the preparer for this “oversight”. They blamed the IRA Provider for distributing the account at full value. They took no responsibility for their account or their tax preparation. The court was not sympathetic. Quite the opposite, the court found that these arguments actually weighed against them.
The moral of this story is this: when you have a self-directed IRA provide an annual valuation, with documentation, when the IRA provider requests it. If the asset is worth zero, provide proof. Much of what is done for those in the publically traded IRA investments is done for them by the IRA investment provider, usually at a fee that is three times what self-directed IRA providers charge, a fee that drastically reduces the rate of return. Self-directed IRAs give you entrance to every investment allowed by law. You find and manage the investment and provide the value annually. Those are the rules. With self-directed IRAs you get unlimited possibilities but you are also expected to know and understand the rules.
