AnchorZero helps tax-savvy digital asset investors get early-stage tokens, when they have the most potential to grow, into tax-advantaged IRAs.
Because early-stage tokens have low cost-basis, the investor can protect the capital appreciation of the tokens from capital gains taxes on sales and future reinvestment.
A frequently asked question from digital asset investors is if they can self-custody the keys to digital assets held in their IRAs. The simple answer is no, because the IRA owner must not have knowledge of the private key.
IRAs require a custodian to provide oversight and self-custody by the IRA owner would almost certainly break that requirement, causing the digital assets to be distributed from the IRA, thereby eliminating the tax benefits of the IRA and exposing the IRA owner to income tax and financial penalties.
AnchorZero IRAs’ private keys are held and protected by Anchorage Digital Bank, thereby ensuring the IRA owner cannot know the private key.
The rest of the article provides background on IRA requirements, why digital asset self-custody is incompatible with those requirements, and why Checkbook LLCs are not a solution, even if their promoters would say otherwise.
IRAs require custodian oversight
Section 408 of the Internal Revenue Code requires that IRAs be overseen by either a bank or another person who demonstrates to the satisfaction of the Commissioner, that the manner in which the IRA will be administered will be consistent with the requirements of section 408.
AnchorZero IRAs fulfill this requirement, because its custodian, AZ Trust Company, is a chartered financial institution and is deemed a bank for the purposes of Section 408.
Having the custodian mediate and monitor IRA investment activity is important to the tax courts:
The presence of such a fiduciary is fundamentally important to the statutory scheme of IRAs, which is intended to encourage retirement savings and to protect those savings for retirement. Independent oversight by a third-party fiduciary to track and monitor investment activities is one of the key aspects of the statutory scheme.
— McNulty v. Comm’r of Internal Revenue, No. 1377-19, 14 (U.S.T.C. Nov. 18, 2021)
Administratively, AnchorZero IRAs work by having AnchorZero’s IRA custodian sign off on investment activity.
For example, in a private transaction, the buyer and the seller may agree to exchange cash for private shares of a startup. If the buyer were an IRA, the IRA custodian would sign as the buyer, not the IRA owner.
Tax courts also believe it is imperative that the custodian, not the IRA owner, is in control.
Personal control over the IRA assets by the IRA owner is against the very nature of an IRA.
— McNulty v. Comm’r of Internal Revenue, No. 1377-19, 14 (U.S.T.C. Nov. 18, 2021)
Digital assets: Private keys are a killer feature
A fundamental feature, and danger, of digital assets, is that they are secured by public-private key encryption and knowledge of a private key is sufficient to direct investment of its associated assets.
This feature is what allows an individual to be “her own bank.” She can flee a despotic government and retain control of her assets (feature) and also presents the danger of having her assets stolen, if the private key were compromised (danger). The danger is well-known to digital asset natives.
Knowing private keys can disqualify IRA tax benefits
The very thing which makes digital assets so powerful, namely the ability to self-custody, is also what can disqualify them from the tax benefits of an IRA, because the IRA owner cannot have unfettered control of her IRA assets.
If digital assets belonging to an IRA were self-custodied by the IRA owner, likely the owner has constructively received the assets.
The essence [of constructive receipt] is that funds which are subject to a taxpayer’s unfettered command and which he is free to enjoy at his option are constructively received by him whether he sees fit to enjoy them or not.
— Harris Trust & Savings Bank v. Comm’r of Internal Revenue (In re EState of Brooks), 50 T.C. 585, 592 (U.S.T.C. 1968)
Constructive receipt occurs where funds are subject to the taxpayer’s unfettered command and she is free to enjoy them as she sees fit
— McNulty v. Comm’r of Internal Revenue, No. 1377-19, 15 (U.S.T.C. Nov. 18, 2021)
And knowledge or even the ability to know the private key likely constitutes constructive receipt and unfettered access to the digital assets.
An owner of a self-directed IRA may not take actual and unfettered possession of the IRA assets. It is a basic axiom of tax law that taxpayers have income when they exercise complete dominion over it.
— McNulty v. Comm’r of Internal Revenue, No. 1377-19, 15 (U.S.T.C. Nov. 18, 2021)
This matters, because McNulty v. Comm’r of Internal Revenue ruled that constructive receipt or unfettered possession or control to IRA assets resulted in a distribution of the assets from the IRA, a taxable event.
Mrs. McNulty’s possession of the AE coins is a taxable distribution. Accordingly, the value of the coins is includible in her gross income. Petitioners’ arguments to the contrary would make permissible a situation that is ripe for abuse and that would undermine the fiduciary requirements of section 408. Mrs. McNulty took possession of the AE coins and had complete control over them. Accordingly, she had taxable distributions from her IRA.
— McNulty v. Comm’r of Internal Revenue, No. 1377-19, 15-16 (U.S.T.C. Nov. 18, 2021)
The assets under consideration in McNulty were American Gold Eagles, an official gold bullion coin of the United States, but otherwise the circumstances were similar.
IRA owners cannot have unfettered command over the IRA assets without tax consequences. It is on the basis of Mrs. McNulty’s control over the AE coins that she had taxable IRA distributions.
— McNulty v. Comm’r of Internal Revenue, No. 1377-19, 13 (U.S.T.C. Nov. 18, 2021)
Checkbook LLCs are not a solution for digital assets
Sometimes investors think they can achieve self-custody of digital assets by using a Checkbook LLC. The idea is to title the public-private key pair (wallet) to the LLC and have the wallet managed by the IRA owner, as manager of the LLC.
However, the proposed Checkbook LLC structure is almost identical to the Checkbook LLC used by McNulty. McNulty used a Checkbook LLC to purchase American Gold Eagles, over which she had unfettered control.
An owner of a self-directed IRA is entitled to direct how her IRA assets are invested without forfeiting the tax benefits of an IRA. McGaugh v. Commissioner, T.C. Memo. 2016-28, at *9, aff’d, 860 F.3d 1014 (7th Cir. 2017). A self-directed IRA is permitted to invest in a single-member LLC. Swanson v. Commissioner, 106 T.C. 76 (1996); … However, IRA owners cannot have unfettered command over the IRA assets without tax consequences. It is on the basis of Mrs. McNulty’s control over the AE coins that she had taxable IRA distributions.
— McNulty v. Comm’r of Internal Revenue, No. 1377-19, 12-13 (U.S.T.C. Nov. 18, 2021)
The court’s hangup was the IRA owner having unfettered control of the assets, regardless of how the assets were titled. It is difficult to see how access to an LLC’s private key would not be deemed to be similarly unfettered control of the associated digital assets.
Beware of promoters who advertise Checkbook LLCs as panaceas
It is common for self-directed IRA service providers to advertise Checkbook LLCs as a self-directed IRA panacea. Even today, some promoters advertise the ability to self-custody digital asset keys through a Checkbook LLC.
Before the McNulty case, promoters advertised the same for the American Gold Eagle coins. In fact, McNulty relied on a promoter’s informational website to make the purchases:
In August 2015 Mrs. McNulty purchased services from Check Book IRA, LLC (Check Book), through its website, that included assistance in establishing a self-directed IRA and forming an LLC to which she would transfer IRA funds through purchases of membership interests and then purchase AE coins using IRA funds. During 2015 Check Book’s website advertised that an LLC owned by an IRA could invest in AE coins and IRA owners could hold the coins at their homes without tax consequences or penalties so long as the coins were “titled” to an LLC.
— McNulty v. Comm’r of Internal Revenue, No. 1377-19, 4 (U.S.T.C. Nov. 18, 2021)
The court was unsympathetic and deemed the assets to have been distributed when McNulty took possession, resulting in income taxes and financial penalties.
Despite what some promoters may have you believe, Checkbook LLCs are not a solution for digital assets.
AnchorZero can help IRAs invest in digital assets
AnchorZero IRAs support digital assets by ensuring the IRA owner never has knowledge of the private key. If you would like to get pre-launch or publicly available tokens in your Roth IRA, get in touch today.