A Word of Caution for Self-Directed Investors: Use a Custodian That Specializes in Alternative Assets

Published on November 14, 2023

The late actor James Caan found himself in a tax tangle in 2015 that his estate has been fighting . . . and lost last month. At issue was an IRA rollover that Mr. Caan claimed was a nontaxable event. It wasn’t.

His IRA at one financial institution held a partnership interest in a hedge fund. Those funds were distributed to another retirement account at a different brokerage house. Mr. Caan, who passed away last year, was hit with a deficiency and an accuracy penalty of nearly $936,000 three years later. He and subsequently his estate challenged this, but in October of this year, the U.S. Tax Court determined that his estate owed the money to the IRS.

The matter centered on two issues:

• The failure of Mr. Caan and/or his financial management team to provide the IRA’s FMV, and
• The correct transfer of a non-publicly traded hedge fund.

It is a somewhat complicated issue. Here’s an outline of what happened.

• The custodial agreement between Mr. Caan and the first financial institution stated that it was his responsibility to provide the brokerage with the fund’s year-end fair market value (FMV) every year. He failed to do this for tax year 2015.
• Having not received the FMV information it requested, the brokerage notified him that it had distributed the funds to him pursuant to the relevant terms of the custodial agreement (to remain compliant with U.S. Treasury regulations).
  • This was done as an in-kind distribution with no actual disbursement of funds directly to Mr. Caan.
• The hedge fund interest in the IRA was liquidated almost a year after the financial institution reported the distribution. The funds were eventually transferred into a new IRA elsewhere.
• The estate argued that Mr. Caan transferred the IRA holdings between the two brokerage firms accurately and that there were many challenges associated with the transfer between the two financial institutions.
• The judge ruled that the actor “did not thereafter contribute the [hedge fund holding] in a manner that would qualify as a nontaxable rollover contribution.”
• The IRS declined to grant late rollover relief to Mr. Caan.
• The judge’s decision “determined that (the first brokerage firm) had indeed disbursed the account” and found the IRS rejection to be valid because “the exact asset distributed from the (that) IRA was not the one transferred to the new IRA.”

Even wealthy celebrities who can afford top financial advisement get caught in the IRS’s crosshairs for faulty rollovers and failure to report the fair market value (FMV) of alternative assets within their retirement plans—which is required by the IRS of the retirement plan’s trustee or custodian.

Avoid IRS Problems and High Penalties. Use an IRA Custodian That Specializes in Alternative Assets.

In Mr. Caan’s case, the two-prong failures of his custodians/brokerage firms and financial team provide a cautionary tale for investors. The failure to report the FMV of his IRA’s partnership holdings led the original brokerage firm to issue its distribution notice based on the asset’s last known value, which was from the prior year. Also, because his financial team did not provide the year-end FMV timely, the brokerage firm ended its custodial relationship with him.

Further aggravating the problem, the alternative asset held in the IRA (the hedge fund partnership interest) was not eligible for the transfer through the Automated Customer Account Transfer Service, which is used by brokers to transfer stocks, bonds, cash, unit trusts, mutual funds, options, and other investment products. Instead, the financial advisor directed the fund to liquidate the holdings and transfer the cash proceeds to the new IRA—which did not take place until nearly a year after the distribution notice was sent out. This was far afield of the 60-day rollover period for IRA distributions.

At Next Generation Trust Company, we know the importance of reporting the FMV of the alternative assets within our clients’ self-directed IRAs. As an administrator and custodian of self-directed retirement plans, we are required to file Form 5498 annually; to do so, we send reminders to our clients to provide us with the updated FMV on the assets held within their accounts. Form 5498 reports the fair market value of the IRA as of December 31^st of every year to clients and the IRS. You can read more about FMVs and Form 5498 on our blog.

If you plan to execute an IRA rollover of assets in kind, our team has the industry knowledge to make sure:

1 – that you are doing the rollover correctly,

2 – the successor custodian is aware that it is a non-publicly traded asset to ensure they will accept it, and

3 – that the transaction is completed within the proper time frame to avoid IRS penalties.

As Mr. Caan’s story tells us, if the brokers/custodians understood how to deal with these non-publicly traded assets and his financial team understood the ramifications of not getting the FMV reported—as well as the intricacies of executing an IRA rollover when alternative assets are involved—the prolonged and expensive legal battle could have been avoided.