What you should know about McNulty v. Comm’r and bitcoin IRAs

On November 18th, 2021, the United States Tax Court issued an opinion, McNulty v Comm’r, 157 TC 120 (2021), which garnered a lot of internet discussion among those interested in bitcoin IRAs. Many existing and prospective Unchained clients have begun to ask what this opinion means, if anything, for Unchained IRAs. To address this, it’s important to understand the concept of a “checkbook” IRA, what the McNulty opinion said, and how Unchained IRAs fall outside the scope of the ruling…

What is a checkbook IRA?

All IRAs are required by law to have a licensed financial institution acting as custodian over the IRA’s assets. This often creates a problem when an IRA account holder wants to invest in an asset which traditional financial institutions do not want to physically custody, such as real estate or bitcoin.

One solution to this problem which has become popular over the past 15 years is the “checkbook” IRA. With a checkbook IRA, an IRA owns only one asset, which is typically either an LLC or an investment trust entity. The IRA owner is appointed manager or trustee of that entity (called a “checkbook entity”), putting the IRA owner in control of the entity’s investments.

In short, the IRA invests in the checkbook entity, and the checkbook entity, in turn, does the actual investing in the alternative assets. This fulfills the custodial requirements for IRAs since the IRA custodian holds title to the IRA’s only asset, the checkbook entity.

In the early 2000s, the IRS challenged structures involving IRAs wholly owning business and investment entities several times and consistently lost in tax court. These IRS losses increased confidence in the idea of a checkbook IRA and led to its surge in popularity.

The recent McNulty opinion represents a drastic departure from most attorneys’ understanding of the legal principles underlying checkbook IRAs.

What did the McNulty opinion actually say?

The McNulty case involved a taxpayer holding gold in a checkbook IRA where such gold was not in the physical possession of a bank or trust company. This is a clear violation of section 408(m) of the Internal Revenue Code (a special provision which applies only to precious metals, not bitcoin), so the taxpayer ultimately was always going to lose this case. Precious metals in an IRA must always be in the physical possession of a qualified licensed custodian under 408(m). This precious metals-specific statute has always been an exception to the principles around checkbook IRAs, and experienced tax advisors have always advised their clients not to hold precious metals in a checkbook IRA without a bank or trust company physically holding the metal.

The opinion in McNulty is very strange in that instead of merely stating that the taxpayer violated section 408(m) and ruling accordingly, the court additionally opined on IRC 408(a)(2), a section which applies to all IRAs, including bitcoin IRAs.

Even stranger, the court applied Treasury Regulation 1.408-2(e) in interpreting IRC 408(a)(2). This is odd because the Treasury Regulation does not apply to IRA holders at all—it’s instead a regulation that lays out licensing standards for certain IRA custodians who are not “banks.” As such, not only was this licensing regulation not applicable to the taxpayer herself, it was also not applicable to the taxpayer’s IRA custodian. This is because the statutory definition of “bank” includes not only banks, but also trust companies regulated by a state department of banking. See IRC 408(n)(3). The IRA custodian in McNulty was a trust company regulated by a state department of banking. It seems very possible that the judge was not aware of how “bank” is defined in this context. Further, even if the Treasury Regulation had been applicable, the Regulation itself states that its requirements for custodians are reduced or eliminated with respect to custodians acting in a solely passive fashion, as nearly all modern IRA custodians do. Treas. Reg. 1.408-2(e)(6)(i).

The McNulty court leaned heavily on the (inapplicable) Treasury Regulation to propose that an IRA custodian must be intimately involved not only with the actual assets owned by an IRA (the LLC or investment trust entity in the context of a checkbook IRA) but also in the investments made by any entities owned by the IRA. This is a requirement found nowhere in the statute, and further contradicts earlier court cases involving IRAs wholly owning business or investment entities. These prior cases in fact are what caused the “checkbook style” self-directed IRA industry to take off in the early 2000s.

In short:

• The holding in McNulty was grounded squarely in section 408(m) of the Internal Revenue Code, a section applicable only to precious metals and not bitcoin. Because the ruling was driven by section 408(m), the court’s additional statements regarding 408(a)(2) and Treasury Regulation 1.408-2(e) were merely dicta (offhand statements of opinion which have no legally binding precedential value on other taxpayers).
• Besides being non-binding dicta, the court’s statements regarding Treas. Reg. 1.408-2(e) were wholly inapplicable to both the taxpayer and her IRA custodian under the exceedingly plain language of the regulation. Further, even if the regulation at large were applicable, the portions cited by the court would still be inapplicable to a passive IRA custodian such as the one in McNulty by their own terms.
• The holding in McNulty is contrary to all prior cases on point, such cases having led to the development of the checkbook IRA industry.

Despite all of the above, in the interest of extreme conservatism, Unchained nonetheless designed its IRA to fall outside of the scope of IRAs which the McNulty opinion sought to prohibit. An Unchained IRA is intended to be even more conservative than a legacy financial system IRA when it comes to the factors analyzed by the court in McNulty.

An Unchained IRA is not a checkbook IRA

An Unchained IRA differs very substantially from a checkbook IRA.

In an Unchained IRA, the IRA custodian (Fortis Bank) holds legal title to the bitcoin directly; there is no intermediary trust or LLC entity involved as there would be in a checkbook IRA. As is standard in IRAs generally, and as is specified on all Unchained IRA account statements, the IRA custodian has legal title in “FBO” format, meaning that equitable title remains with the accountholder and as such all Unchained IRAs are fully protected against hypothetical creditor or other legal claims against the IRA custodian. Fortis executes a special tri-party agreement with Unchained and each Unchained client by which it delegates private key responsibility to both the client himself (two private keys) and also Unchained (one private key). While Fortis does not have access to private keys, it does have access to the related public keys and wallet configuration such that it is aware of all transactions.

Both Unchained and the client agree that in holding private keys they act as agents and conduits for Fortis as the IRA custodian and contractually agree to use the keys they hold only upon filing of appropriate paperwork with the IRA custodian. In the words of the McNulty court, “an IRA owner may act as an agent or conduit of the underlying custodian…so long as she is not in constructive or actual receipt of the IRA assets.” The concept of “constructive receipt” is key. An Unchained IRA client would not want to have constructive receipt of the bitcoin in his IRA vault until such time he uses his keys to take legal title to the coins by taking an IRA distribution.

Application of the doctrine of constructive receipt to IRAs is a novel idea, and it is difficult to determine what constructive receipt could even mean in the context of an IRA. When evaluating constructive receipt as a general tax law doctrine, a Taxpayer with the legal right to request an asset on demand is deemed to be in “constructive receipt” of that asset. That can not, however, be what the court meant by “constructive receipt” in the context of an IRA, as nearly all modern IRAs, including the most milquetoast and noncontroversial brokerage IRAs in the legacy financial system, allow the account holder to receive a distribution on demand. To choose one well-known example, Fidelity contractually guarantees to all of its IRA accountholders the right to request an IRA distribution on demand in section 11 of its IRA Custodial Agreement, and goes even further by issuing its IRA accountholders checkbooks which they can use to write checks from their IRA funds to any party, including themselves, at any time without notice to the IRA custodian. It cannot be the case that the McNulty court intended to invalidate Fidelity IRAs along with nearly all other brokerage IRAs currently in existence.

When citing constructive receipt, the court’s main concern was that the taxpayer could potentially withdraw assets from the IRA outside of the custodian’s knowledge, evading IRS reporting. The court felt this situation created a deemed IRA distribution because such “unfettered command” without custodial monitoring implied constructive receipt of the IRA’s assets. An Unchained IRA is significantly different on this point, as in an Unchained IRA, all bitcoin remain at all times in a designated multisig vault. That vault is consistently monitored by the IRA custodian (through Unchained) such that no transaction can possibly take place outside of the IRA custodian’s knowledge. Both Unchained and Fortis have access to the vault’s master public keys and wallet configuration file, and as a result are able to view all transactions on the public bitcoin blockchain. Further, to the extent an accountholder in an Unchained IRA holds keys, his command over the associated bitcoin is never “unfettered,” as it is restrained by a contractual requirement in the Unchained Terms of Service to only use such keys as agent and conduit of the custodian, with filing of appropriate paperwork. Violation of this contractual restraint would be detected by vault monitoring and reported to the IRS accordingly. On this point, an accountholder’s level of command over an Unchained IRA is less “unfettered” than a comparable legacy brokerage IRA, as an accountholder in a legacy brokerage IRA can write a check to himself from his account at any time using the checkbook which is in his possession at all times.

To put it plainly: an Unchained IRA creates less potential for tax abuse than a legacy financial system IRA and is more compliant with the rationale of McNulty than a legacy financial system IRA. The idea that an Unchained IRA somehow creates “constructive receipt” of IRA assets would necessarily also implicate nearly every legacy IRA currently in existence with the same problem.

Best of both worlds

An Unchained IRA is designed to allow clients private key control over their own bitcoin, while still providing transparency for tax reporting purposes. We believe it is the best solution available to eliminate trusted third parties while still remaining compliant with the tax laws around retirement accounts.

This article is provided for educational purposes only, and cannot be relied upon as tax advice. It has not been catered to your individual tax circumstances. Unchained makes no representations regarding the tax consequences of any structure described herein, and all such questions should be directed to an attorney or CPA of your choice.