Most stocks and other traditional investments are easy to value. The price is determined by the markets or found on a bank statement. But some assets are not so easy to find a value for, and that's a problem if those assets are held in an individual retirement account or other tax-deferred retirement account.
The funds in these accounts have not yet been taxed and need to be valued for distributions, such as required minimum distributions or Roth conversions, since the tax due is based on the fair market value on the date of the distribution. IRA valuations are also needed for annual tax reporting on Form 5498, and required-minimum-distribution calculations are based on year-end IRA values.
Many IRA investors, usually through self-directed IRAs, have alternative investments such as real estate, business interests or other nontraditional investments. These too need to be valued, and that value needs to be accurate and credible in the eyes of the Internal Revenue Service.
For example, you cannot report an artificially created low value when distributing these assets for a Roth conversion and underpay the tax, as a much higher value sits growing tax-free in a Roth IRA. This strategy has been featured in several recent tax court cases, and each time, the IRS won and the taxpayers incurred huge taxes and penalties.
To address IRA valuation abuses, on Nov. 13, the IRS proposed additional reporting requirements for hard-to-value IRA assets, on both Form 5498 (for contributions) and on Form 1099-R (for distributions). This reporting was supposed to take effect this year but instead will be optional, with required reporting postponed until 2015.
According to the IRS: “New information-reporting requirements are proposed to apply to certain IRA investments with no readily available fair market value. Reportable investments may include:
• Nonpublicly traded stock.
• Partnership or [limited-liability] interests.
• Real estate, options.
• Other hard-to-value investments.”
When the requirements take effect, IRA custodians will have to code the two forms mentioned above to indicate transactions involving assets without a clear value. This may point IRS examiners toward certain IRA owners for scrutiny.
It would appear that the IRS wants all assets to be fairly valued for Roth IRA conversions and for in-kind distributions to the account owner. Both of those events are taxable, so the IRS stands to lose revenue when an asset is undervalued. This new reporting should help reduce that risk.
Now the good news. These reporting requirements could help IRA owners with hard-to-value assets that have dropped in value. Some custodians have refused to reflect valuation declines accurately on the account owner's statement.
For example, an illiquid IRA asset purchased for $40,000 might be listed at a $40,000 value on the next IRA statement. Even if that asset declines in value — perhaps all the way to zero — some custodians insist on maintaining the $40,000 valuation on IRA statements, which could lead to higher tax on distributions and Roth IRA conversions.
This scenario just played out in two recent tax court cases, both decided Jan. 6. The IRA owners, Bernard Berks and Steven Gist, paid dearly not only for bad investments but also for inaccurate IRA valuations.
In each case, the IRA owners and their spouses invested their self-directed IRA funds in dubious real estate partnerships that eventually became worthless. Their IRA accounts were closed, but the partnership issued 1099-R forms reporting that the Berkses had received over $77,000 and that the Gists had received over $45,000 from their IRAs, even though they received only worthless notes. In both cases, the court found the IRA owners liable for the tax and accuracy-related penalties on the distribution of worthless property to them, even though the promoter of these investments (a financial adviser) testified that the notes they issued “had become worthless.”
Even though the new valuation proposal from the IRS is designed to prevent abuse by taxpayers using low values for IRA distributions to lower their tax bills, these new proposals by the IRS might have helped in these two cases. If the 1099-R form had shown a proper value (zero), they may have avoided this tax disaster.