James Caan estate case highlights rollover rules advisors need to know

An offer the IRS refused! The estate owes nearly $1 million in taxes and penalties.

The jokes began as soon as the court decision came out: “The Godfather made the IRS an offer it could refuse.” “Sonny Corleone shot down again.” “Estate of James Caan whacked in tax case.”

Yet it’s doubtful that the Tax Court’s decision in Estate of James Caan et al v. Commissioner, released October 18, was very funny to the heirs of the late actor James Caan, most famous for his role as Sonny Corleone in The Godfather.

The court ruled that because of an improper IRA rollover Caan made before his death, his estate owed close to $1 million in taxes and penalties. The judge found that Caan’s rollover failed because it violated the same-property rule – a violation that cannot be fixed – and the 60-day rollover rule. The judge also concluded that the IRS acted properly when it denied Caan’s request to extend the 60-day deadline.

FACTS OF THE CASE

Before his death in 2022, James Caan owned two traditional individual retirement accounts and invested a part of one in a partnership interest in a hedge fund. The custodian of his IRAs was UBS. The custodial agreement between UBS and Caan stated that Caan was responsible for providing UBS with the hedge fund’s year-end fair market value.

In 2015, despite numerous attempts, UBS was unable to obtain the hedge fund’s 2014 year-end valuation from Caan. Meanwhile, Caan’s financial advisor left UBS and joined Merrill Lynch, and he persuaded Caan to transfer his IRAs to Merrill Lynch. All the assets in both IRAs were transferred, except for the hedge fund interest, which temporarily remained at UBS because it was not eligible for an Automated Customer Account Transfer, or ACAT.

Having failed to receive a valuation, UBS resigned as custodian of the remaining IRA funds (the hedge fund interest), and on November 25, 2015, it made an in-kind distribution of the hedge fund interest to Caan. UBS subsequently issued a 2015 1099-R to Caan that valued the hedge fund distribution at $1,910,903, its 2013 year-end fair market value.

On his 2015 federal income tax return, Caan reported a total of $2,299,567 in IRA distributions, including the $1,910,903 hedge fund interest. However, he reported only $388,664 as taxable income. He reported the hedge fund distribution as nontaxable.

In December 2016, well beyond the 60-day rollover deadline, Caan requested that the hedge fund completely liquidate his interest and roll the cash proceeds over to his Merrill Lynch IRA. The rollover was made through three wire transfers between January and June of 2017.

The IRS caught up with Caan’s failed rollover, notifying him that he had a $779,915 income tax deficiency for 2015 because the hedge fund distribution was taxable. The IRS also assessed him a $155,983 “accuracy-related penalty” for substantially understating his 2015 taxes.

Caan subsequently asked the IRS for a private letter ruling that would waive his failure to complete the rollover within 60 days. But the IRS refused. Caan then appealed to the Tax Court.

THE COURT’S DECISION

Caan died in 2022, and his estate had no better luck in court. The crux of the decision was that Caan’s attempted rollover did not qualify as a tax-free transaction and he therefore received a taxable distribution. The court ruled that Caan’s rollover ran afoul of the tax code’s same-property rule, which says that the property distributed from an IRA must be the same property that’s subsequently rolled over. Here, Caan received a distribution of a hedge fund interest and rolled over cash.

The judge also found that the rollover was not completed within 60 days, since the distribution was made on November 25, 2015, but the transfers did not take place until between January and June of 2017.

IRA INVESTMENTS IN ALTS

James Caan’s whole ordeal started with the hedge fund’s inability to provide the custodian with a year-end valuation. Unfortunately, valuation issues are not uncommon when IRAs are invested in alternative assets, such as real estate or other nonliquid assets. The IRS requires custodians to report annual valuations on Form 5498. A proper valuation is also necessary for calculating required minimum distributions.

Investing IRA funds in alternative assets can also create problems for paying out RMDs if, as is often the case, the asset is not liquid. There is no exception for illiquid assets in the RMD rules. This is a particular problem for real estate. If the IRA owner has no other liquid assets, how can a part of the real estate be distributed each year to meet the RMD rules?

These problems with holding alternative investments in an IRA were aptly summarized by the Tax Court in the Caan decision: “This case is a quintessential example of the pitfalls of holding nontraditional, non-publicly traded assets in an IRA. Failure to follow the labyrinth of rules surrounding these assets can mean forfeiting their tax-advantaged status.”

Amazingly, Caan’s high-priced, Beverly Hills-based financial advisor was apparently unaware of the rollover rules, and it cost Caan’s estate a fortune. Your clients expect better of you. Know the rollover rules and monitor clients’ rollover transactions to make sure they are completed correctly.

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