Amended FORM 5498 reporting requirements for IRA custodians in 2014. Do changes signal more scrutiny on “nontraditional” investments within self-directed IRAs?

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The current draft instructions for the 2014 version of Form 5498 reflect a change in the way the IRS receives information from IRA custodians. Under current law, IRA custodians must report certain information about every IRA they hold – this is done using Form 5498. Whether IRA account holders realize it or not, the federal government maintains information regarding retirement accounts – with these reports helping the IRS identify when inaccuracies are occuring that might require further scrutiny. For example, if the owner of an IRA makes a maximum annual contribution to three different Roth IRAs (there by exceeding the normal limit), the IRS would know (based on the 5498 reports from each IRA custodian) that an “excess” IRA contribution was made. Without the 5498 reporting, this error would likely go unnoticed.

IRS Form 5498 (2012)

The current version of the Form 5498 (see 2012 version in picture above) lists certain information that occurred within the IRA during the tax year, including: IRA contributions, rollover from other qualified accounts, required minimum distributions (if applicable), and the fair market value of the IRA. This last requirement (FMV) is a tricky one in the context of a “self-directed IRAs” – i.e. IRAs that hold “nontraditional” (not publicly traded) assets – because the investments within these IRAs is inherently difficult to value. For example, if an IRA owns 100% of an LLC and the LLC executes a real estate investment, the IRA custodian must rely on the manager of the LLC to report the LLCs value once per year. Without this LLC “valuation” (it is normally more of a rough estimate), the IRA custodian cannot accurately report the value of the IRA on Form 5498.

The current Draft instructions for 1099-R & 5498 – changes for 2014 add a new category that has not previously appeared on the form. Box 15a requires the IRA custodian to list the “fair market value of certain specified assets”. Box 15b then requires the IRA custodian to write a “Code” relating to the type of asset (e.g. real estate, LLC, debt oblication, etc.). These assets include basically any investment that is not publicly traded – which would apply to most assets that would appear within a self-directed IRA. This new reporting information is in addition to the original Box 5, which requires a total fair market value of the IRA to be listed.

An example IRA situation will hopefully help show why this change to the Form 5498 matters… John Smith has an IRA at Provident Trust Group, LLC (an example custodian that holds many IRAs with nontraditional assets) that holds $50,000 of mutual funds and $200,000 of real estate. On the annual Form 5498 for John Smith’s IRA, Provident would need to list $250,000 in Box 5 (i.e. total FMV), $200,000 in Box 15a (i.e. FMV of “certain specified assets”), and Code “D” in Box 15b (i.e. real estate). Of course, as always, Provident would likely need to rely upon the IRA owner to supply a valuation of the real estate. Prior to the 2014 changes, Provident would only list $250,000 in Box 5.

Several inherent questions arise from these changes that are important to the self-directed IRA marketplace. First, why does the IRS wants to see new information relating to nontraditional IRA investments? The IRS is definitely aware that more and more IRA investors are venturing into nontraditional investments, and perhaps the IRS simply wants to have a way to track the approximate amount of value in these types of assets. However, adding Boxes 15a and 15b to the Form 5498 does not automatically tell the IRS that something is wrong with the underlying IRA investments – it also does necessarily mean that the information reported in Boxes 15a and 15b is accurate. But, in theory, it would allow the IRS to target certain IRAs in a way that was not previously possible.

Said another way, the change to the Form 5498 will make it easier for the IRS to identify who might be a good canditate for an audit. For example, if the IRS believes (for whatever reason) that IRAs that invest into privately-held partnerships have a high likelihood of non-compliance, then the IRS could randomly audit taxpayers who have IRAs with 5498 reporting that shows “E” in Box 15b (i.e. “ownership interest in a partnership, trust, or similar entity”). Without the changes to Form 5498, it is impossible to know what IRAs own interests in these types of privately-held companies. This same concept could apply to IRA-owned LLC structures (code “C” in Box 15b – “ownership interest in a limited company or similar entity” – which have become very popular with self-directed IRA investors.

It is also possible that the IRS wants to discourage new self-directed IRA custodians from entering the marketplace by imposing additional reporting burdens on them. It seems likely that if the IRA custodians are required to report more specific information about nontraditional assets and these changes result in more administrative burden, some custodians will either exit the marketplace and/or raise their fees on IRA account holders. Either result would have a negative consequence on individual self-directed IRA account holders – which, again, might be the secondary goal of the Form 5498 changes. Note: there are already many small banks and trust companies that have voluntarily withdrawn as self-directed IRA custodians – presumably due to the liability risks and administrative hassle of holding non-publicly traded asses.

The second question that arises is: will the IRA custodians will require more specific fair market value reporting of nontraditional assets as a result of Form 5498 changes? As mentioned above, currently, most IRA custodians require IRA accountholders to provide an estimate of the value of nontraditional investments – except in situations where the specific value of the IRA is important for current-year tax reasons (e.g. Roth conversion, required minimum distribution year, in-kind distribution of nontraditional asset). It is possible that IRA custodians will require IRA accountholders to get a certified appraisal of IRA assets every year because the value of these assets must be specifically listed in Box 15a. Don’t get me wrong, the wording of the Form 5498 does not specifically require this change in valuation technique, but I can imagine IRA custodians jumping to this conclusion. In my opinion, requiring a third-party valuation for every nontraditional IRA asset would be unduly burdensome to the self-directed IRA marketplace – because, after all, the year-to-year value increase or decrease of an IRA is generally irrelevant – similar to how an IRA that owns Apple stock will flucuate in value on a yearly basis. Said another way, the value of an IRA going up or down does not have a tax consequence in and of itself.

It is yet to be seen how the changes to the Form 5498 will affect IRA custodians and IRA investors in the years ahead. However, based on two recent Tax Court opinions (Peek v. Commissioner (140 T.C. No 12) – 5-9-2013 and Terry Ellis (TC Memo 2013-245) – October 29, 2013), it seems clear that the IRS is willing and able to scrutinize transactions witihn self-directed IRA structures.