In last week’s “Ask the Ambassador,” I answered a question from Mike from Portland regarding the reporting and taxation of cryptocurrencies. To review that article, click here. One element that we didn’t spend much time or space on concerned holding cryptocurrency in IRA accounts. Because Americans hold over 25 trillion dollars in retirement accounts, I believe this method of investing in cryptocurrencies such as Bitcoin, Ethereum, or UTRUST needs to be fully explored.
This, of course, begs the separate question: How do I purchase cryptocurrencies in my retirement accounts? For my Canadian friends, the answer is simple: You cannot.
RRSP accounts (the equivalent of U.S. retirement accounts) have a number of limitations that would prohibit Canadian investors from purchasing cryptocurrencies altogether. For an overview of RRSP account limitations, click here.
For U.S. persons, the best way to purchase cryptocurrencies in a retirement account will be through a self-directed IRA. Pension, Keogh, and 401(k) plans are all more restrictive than IRAs when it comes to what type of investments you can make. So, if you have one of these other types of accounts, you might want to look at the rules to “roll over” some or all of your retirement account funds to an IRA, preferably an IRA which is self-directed.
IRA legislation in the United States has only several limitations on what you can do with those retirement funds. These limitations are as follows:
1) You cannot purchase life insurance inside an IRA.
2) You cannot purchase certain collectibles inside an IRA.
3) You cannot “self-deal,” make loans to yourself or to close family members or pay yourself or close family members for services such as investment advisory services from your IRA.
4) You can’t run your own active business through your IRA, and investments in an active business may subject you to Unrelated Business Income Tax (UBIT).
But, basically, if you observe the above rules, you can make whatever investments that you want inside your IRA, including cryptocurrency. But being legally “able” to purchase cryptocurrencies and actually doing so are quite different topics indeed. If you go to your broker at Charles Schwab, Fidelity, or most other large institutional brokerage firms that handle IRAs and request that they purchase Bitcoin or UTRUST on your behalf, you’ll probably get laughed at or told politely that you can’t purchase cryptocurrency in your IRA (which would be an incorrect statement), or that they can’t or won’t purchase it on your behalf (which is a true statement).
There is no reason Charles Schwab couldn’t buy UTRUST for you, for example, through such a brokerage account, but buying something other than publicly traded stocks, bonds, and mutual funds simply does not fit their business model. So, at best, you might be able to buy a publicly traded mutual fund that has some exposure to cryptocurrencies, but not the currencies themselves.
A better alternative to achieve your goals is to set up a self-directed (sometimes referred to as a “checkbook” IRA), in which the direct investment control is maintained by the investor. The best way to have and maintain the control is to first find an IRA custodian willing to allow the type of self-directed investments that you wish to make. These are generally smaller, niche custodians whose business model is centered around earning custodian compliance fees rather than charging trading fees.
Once you have identified the appropriate IRA custodian, you can then rollover some or all of your existing retirement accounts to that custodian. From there, you will establish either an onshore or offshore LLC to be owned by the IRA custodian, in which you are named the LLC manager.
The LLC is a “pass through” entity for tax purposes, meaning there are no taxes levied by the IRS on the income or investment gains. The tax consequences “pass through” to the owner, which in this case is the IRA custodian for the benefit of (FBO) your IRA account. Because IRAs are generally not subject to taxation (except where UBIT income is realized), the income or gains from your various investments goes into your IRA account without tax, and tax is paid upon funds being withdrawn (unless it is a Roth IRA, in which case there are no taxes even when funds are distributed).
Once the LLC is established and properly connected back to your IRA, then the LLC can establish its own onshore or offshore bank accounts. The funds from your IRA flow into the LLC as the LLC’s capitalization, which of course is under the umbrella of your tax deferred (or tax free in the case of Roth) IRA. As the LLC manager, you now have complete freedom to make whatever investments you wish domestically or internationally for the IRA, as long as you avoid the prohibitions outlined above.
Whether you decide to create an onshore LLC or offshore LLC, and corresponding onshore or offshore bank account, depends largely on where you want to invest and what type of investments you wish to make. For the vast majority of investors, an onshore LLC in Delaware or Nevada with a corresponding local bank account will be sufficient for all of your needs.
But if you want to use your IRA account for foreign investments, including foreign issued stocks, bonds, foreign real estate, or private placement investments issued outside the U.S., the offshore LLC may be a better alternative. Many foreign issuers of all types of investments now restrict U.S. investors from participating in their offerings. This development has been happening for many years now but has accelerated in recent times, especially since the dawn of FATCA as it relates to foreign disclosure of income for U.S. persons by foreign financial institutions back to the IRS. In many cases it is simply easier for foreign issuers to exclude U.S. investors than to comply with all of the reporting requirements that the IRS demands. For more information, visit our Knowledge Center at www.Nagellaw.com.
Additionally, the U.S. Securities & Exchange Commission (SEC), The Commodities Futures Trading Commission (CFTC), and other regulatory agencies have claimed the right to regulate and bring enforcement action prosecutions against anyone worldwide if they sell their securities, commodities, or other investments to U.S. persons. The natural backlash is that more and more foreign issuers simply exclude U.S. persons from their offerings and, by some estimates, more than 70 percent of the total investment securities offered in the world today are “closed” for U.S. persons to buy.
In the case of an offshore LLC operating through a foreign bank account, even with a U.S. beneficial owner, these investments can frequently be made. Whereas without the corporate structure it would be impossible to make the same investment.
In the case of cryptocurrencies and cryptocurrency exchanges, it will depend on a variety of factors including where the currency is being issued (i.e. foreign or domestic) and whether some kind of securities filing or exemption (as in the case of accredited investors under Reg D) exists that permits direct or indirect U.S. investment. The use of a corporate entity will enable the IRA account holder to buy the cryptocurrency, whether onshore or offshore inside their tax advantaged IRA.
In this scenario, none of the various issues discussed last week about realization of short or long term capital gains, dividend treatment, or ordinary income tax rates apply. The cryptocurrency can be bought, sold, bought again, or traded as one cryptocurrency for another without any immediate tax consequences. The need for detailed record keeping goes away as long as all of the activity is done inside the IRA/LLC structure.
Instead, you’ll need to supply your IRA custodian with the year-end net asset value of your LLC, which will be the sum total of your LLC’s investments. This will include everything inside the LLC’s accounts, including your cryptocurrencies. This is much simpler than the type of transaction-by-transaction documentation which I outlined in last week’s column for non-IRA investment accounts.
Eventually, you’ll pay ordinary income tax on distributions you take from your IRA account, but this may be many years in the future depending on your age. And while cryptocurrencies are risky and volatile, the ability to dabble and position size those investments within the larger context of your overall investment portfolio may allow you to substantially increase the value of your retirement account without undue risk, current taxation, without complex record keeping. From my perspective, using a self- directed IRA is clearly the right and easiest way to make cryptocurrency purchases.
For assistance in setting up an international IRA, feel free to reach out to my law offices at +1-412-749-0500 or go to my firm website at www.nagellaw.com. For more frequent information about cryptocurrencies and other international legal matters, follow me on twitter at: @Nagellaw (https://twitter.com/nagellaw).