Individual Retirement Accounts: IRS Could Better Inform Taxpayers about and Detect Noncompliance Related to Unconventional Assets

Unconventional IRA investments—such as real estate, certain precious metals, private equity, and virtual currency—can introduce risks to account owners who assume greater responsibility for navigating the complex rules that govern tax-favored retirement savings. IRS enforces tax rules relating to IRAs and can assess additional taxes.

GAO was asked to examine the challenges associated with enforcing rules governing IRAs invested in unconventional assets. This report examines (1) the extent to which IRS offers guidance to help taxpayers understand the rules governing unconventional IRA assets; and (2) the challenges IRS faces in enforcing those rules. GAO identified and analyzed IRS information to help taxpayers understand four compliance areas. GAO reviewed IRS analysis of nonmarket IRA assets reported by IRA custodians, and IRS audit procedures and training materials; and interviewed relevant IRS officials to identify enforcement challenges.

The Internal Revenue Service's (IRS) Publications 590-A and 590-B serve as a general handbook for millions of taxpayers with individual retirement accounts (IRA). However, the two-part publication provides limited information for IRA owners with unconventional assets surrounding complex tax rules in four compliance areas: (1) barred investments, (2) prohibited transactions, (3) unrelated business income, and (4) fair market value. GAO found other limited information about these topics on IRS's website. With only about 2 percent of IRAs invested in unconventional assets, adding more pages to Publications 590-A and 590-B may not be practical. By assessing options for informing IRA owners investing in unconventional assets, such as directing them to web pages with specialized information and technical regulations, IRS could better help them comply.

Noncompliance involving unconventional IRA assets is difficult to detect and time consuming for IRS to pursue. Whereas IRS relies on automated enforcement for IRAs invested in conventional assets held by custodians and trustees, enforcement for IRAs invested in unconventional assets or under IRA owner control requires labor-intensive audits of individual taxpayers. Using newly compiled information, IRS identified about 2 million IRAs that held certain types of hard-to-value assets as of 2016; however, about 20 percent of the forms were missing fair market value amounts for these assets (see fig.).

IRS officials said this type of reporting alone may be inadequate for audit selection and identifying potentially abusive IRAs. When IRS lacks sufficient data to detect abusive transactions, IRS can require taxpayers to self-report certain transactions that have been used by other taxpayers to avoid taxes. Additional taxpayer or custodian disclosure of potentially abusive IRA transactions coupled with IRS analysis of reported details may help IRS to select IRA owner tax returns to audit.

Fragmented responsibility among IRS divisions creates challenges for examiners who need to share expertise and collaborate on IRA enforcement. The division responsible for tax-exempt entities trains its examiners on how to determine if an employee retirement plan has engaged in business activities subject to taxation. However, examiners in the division that audits complex individual tax returns, including those involving IRAs, do not receive such training. Training for those examiners could help improve collaboration on IRA enforcement.

GAO is recommending that IRS (1) assess options for updating its IRA publications to provide more information for taxpayers with unconventional assets, (2) evaluate the feasibility of requiring disclosure for high-risk IRA asset types associated with abusive tax schemes, and (3) develop auditor resources (such as training materials or job aids) that explain how IRAs with unconventional assets can generate unrelated business income tax. IRS generally agreed with GAO's recommendations.

Individual retirement accounts (IRA) are a key vehicle for individuals to  save for retirement or roll over savings from employer-provided retirement  plans, such as a 401(k) plan. For tax year 2016 (the most recent  statistical data available), an estimated 59 million taxpayers had IRAs  with a total estimated fair market value (FMV) of $8 trillion. IRA owners  are able to invest their IRA savings in a wide variety of asset types. Many  IRA owners choose to invest in publicly traded assets, such as stocks,  bonds, and mutual funds, through a bank or qualified firm that acts as a  trustee or custodian of those investments. Some IRA owners seek out  alternative investment opportunities in less conventional or nonpublicly  traded assets such as real estate, certain precious metals, private equity,  and virtual currency. We previously found that IRA owners who have  accumulated unusually large IRA balances likely have invested in  unconventional assets like nonpublicly traded shares of stock and  partnership interests.

As we also previously found, unconventional IRA investments can  introduce new risks to account owners who assume greater responsibility  for navigating the complex rules that govern tax-favored retirement  investments. Difficulty in valuing nonpublicly traded investments can  heighten the risk of noncompliance. We have also found that  noncompliance associated with nonpublicly traded IRA assets has been  difficult for Internal Revenue Service (IRS) to detect and time consuming to pursue. Overall, IRS audits of individual tax returns have declined in  recent years.

You asked us to examine the challenges associated with enforcing rules  governing IRAs invested in unconventional assets. This report examines:  (1) the extent to which IRS offers guidance to help taxpayers understand  the rules governing unconventional IRA assets and (2) the challenges  IRS faces in enforcing IRA rules for unconventional assets. In June 2019,  we issued a separate report on IRS and Department of Labor (DOL)  collaboration on shared oversight of prohibited transaction rules for IRAs  and the DOL process for granting exemptions for prohibited IRA  transactions. These reports are part of a larger body of work on  retirement security—a key issue we have identified facing the nation.

To determine the extent to which IRS offers published guidance to help  taxpayers understand rules governing unconventional IRA assets, we  identified and analyzed publicly available IRS information on four  compliance areas where complex rules are likely to apply: (1) barred  investments, (2) prohibited transactions, (3) unrelated business income,  and (4) fair market value (FMV). Information sources reviewed include  federal laws and regulations and guidance published in the Internal  Revenue Bulletin such as revenue rulings and revenue procedures. We  also reviewed IRS publications, forms and instructions, as well as  information on IRS.gov, including frequently asked questions (FAQ).

To identify challenges IRS faces in enforcing rules for IRAs invested in  unconventional assets, we built on the analyses of IRA rules developed  for the first objective by reviewing relevant sections of the Internal  Revenue Manual, IRS audit procedures, and internal training materials  covering IRA rules to determine how IRS detects when violations of the  rules occur, resolves noncompliance, and develops strategies to promote  IRA owner compliance.

We interviewed IRS officials from the Small Business/Self Employed  (SB/SE) division, and the Tax-Exempt and Government Entities (TE/GE)  division’s Exempt Organizations and Employee Plans groups to identify  enforcement challenges and how these units communicate and  coordinate in handling IRA issues. We also discussed with SB/SE and  TE/GE officials the status of implementing our prior recommendations  related to IRAs with unconventional assets. We reviewed documentation  and analysis of nonpublicly traded IRA assets from an IRS team studying  IRA noncompliance. We reviewed the IRS data tabulations and  interviewed staff responsible for compiling the data. Based on our review  and interviews with IRS officials, we determined the data reported on  IRAs with unconventional assets were sufficiently reliable for purposes of  this report.

We conducted this performance audit from December 2016 to January  2020 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.

Created as part of the Employee Retirement Income Security Act of 1974,  as amended (ERISA), traditional IRAs provide tax advantages to help  individuals—including small business owners, independent contractors,  and other workers not covered by employer-sponsored retirement plans— save for retirement. Employees who have employer-sponsored  retirement plans, such as a 401(k), can also roll over these assets into an  IRA when they retire or change jobs.

Since the enactment of ERISA, different types of IRAs with different  features for individuals and small businesses have been created. The two  IRA types with federal income tax benefits for individuals are traditional IRAs (which allow eligible individuals to make tax-deductible contributions  and accumulate tax-deferred investment earnings) and Roth IRAs (which  allow eligible individuals to make after-tax contributions and accumulate  investment earnings tax free).

IRA owners are able to invest their IRA savings in a wide variety of asset  types. IRA owners generally make tax-favored contributions to their  accounts to purchase assets from investment options offered through  banks or other IRS-qualified firms acting as custodians of the IRA  assets. Most IRA custodians limit holdings in IRA accounts to firm- approved stocks, bonds, mutual funds, and CDs.

Some custodians offer so-called “self-directed IRAs” that allow  investments in a broader set of unconventional assets—such as real  estate, certain precious metals, private equity, and virtual currency—than  is permitted by most IRA custodians. As we previously reported, custodial  agreements for these accounts often require IRA account owners to be  responsible for directing their investments, and to oversee the selection,  management, monitoring, and retention of all investments in the  account. The account owners bear the consequences of any mistakes  made in managing their accounts, such as being noncompliant with IRA  rules.

Through our prior work, we identified the following four areas where  complex rules are likely to apply to IRA owners investing in  unconventional assets:

Barred investments. Investments in life insurance contracts and  collectibles, such as artwork and antiques, are prohibited. Although  precious metals are generally prohibited collectibles, certain types of  coins and bullion are permitted provided that they meet specific purity  and custody requirements.

Prohibited transactions. IRA owners are not permitted to engage in  prohibited transactions that personally benefit the owner or other  disqualified persons in a way other than as a vehicle to save for  retirement. Examples of such prohibited transactions include IRA  owners selling their own property to an IRA, or taking a salary from an  IRA-funded business. IRA owners who believe that an otherwise  prohibited transaction should be permitted, may apply to the  Department of Labor (DOL) to request an exemption for a specific  transaction.

Unrelated business income. Earnings and profits made in tax- deferred savings vehicles like IRAs generally are reinvested in the  account without generating current federal tax liability, but  investments in certain unconventional assets can generate ongoing  tax liability for IRA owners. Any IRA that earns $1,000 or more of  gross income from an unrelated business must file Form 990-T  Exempt Organization Business Income Tax Return with IRS and pay  related taxes.

Fair market value (FMV). When IRA owners invest in less  conventional and nonpublicly traded assets, custodians may find it  challenging to properly report the FMV of those assets. Starting with  tax year 2015, IRS began requiring IRA custodians to report selected  information on unconventional assets in their clients’ accounts. For  some hard-to-value unconventional assets, IRA owners may need to  supply custodians with independent appraisals or other evidence to  substantiate an asset’s current FMV.

Failure to abide by the rules governing IRAs with unconventional assets  can have significant consequences for IRA owners. For example, if an  IRA owner engages in a prohibited transaction that has not been  exempted by DOL, the IRA will lose its tax-favored status, and the  account is treated as distributing all of its assets to the owner at the FMV  on the first day of the year in which the prohibited transaction occurred.  Noncompliance with IRA rules—if not detected—can also lead to millions  of dollars in uncollected tax revenue for the government.

Individuals who invest in certain unconventional assets using Roth IRAs  can avoid taxation on investment gains. For example, founders of  companies (or key initial investors) who use IRAs to invest in nonpublicly  traded shares of their newly formed companies can realize many millions  of dollars in tax-favored gains on their investment if the company is  successful.

IRS is responsible for enforcing IRA tax laws, including rules that apply  when IRA owners invest in unconventional assets. Within IRS, four  business operating divisions have responsibilities for enforcing  compliance with IRA rules. Table 1 provides an overview of each  division’s IRA enforcement activities.

Third-party reporting by IRA custodians provides information that  taxpayers can use in preparing their tax returns and that IRS can use to  identify noncompliant taxpayers and help close the tax gap. In 2015,  IRS began requiring custodians to report new information to help identify  IRAs with hard-to-value unconventional assets. IRS Form 5498 IRA  Contribution Information has a new box 15a for custodians to report the  portion of the IRA FMV attributable to nonmarket assets as well as a box  15b with codes describing the type of nonmarket assets. Custodians are  to report similar information on IRS Form 1099-R identifying distributions  of IRA assets that do not have a readily available FMV.

Primary IRS Publication Could Better Help IRA Owners with Unconventional Assets Understand Complex Rules

The first article in the Taxpayer Bill of Rights is the right to be informed  which means that taxpayers have the right to know what they need to do  to comply with tax laws. IRS’s Publication 1, Your Rights as a Taxpayer,  further states that taxpayers are entitled to clear explanations of the laws  and IRS procedures in all forms, instructions, publications, notices, and  correspondence.

To help taxpayers and their advisors better understand tax rules, such as  those governing IRAs with unconventional assets, IRS produces several  types of resources. Taxpayers (or their advisers and paid tax preparers)  with complicated returns or transactions may require detailed and  technical resources, such as guidance published in a weekly IRS  publication called the Internal Revenue Bulletin (IRB). Tax regulations— issued by the Department of the Treasury (Treasury)—are published in  the IRB together with technical IRS guidance such as revenue rulings and  revenue procedures. IRS has stated that only guidance published in the  IRB contains IRS’s authoritative interpretation of the law.

IRS also produces resources that are less technical and intended to be  more easily understood by most taxpayers. IRS issues hundreds of  publications on a variety of tax topics, and many are updated annually.  IRS also produces a variety of information on its website (IRS.gov) such  as online tools, instructions, and FAQs.

IRS’s Publication 590-A, Contributions to Individual Retirement  Arrangements (IRAs), and Publication 590-B, Distributions from Individual  Retirement Arrangements (IRAs), serve as a general IRA handbook for  IRA owners and a logical starting point for all IRA owners with tax  questions, including those with unconventional assets. At more than 120  pages combined, Publications 590-A and 590-B comprise one of IRS’s  longest publications on retirement related topics. Publications 590-A and  590-B provide some limited information on the four compliance topics that  we identified through prior work as likely to affect IRA owners with  unconventional assets. However, the two-part publication lacks additional  information that IRA owners with unconventional assets need to comply.

Publications 590-A and 590-B recommend that taxpayers research IRS’s  website (IRS.gov) for additional information. We found some additional  information on IRS’s website about three of the four compliance topics.  This information was typically in the form of FAQs in a section of IRS’s  website about retirement plans (https://www.irs.gov/retirement-plans).

Table 2 summarizes: what information for IRA owners with  unconventional assets can be found in Publications 590-A and 590-B;  what other IRS sources provide relevant information; and what  information was not readily available on the IRS website for the four  compliance areas likely to affect IRA owners with unconventional assets.  Appendix II describes in more detail the information available and the  information lacking in Publications 590-A and 590-B and other IRS  sources.

Given the complexity of the four compliance topics we identified as well  as the relatively few numbers of taxpayers affected and the already large  publication size, it may not be feasible to provide complete information on  these topics within Publications 590-A and 590-B. IRS publications (like  590-A and 590-B) are intended to explain the law in plain language for  taxpayers and their advisors. They generally summarize and translate  into layperson’s terms more complex and technical information from  authoritative sources like the Internal Revenue Code and more  authoritative guidance like tax regulations, revenue procedures, and  revenue rulings.

IRS analysis indicates that perhaps only about 2 percent of IRAs have  invested in hard-to-value unconventional assets. However, even small  numbers of taxpayers with particular circumstances have the right to  know what they need to do to comply with tax laws. IRA owners with  unconventional assets who turn to Publications 590-A and 590-B are  unlikely to fully understand how certain IRA investment decisions can  increase their risks for noncompliance. Misunderstanding the rules  governing IRAs could result in increased tax liability for taxpayers making  unintentional errors and jeopardize their retirement savings.

Given the serious consequences that could result for a taxpayer found to  be noncompliant, IRS’s current publications are not clearly providing  information for IRA owners with unconventional assets. Adding  information to Publications 590-A and 590-B would be one solution that  IRS could explore, but we recognize that it may not be practical for IRS to  add substantially more information to Publications 590-A and 590-B for a  relatively small percentage of IRA owners. Alternatives to adding more  pages to Publications 590-A and 590-B could include directing readers  with questions about rules affecting unconventional IRA assets to other  IRS resources, such as IRS web pages or tax regulations that contain  more technical and specialized information. As shown in table 2 above,  we found some additional information on IRS web pages that would be  helpful to IRA owners with unconventional assets. Adding language in  Publication 590-A or 590-B directing taxpayers to specific web page URL  addresses for additional information could help taxpayers more easily  locate this information. For more technical or specialized information,  IRS could direct readers of Publications 590-A and 590-B to the relevant  sections of the Internal Revenue Code and related tax regulations. This  additional information could help IRA owners better understand and  navigate the potential compliance challenges associated with certain  types of unconventional assets.

Insufficient Data and Fragmented Expertise across IRS Organizational Units Complicate Enforcement of IRA Rules Involving Unconventional Assets

IRS Cross-Divisional Team Identified Risks of IRA Noncompliance Based on Different Asset Types

In October 2017, the Deputy Commissioner for Service and Enforcement  commissioned a cross-divisional team comprised of representatives from  all four IRS operating divisions to identify, assess, and mitigate risks of  IRA noncompliance. In its February 2018 interim presentation, the IRS  cross-divisional team categorized potential noncompliance risks over an  IRA life cycle into two mitigation strategies, which are summarized  below.  1.  Noncompliance risks for most contribution and distribution IRA rules  can be mitigated systemically through automated enforcement. For  example, IRS can detect excess IRA contribution deductions and  unreported IRA distributions by matching information from taxpayer  returns with information reported by custodians. For the large  population of IRA owners investing in conventional assets held by  custodians, IRS relies on automated enforcement.  2.  Noncompliance risks associated with the small population of IRAs  with hard-to-value unconventional assets or under direct control of the  IRA owner are generally mitigated through case-by-case audits. For  example, noncompliance with the complex rules governing prohibited  transactions and unrelated business income is generally not reflected  on individual tax returns. Some custodians rely on IRA owners to  provide asset value information and may not have complete and  accurate data to report to IRS. Undervaluing IRA assets hampers  automated enforcement, for example, to detect excess contributions  and taxable distributions.

Noncompliance involving IRAs with unconventional assets is generally  detected through labor-intensive audits of individual taxpayers. IRS’s  SB/SE division uses field audits to pursue complex individual tax return  cases, including those that could involve IRAs with unconventional  assets. In February 2018, an IRS cross-divisional team that studied the  risks of IRA noncompliance reported that, from fiscal years 2012 to 2016,  IRS audited about 26,000 tax returns with IRA issues.

IRS officials provided us examples of SB/SE job aides and training  materials designed to help examiners recognize different types of  noncompliance associated with IRAs invested in unconventional assets.  For example, the job aides provide instructions on prohibited transactions,  barred collectibles, and FMV issues involving IRAs. When interviewing  taxpayers, examiners are instructed to ask a series of questions covering  subjects such as: what kind of advice the taxpayer received from promoters or  custodians of self-directed IRAs, whether the taxpayer had direct involvement in purchasing  unconventional assets through a control feature known as “checkbook  access,” whether the taxpayer has a limited liability company (LLC) tied to the how the taxpayer determined the FMV of unconventional assets.

IRS officials told us that enforcing rules associated with IRAs investing in  unconventional assets can be particularly challenging for investments  involving LLCs or special partnership arrangements. An IRA owner may  establish an LLC that is owned by the IRA. Once the LLC is set up, a  business checking account is linked to the IRA funds and the account  owner is named the manager of the LLC with control over the checkbook.  This allows IRA owners to purchase assets directly from investment  sponsors without having to wait for custodians to execute a purchase or  sale.

The LLC may be used to invest in businesses that could generate  unrelated business income. According to IRS officials, prohibited  transactions may also be more likely to occur when custodians allow  “checkbook” access to IRAs, in part because the marketing of this IRA  structure is appealing to individuals who want less oversight of their IRA  transactions and are more likely to intentionally engage in self-dealing  transactions.

IRS examination officials told us that the 3-year statute of limitations for  assessing taxes owed remains an obstacle in pursuing noncompliance  that may span the many years of an IRA investment. For example,  abuses involving prohibited transactions frequently are not reflected on  any filed tax return and may be difficult to detect within the general 3-year  statute of limitations period. IRS agreed with our October 2014  recommendation for the Commissioner to work in consultation with the  Department of the Treasury (Treasury) on a legislative proposal to  expand the statute of limitations on IRA noncompliance. IRS said  Treasury is aware of IRS’ support for changing the limitation period for  IRA noncompliance. Treasury reviews and presents the administration’s  tax proposals and has not released a legislative proposal as of October  2019.

Data Collection Has Improved, but Opportunities Exist to Further Strengthen Identification of Potentially Abusive IRAs

With electronically compiled data for tax year 2016 filed in 2017, IRS was  positioned for the first time to quantify the number of IRAs with specified  types of hard-to-value assets. IRS officials said that even with the new  custodian reporting, the broad IRA asset type data alone may be  inadequate for improving audit selection criteria and identifying potentially  abusive IRAs in a timely manner. In February 2018, using the newly  available data, an IRS cross-divisional team identified that about 2 million  IRAs included one or more types of hard-to-value assets for tax year  2016. However, custodians reported an FMV dollar amount for hard-to- value assets for only 1.6 million of those IRAs, as shown in table 3. The  combined FMV was approximately $137 billion.

As shown in table 3, about 400,000 (about 20 percent) of the Form 5498s  reporting that the IRA held investments in one or more of the specified  unconventional categories were missing the 2016 FMV dollar amount for  those assets. The cross-divisional team identified that undervaluation risk  affects custodian reporting. IRS officials said that the team did not review  the custodian reporting patterns as part of its initial analysis of the 2016  Form 5498 data. Forthcoming tax regulations on IRAs may help to  improve custodian reporting of FMVs on Form 5498. IRS officials told us  that the new IRA regulations would address FMV for certain categories of  hard-to-value unconventional assets. IRS officials also told us that it  would be premature to publish new guidance for IRA owners and  custodians on the FMV of unconventional assets until the new regulations  are issued.

The tax year 2016 Form 5498 information indicated about 141,000 IRAs  invested in LLCs—an asset type which IRS has determined presents  greater noncompliance risk. Prior to the newly available asset type data,  SB/SE conducted an interim Compliance Initiative Project (CIP) using  external state government information to identify businesses, including  LLCs and partnerships, owned by IRAs as a way to select IRA owners for  audit. Completed in October 2019, the interim compliance research  revealed that audits detecting prohibited transactions can result in  substantial tax adjustments.

In September 2018, SB/SE approved a new CIP using the asset type  data from Form 5498s for tax year 2017 to select a sample of traditional  and Roth IRAs that had an ownership in an LLC or real estate. The latest  compliance research field work began in February 2019 and is to be  completed in January 2021. IRS officials told us they plan to use this  research in combination with the interim research results to improve  criteria for selecting tax returns with IRAs at greater risk of noncompliance  for audit.

To detect abusive transactions, IRS can require taxpayers to self-report  certain transactions that have been used by other taxpayers to avoid  taxes. Transactions become “reportable” (meaning a taxpayer must report  it to IRS) when IRS designates them as a “listed transaction” or  “transactions of interest.”

Listed Transaction. A listed transaction is reportable when it is the  same or substantially similar to one of the types of transactions that  IRS has determined to be an avoidance transaction. In 2004, IRS  determined that Roth IRA “stuffing” is an abusive tax avoidance  transaction that taxpayers must report to IRS as a listed transaction.  “Stuffing” involves shifting value through transactions that disguise  Roth IRA contributions exceeding annual IRA limits, such as selling  receivables at less than FMV to a Roth IRA, or other transactions  between a closely-held business in which the Roth IRA invests and  another closely-held business of the Roth IRA owner.

Transaction of Interest. A transaction of interest is one that IRS and  Treasury believe to have the potential for tax avoidance or evasion,  but which lacks enough information for IRS and Treasury to determine  whether the transaction should be identified as a tax avoidance  transaction. As of December 2019, IRS has not identified or classified  any IRA asset types or investment transactions as reportable  transactions of interest.

Taxpayers are required to disclose all types of reportable transactions on  Form 8886, Reportable Transaction Disclosure Statement. Similarly,  advisers helping taxpayers conduct reportable transactions are required  to file Form 8918, Material Advisor Disclosure Statement.

Results from the ongoing IRS compliance research may yield insights  about existing and emerging abusive schemes involving IRAs. This information could be useful for evaluating the feasibility of requiring  greater disclosure by IRA owners and their custodians and advisors. For  example, IRS could consider requiring reporting of known abusive IRA  arrangements and prohibited transactions as listed transactions. Also,  IRS could explore disclosure of high-risk IRA asset types susceptible to  gross valuation misstatements, such as LLCs, as transactions of  interest. We recently found that IRS’s Research, Analysis and Statistics  office had developed the capability to analyze the narrative fields of tax  forms. Additional disclosure of potentially abusive IRA transactions  coupled with greater use of tax form’s narrative fields may help IRS to  select IRA owner tax returns for more detailed review. The cases  identified by such detailed review would help IRS better allocate limited  audit resources.

Enforcing IRA Rules for Unconventional Assets Draws on Expertise and Roles of Multiple IRS Organizational Units

Responsibility for addressing IRA noncompliance detected through case- by-case audits is fragmented among multiple IRS organizational units.  This fragmentation creates challenges for IRS examiners from different  units that may need to share expertise and collaborate on enforcement of  complex rules applicable to IRAs that invest in unconventional assets. In  February 2018, the IRS cross-divisional team concluded that no one IRS  operating division alone can effectively identify and penalize IRA  noncompliance regarding unrelated business income and undervaluation  of unconventional assets.

Unrelated business income. SB/SE and TE/GE officials told us  that detecting unrelated business income unreported by an IRA  can also require the involvement of multiple IRS divisions. IRS  responsibility and expertise in detecting noncompliance with the  rules for unrelated business income resides in IRS’s TE/GE  division. TE/GE is responsible for enforcing the unrelated  business income taxation rules across tax-exempt organizations.  Its Exempt Organizations group audits Form 990-T filed by tax- exempt charities and its examiners are required to check if tax  exempt charities have reported unrelated business income.  Examiners in TE/GE’s Employee Plans group have been trained  on how to determine if a tax-exempt employee retirement plan has  engaged in activities that constitute unrelated trade or business.

SB/SE has primary responsibility for auditing individuals owning  IRAs, and its examiners are to verify that all returns within the  taxpayer’s sphere of influence are filed. IRS officials told us that  when SB/SE examiners discover potential unrelated business  income issues when reviewing an individual taxpayer’s IRAs,  those examiners can seek assistance from TE/GE examiners via  an internal Specialist Referral System used to refer cases to other  divisions.

Although IRS officials described to us how SB/SE examiners, at  their own initiative, can seek out expertise on unrelated business  income, the topic is not addressed in SB/SE examiner training  materials and job aids on auditing IRAs with unconventional  assets. SB/SE officials provided us training slides used to teach  examiners how to recognize excess contributions, prohibited  transactions, barred collectibles, and valuation issues involving  IRAs. While the slides instruct examiners to contact a Senior  Program Analyst or Counsel for assistance with complicated  issues or cases, there is no information educating SB/SE  examiners about unrelated business income or informing  examiners that specialized knowledge about this topic resides in  the TE/GE division. Without resources, such as training materials  or job aides, that provide such information, SB/SE examiners  carrying out the ongoing compliance initiative project are not  positioned to surface unrelated business income tax issues for  referral to TE/GE. Given that IRS plans to use those research  results to refine its audit selection criteria, IRS is missing an  opportunity to learn more about IRA noncompliance with unrelated  business income taxation.

Undervaluation of unconventional assets. In February 2018,  the cross-divisional IRA team cited undervaluation of  unconventional assets as another compliance risk that involves  the expertise and enforcement responses from multiple IRS  units. If SB/SE examiners determine in auditing an IRA owner  that the IRA custodian had inaccurately reported IRA asset  values, other IRS divisions can take action against the custodian.  LB&I can penalize a large financial institution custodian, although  the cross-divisional IRA team reported the $50 penalty for filing an  incorrect Form 5498 poses little deterrent effect. For the  approximately 75 non-bank IRA trustees approved by IRS, TE/GE  can revoke a non-bank’s trustee status for violating any fiduciary,  accounting, or financial requirements.

The cross-divisional IRA team explored an approach for joint examination  to more effectively identify and penalize noncompliance associated with  prohibited transactions, unreported unrelated business income, and  undervaluation of IRA assets. Based on knowledge from prior  examinations, the team identified a small subset of non-bank trustees  publicly marketing alternative investments that held IRAs more than $5  million in reported FMV as of tax year 2016.

As of February 2018, the team reported that it had been premature for the  separate divisions to commit examination resources. As of October 2019,  IRS officials said they plan to reconvene the cross-divisional IRA team  after the ongoing SB/SE compliance initiative project is complete in 2021.  IRS officials said the plan is for the team to use the compliance research  results to refine audit selection. Also, the team could continue work on  establishing a joint examination approach for IRA noncompliance  associated with hard-to-value unconventional assets.

IRA owners that invest in unconventional assets—such as real estate,  certain precious metals, virtual currency, or private equity—assume  greater responsibility for navigating complex rules that govern tax-favored  retirement investments. To understand these rules, taxpayers are likely to  consult IRS Publications 590-A and 590-B. While this two-part publication  provides some information on compliance issues likely to affect IRA  owners with unconventional assets, the information in the publication as  well as on IRS web pages is limited. By assessing options for making  such information clearer, IRS could better inform taxpayers and help them  comply. This is particularly important because misunderstanding the rules  governing IRAs can result in increased tax liability for these taxpayers  and jeopardize their retirement savings.

Noncompliance associated with nonpublicly traded IRA assets has been  difficult for IRS to detect and time consuming to pursue. In contrast to  automated enforcement for IRAs with conventional investments,  noncompliance involving IRAs with unconventional assets is generally  detected on a case-by-case basis through labor-intensive audits of  individual taxpayers. In recent years, IRS has begun collect information  from IRA custodians that IRS can use to quantify the dollar amounts of  specified types of hard-to-value assets held by IRAs.

However, the broad IRA asset type data alone may not be sufficient for  audit selection and identifying potentially abusive IRAs in a timely  manner. When IRS lacks sufficient data to detect abusive transactions,  IRS can require taxpayers to self-report certain transactions that have  been used by other taxpayers to avoid taxes. Additional disclosure of  certain IRA transactions coupled with mining the narrative fields of tax  forms could help IRS to efficiently identify potentially abusive IRA activity  and better allocate limited audit resources.

Fragmented responsibility among IRS operating divisions creates  additional challenges for IRA enforcement. The division responsible for  tax-exempt entities trains its examiners on how to determine if an  employee retirement plan has unrelated business activities subject to  taxation. Yet, examiners in the division that audits complex individual tax  returns, including those involving IRAs, do not receive similar training.  Training for those examiners on unrelated business income tax issues,  and how examiners can refer those cases to other divisions for  assistance, could help improve collaboration on IRA enforcement.

We are making the following three recommendations to IRS:  The Commissioner of Internal Revenue should assess options for  updating Publications 590-A and 590-B to either include more information  or direct taxpayers to other resources for IRA owners with investments in  unconventional assets. Such information could include: storage  requirements for IRA investments in certain precious metals; valuation  methods for hard-to-value IRA assets; the Department of Labor’s process  for granting exemptions to IRA prohibited transactions rules; and IRA  investments with the potential to create unrelated business income tax  liabilities. (Recommendation 1)

The Commissioner of Internal Revenue, building on forthcoming  compliance research using new IRA asset data, should evaluate the  feasibility of requiring disclosure for high-risk IRA asset types associated  with abusive schemes as transactions of interest. (Recommendation 2)

The Commissioner of Internal Revenue should develop resources (such  as training materials or job aids) for Small Business/Self-Employed  examiners conducting IRA owner audits that explain how IRAs with  unconventional assets can generate unrelated business income tax  liability, and how examiners can refer cases to unrelated business income  experts in IRS for assistance. (Recommendation 3)

We provided a draft of this report to the Treasury and IRS for review and  comment.

In its comments, reproduced in appendix III, IRS generally agreed with  our recommendations. For recommendation 1, IRS said it will review its  educational publications and web pages for appropriate updates within  the scope of the tax code. For recommendation 2, IRS said that it will  determine whether there are abusive schemes associated with certain  IRA asset types, and if the data indicate such a correlation, it will evaluate  the feasibility of requiring disclosure of such arrangements as  transactions of interest. For recommendation 3, IRS said it will review and  update resources for examiners conducting IRA owner audits, including  guidance on how to address unrelated business income tax (UBIT). It will  incorporate guidance for agents on how to refer such cases to UBIT  experts when assistance is needed. IRS also said that it will renew its  efforts at ensuring collaboration with relevant subject matter experts.

IRS in consultation with Treasury also provided technical comments  which we incorporated as appropriate.

As agreed with your office, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from the  report date. At that time, we will send copies to the Secretary of the  Treasury, the Commissioner of Internal Revenue, the Secretary of Labor,  and other interested parties. In addition, the report will be available at no  charge on the GAO website at http://www.gao.gov.

If you or your staff have any questions about this report, please contact  James R. McTigue, Jr. at (202) 512-9110 or Charles A. Jeszeck at (202)  512-7215. You may also reach us by email at jeszeckc@gao.gov or  mctiguej@gao.gov. Contact points for our Office of Congressional  Relations and Public Affairs may be found on the last page of this report.  GAO staff making key contributions to this report are listed in appendix  IV.

Appendix I: Status of GAO Recommendations

Appendix II: IRS Information for IRA Owners Investing in Unconventional Assets

This appendix describes: what information for individual retirement  account (IRA) owners with unconventional assets can be found in  Publications 590-A and 590-B, what other Internal Revenue Service (IRS)  sources provide relevant information, and what information was not  readily available on the IRS website for the four compliance areas we  identified through prior work as likely to affect IRA owners with  unconventional assets. The information below does not include the  Internal Revenue Code or detailed and technical resources published in  the weekly Internal Revenue Bulletin, such as tax regulations, revenue  rulings, and revenue procedures.

Publications 590-A and 590-B explain what types of IRA investments are  barred, such as collectibles, but the publication does not have additional  information that could be useful to IRA owners with allowable investments  in coins and bullion. The publications define collectibles as including  artworks, rugs, antiques, metals, gems, stamps, coins, alcoholic  beverages, and certain other tangible personal property. The  publications explain that if a traditional IRA invests in collectibles, the  amount invested is considered distributed, and that the IRA owner could  be subject to an additional tax on early distributions. Publications 590-A  and 590-B further explain that an exception exists for IRA investments in  certain types of coins and bullion. However, the two-part publication does  not indicate that certain types of bullion must be stored by a bank or an  IRS-approved non-bank trustee. The two-part publication also does not  mention that IRA investments in life insurance contracts are not  permitted.

Two IRS web pages listing frequently asked questions (FAQs) about  retirement plans contain additional information about bullion storage  requirements and IRA investments in life insurance contracts. Both web  pages state that investing IRA funds in life insurance contracts and  collectibles are prohibited, and they also note the exception for certain  precious metals. One of the web pages further explains that allowable  bullion must be stored with a bank or an IRS-approved non-bank trustee.

Publications 590-A and 590-B define prohibited transactions in general  terms, list examples, and explain the consequences of engaging in a  prohibited transaction. The two-part publication also cautions that the risk  of engaging in a prohibited transaction in connection with an IRA account  may be increased when an IRA owner invests in nonpublicly traded  assets or assets that an IRA owner directly controls. However, the  publication does not provide any information about applying for an  exception to the prohibited transaction rules.

We found some limited information about exemptions to the prohibited  transaction rules on an IRS web page entitled “Retirement Plan  Investments FAQs.” The web page explains that the Department of  Labor (DOL) has granted class exemptions for certain types of  investments under specific conditions, and that a plan sponsor may apply  to DOL to obtain an administrative exemption for a particular proposed  transaction that would otherwise be prohibited. However, the web page  does not provide any links to DOL information such as a DOL publication  that explains the prohibited transactions exemption process.

In February 2018, IRS updated Publications 590-A and 590-B to include  information about IRAs with unrelated business income. Publications 590- A and 590-B now explain that an IRA is subject to tax on unrelated  business income if the IRA carries on an unrelated trade or business.  Publications 590-A and 590-B state that the IRA trustee is required to file  a Form 990-T if an IRA has $1,000 or more of unrelated trade or business  gross income. For more information, Publications 590-A and 590-B direct  taxpayers to consult Publication 598, Tax on Unrelated Business Income  of Exempt Organizations.

Publication 598 lists IRAs as one of many exempt entities subject to taxes  on unrelated business income, and the requirement to file Form 990-T for  gross income of $1,000 or more. Publication 598 describes dozens of  activities by tax-exempt organizations that would be considered an  unrelated business; but the publication does not include any examples  specific to IRA investments that could also be considered unrelated  business activities and subject to taxes. Our search did not find additional  information on IRS.gov relating to IRAs and unrelated business income  taxes.

Publications 590-A and 590-B do not provide guidance about how to  accurately determine the FMV of hard-to-value unconventional assets.  IRS requires custodians to report (on Form 5498) an IRA’s FMV at year’s  end as well as some additional information for IRAs with unconventional  assets. The instructions for completing Form 5498 explain that IRA  custodians are responsible for ensuring that “all IRA assets (including  those not traded on established markets or not having a readily  determinable market value) are valued annually at their FMV.” However,  neither the form’s instructions nor Publications 590-A and 590-B provide  guidance or tips on how to determine the FMV of non-publicly traded or  other hard-to-value assets. As we previously reported, some unconventional assets may require a third-party appraisal to determine  their FMV.

One IRS web page titled, “Valuation of Plan Assets at Fair Market Value,”  provides some additional FMV information but it is intended more for the  valuing assets in employer-provided retirement benefits like traditional  pensions and 401(k) plans. The web page states that an accurate  assessment of the FMV of retirement plan assets is essential for  complying with Internal Revenue Code requirements and avoiding  prohibited transactions. The web page also states that for defined  contribution plans like a 401(k) plan, investments must be valued at least  once per year in accordance with a consistent and uniform method. For  traditional pensions (defined benefit plans), tax regulations define FMV for  purposes of valuing plan assets as “the price at which the property would  change hands between a willing buyer and a willing seller, neither being  under any compulsion to buy or sell and both having reasonable  knowledge of relevant facts.”

The Department of the Treasury (Treasury) plans to issue regulations on  IRAs. IRS officials told us that these new regulations would address FMV  for certain categories of hard-to-value unconventional assets. IRS officials  also told us that it would be premature to publish new guidance for IRA  owners and custodians on the FMV of unconventional assets until the  new regulations are issued. In their October 2019 update of planned  guidance projects, Treasury’s Office of Tax Policy and IRS listed planned  IRA regulations.

Appendix III: Comments from the Internal Revenue Service

Appendix IV: GAO Contacts and Staff Acknowledgments

In addition to the contacts named above, MaryLynn Sergent and David  Lehrer (Assistant Directors), Ted Burik, Susan Chin, Steven Flint, Emily  Gruenwald, Mark Kehoe, Jungjin Park, and David Reed made key  contributions to this report. James Bennett, Amy Bowser, Jacqueline  Chapin, Edward J. Nannenhorn, Andrew J. Stephens, Walter Vance, and  Adam Wendel also provided support.

Individual retirement accounts (IRA) help taxpayers save for retirement. Most IRAs invest in assets like stocks and mutual funds, but some IRA owners want to invest in unconventional assets like real estate or virtual currency.

IRS Publications 590-A and B offer guidance to taxpayers with IRAs, but details on unconventional assets are limited. For example, investing in some types of bullion is permitted, but storage requirements are not explained.

We recommended that IRS assess its options—like directing IRA owners to webpages with specialized information and technical regulations—to help taxpayers fully understand the rules on unconventional assets.