No Taxable IRA Distribution Where Taxpayer Had Funds Wired to Buy Stock That Custodian Later Refused to Accept

In the case of McGaugh v. Commissioner, Case No. 13665-14, CA7 the taxpayer had wired funds from his IRA account to purchase stock which we expected to be held in his IRA account.  However, the taxpayer’s IRA custodian refused to accept the share certificate that was received.  The IRS took the position that this resulted in a taxable distribution to the taxpayer from the IRA account.

The Tax Court decided that the taxpayer had not actually or constructively received a distribution from his IRA. (TC Memo 2016-28)  The IRS, not happy with this result, appealed the case to the Seventh Circuit Court of Appeals.

The Tax Court summarized the facts of this case as follows:

Since 2002 Mr. McGaugh has maintained a self-directed IRA with custodian Merrill Lynch, and the IRA held 10,000 shares of stock in First Personal Financial Corp. (“FPFC”). The Commissioner asserts, and we assume, that Mr. McGaugh is a member of the board of directors of FPFC, but the Commissioner has not denied that FPFC stock is permitted to be an asset in the IRA. In the summer of 2011, Mr. McGaugh requested that Merrill Lynch use funds from his IRA to purchase an additional 7,500 shares of FPFC stock. However, for reasons the record does not show, Merrill Lynch would not purchase the shares directly on Mr. McGaugh’s behalf.

Consequently, Mr. McGaugh requested that Merrill Lynch initiate a wire transfer of $50,000 directly to FPFC. On October 7, 2011, Merrill Lynch initiated and FPFC received the wire transfer. (There is no evidence that Mr. McGaugh requested an IRA distribution to himself.) On November 28, 2011, FPFC issued the stock certificate not in Mr. McGaugh’s name but instead in the name of “Raymond McGaugh IRA FBO Raymond McGaugh”, as Mr. McGaugh had requested. FPFC claims that the stock certificate was mailed to Merrill Lynch on or about the same day as the November 28, 2011, issuance date on the certificate; but because Merrill Lynch states that the stock certificate was not received until “early 2012”, we treat the timing of the transmittal of the stock certificate to Merrill Lynch as being in dispute and assume it was in 2012. Thereafter Merrill Lynch attempted to mail the stock certificate to Mr. McGaugh, but it was returned by the postal service at least twice. The record does not show where the original stock certificate is currently located; but we assume (as the IRS asserts) that Mr. McGaugh holds it (an assertion he denies).

Merrill Lynch issued a Form 1099R for 2011 in the amount of the wire and, not surprisingly, the IRS took the position that Mr. McGaugh owed tax on that amount.  However the Tax Court found that he never had actual or constructive receipt of either the funds or the stock and, thus, no tax was due.

The Seventh Circuit looked at the case and came to the same conclusion.  The Court noted that the IRS’s position was that Mr. McGaugh had constructive receipt of the IRA proceeds in 2011. As the Court notes, Mr. McGaugh clearly did not have actual possession of the stock in 2011, as Merrill Lynch did not receive the stock and begin trying to send the stock certificate to Mr. McGaugh until 2012.

The appellate panel outlines the requirements for constructive receipt as follows:

Under the doctrine of constructive receipt, a person receives income “not only when paid in hand but also when the economic value is within the taxpayer’s control.” United States v. Fletcher, 562 F.3d 839, 843 (7th Cir. 2009). Constructive receipt thus occurs where income “is credited to [an individual’s] account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.” 26 C.F.R. § 1.451‐2(a).

The Court concluded that Mr. McGaugh did have such constructive receipt in 2011, noting:

A review of the record reveals no evidence that McGaugh was in constructive receipt of assets from his IRA. First, as the IRS essentially conceded at oral argument, it is clear McGaugh did not constructively receive stock. The FPFC share certificate was never in his physical possession during the 2011 tax year. There is also no evidence that he had any control over those shares or the rights associated with them that could give rise to a finding of constructive receipt. See Ancira v. Commissioner, 119 T.C. 135, 138–39 (2002); United States v. Fort, 638 F.3d 1334, 1340–41 (11th Cir. 2011). Indeed, the share certificate was issued in the name of “Raymond McGaugh IRA FBO Raymond McGaugh” rather than McGaugh’s own name. And when McGaugh requested a replacement share certificate, FPFC refused to issue one without first receiving indemnification from Merrill Lynch. Thus, this case is similar to Ancira, in which the Tax Court found no constructive receipt where the petitioner was not a holder of, and accordingly could not negotiate the check at issue.

The IRS’ primary argument is that McGaugh constructively received funds from his IRA when he directed Merrill Lynch to wire them at his discretion to FPFC. It notes that a party cannot circumvent the rules on taxable income simply by directing a distribution to a third party. We have recognized this commonsense proposition before. Fletcher, 562 F.3d at 843 (“a person who earns income can’t avoid tax by telling his employer to send a paycheck to his college, or his son, rather than to his bank”); see also Old Colony Trust Co. v. Commissioner, 279 U.S. 716, 729 (1929) (finding that an employee received taxable income where his employer paid tax liability on his behalf).

It is not, however, implicated in this case. McGaugh didn’t direct a distribution to a third party; he bought stock. That is a prototypical, permissible IRA transaction. See Ancira, 119 T.C. at 137 (noting that there is unquestionably no distribution where a beneficiary merely directs his IRA custodian to purchase stock); Hampshire Grp., Ltd. v. Kuttner, No. 3607, 2010 WL 2739995, at *27 (Del. Ch. July 12, 2010) (noting that constructive receipt concerns not whether a deferred compensation plan participant “can participate in the plan’s choice of investments” but whether “the funds were made currently available to the plan participant to meet immediate financial needs.”). Further, there is no indication that McGaugh orchestrated this purchase for the benefit of FPFC or for any reason other than because he wished to obtain stock to be held in his IRA. Thus, there is no evidence that he constructively received funds, either in ordering Merrill Lynch to wire funds to FPFC, or in any other respect.