GAO report finds IRS could bolster enforcement of multimillion dollar IRAs

The U.S. Government Accountability Office (GAO) has provided Congress with a report on IRA balances that shows that a small number of taxpayers have accumulated very large IRA balances. The GAO’s report found that while 43 million taxpayers have an IRA—most with balances of $1 million or less—one percent of IRA owners, or more than 600,000 taxpayers, have IRA balances exceeding $1 million. The GAO report comes on the heels of the Senate Finance Committee’s hearing on retirement savings and tax reform held just days before the Senate adjourned for the November mid-term elections.

Congress requested the GAO to measure IRA balances and assess IRS enforcement of IRA laws as part of its examination of retirement savings tax incentives in anticipation of comprehensive tax reform. This year alone, the federal government will forgo an estimated $17.45 billion in tax revenue from IRAs. And, because concerns have been raised as to whether the tax savings encourage new or additional savings for retirement, Congress is scrutinizing retirement savings tax incentives.

The GAO report found that IRAs are an important vehicle for retirement savings, yet most eligible taxpayers do not take advantage of IRAs to save for retirement. Of the estimated 145.6 million taxpayers eligible to contribute to an IRA in 2010, less than eight percent actually contributed. And, while IRA balances reached $5.2 trillion at the end of 2011, 22 percent of all IRA assets were held by the 600,000 taxpayers with IRA balances exceeding $1 million.

The small number of taxpayers with very large IRA balances led the GAO to focus on methods by which such large IRA balances have been accumulated and the potential for tax code abuses and accounting irregularities associated with them.

Interviews with industry stakeholders indicate that individuals have likely used alternate strategies—rather than steady contributions and investments in publicly traded stocks, bonds, and mutual funds—to accumulate such large IRA balances. These alternate strategies involve investments that have a low initial investment value and the potential for unusually high investment returns, such as nonpublicly traded shares and partnership interests. These types of investments are usually not available to the general public and can be accessed by only a small number of individuals at private equity firms and hedge funds because of securities regulations.

In one publicly reported private equity transaction, employees of a private equity firm used their IRAs to purchase $25,000 worth of low-valued, nonpublicly traded shares the firm created for a portfolio company. The shares were worth nearly $14 million when the private equity firm brought the portfolio company back onto public stock exchanges less than two years later. The employees eventually sold their shares for more than $23 million, realizing more than 1,000 times their initial investment.

While there is no prohibition against these types of investment strategies, the GAO report found that individuals who invest in nonpublicly traded shares or partnership interests may undervalue these assets, which could substantially increase their tax benefits. The GAO report questioned whether Congress intended IRAs to be used in such a manner. In the view of the GAO report, these alternative strategies may raise concerns and pose a greater risk for noncompliance, but are difficult for the IRS to address because the IRS does not collect data on the types of assets held in IRAs.

This will change for tax year 2015 as the IRS has revised Form 5498, IRA Contribution Information, to require reporting of certain hard-to-value IRA investments, such as nonpublicly traded stock, partnership interests, and real estate. Starting in 2015, IRA trustees and custodians will be required to report the fair market value (FMV) of these hard-to-value investments on Form 5498 and identify the type of hard-to-value assets held in the IRA. They also will be required to report similar information on Form 1099-R, Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.,to identify distributions of IRA assets that do not have a readily available FMV. The IRS intends to use this data to identify IRAs with riskier nonpublic assets and ensure compliance with the tax laws.

To help the IRS better detect and pursue potential noncompliance associated with undervalued IRA assets and prohibited transactions, the GAO recommended that the IRS

• compile and digitize Form 5498 data on hard-to-value assets to ensure efficient use of information on nonpublicly traded IRA assets,
• research Form 5498 data to identify IRAs holding hard-to-value IRA assets and use the information for an IRS-wide strategy to target enforcement efforts,
• work with the Treasury Department on a legislative proposal to expand the statute of limitations on IRA noncompliance to help the IRS address valuation-related misreporting and prohibited transactions that have occurred outside of the current statute of limitation’s 3-year window,
• provide outreach to taxpayers holding hard-to-value assets in their IRAs and the IRA trustees and custodians of those IRAs, reminding them that engaging in prohibited transactions can result in the loss of the IRA’s tax-favored status, and
• add an explicit caution for taxpayers in Publication 590, Individual Retirement Arrangements (IRAs),about the potential risk of committing prohibited transactions when investing in nonpublicly traded assets or directly controlling IRA assets.

To promote retirement savings and ensure equity, the GAO report recommends that Congress consider revisiting the use of IRAs to accumulate large balances and consider ways to improve the equity of the existing tax expenditures on IRAs. The GAO suggested options could include limits on (1) the types of assets permitted in IRAs, (2) the minimum valuation for an asset purchased by an IRA, or (3) the amount of assets that can be accumulated in IRAs and employer-sponsored retirement plans that receive preferential tax treatment.

The GAO report and its findings signal that the IRS is likely to further scrutinize large balance IRAs for noncompliance, and Congress will carefully study the cost and effectiveness of IRAs and retirement savings tax incentives as part of any comprehensive tax reform plan.