Published: January 6, 2023

Overview

Self-Directed Individual Retirement Accounts (“SD IRAs”) have become all the rage in the US since crypto entered the main stream and became widely viewed as an investable asset class. SD IRAs give you, the taxpayer, the power to invest retirement funds in assets other than publicly traded stock such as real estate, start-ups, crypto, and other investments that you cannot buy in your Managed IRA brokerage account (e.g. at Schwab, Fidelity, etc).

But there is a danger lurking under the hood: your SD IRA crypto may be sitting inside of an account that will issue you Forms 1099-MISC or even Forms 1099-B at the end of each year. Why is this bad? The whole point of an SD IRA is to defer taxation until a later point in time (retirement). If your SD IRA is receiving Forms 1099 today, and presumably not paying the tax on the reported income, then your SD IRA is setting itself up for an IRS audit risk. Not to mention the annual reconciliation mess your accountant might have on their hands.

Today’s blog explores why this Form 1099 reporting is happening and the outlook for future.

Though there are other types of Self-Directed tax deferred accounts out there that have some slightly different setups (e.g. Solo 401K), we will use SD IRA for the remainder of this blog for simplification. The core issue remains the same.

How are SD IRAs different from Managed IRAs?

A Managed IRA is what we could call “the default tax-deferred retirement vehicle”. It is for people who like simplicity and just want to invest in stocks, ETFs, mutual funds, etc. Two well known providers are Schwab and Fidelity. These organizations setup the IRA for you, act as IRA and Asset Custodian, and do all required record keeping and tax reporting. An SD IRA puts more control in the hands of the taxpayer by splitting out the various roles and tasks involved in operating an IRA and putting the checkbook for making investments into your hands. Let’s outline the key roles found in IRAs:

Promotor / Provider / Administrator / Recordkeeper: though these can be split into various parties we have accumulated them into a single group for the sake of simplicity in this discussion. This group of parties are typically “the face” of the IRA product itself. For SD IRAs, they help the taxpayer setup an LLC which is 100% owned by (i.e. disregarded into) the IRA as well as the LLC bank account. The purpose of the LLC is to facilitate making investments into the various self-selected investments. Managed IRA’s do not typically need or use an LLC.
IRA Custodian / Trustee: is required by IRS regulations, is the primary party obligated to comply with the IRA regulations, monitors SD IRAs for prohibited transactions (stuff you are not allowed to invest in), is state regulated, and does any IRS tax reporting specifically for the IRA when required (like filing Form 5500 or Form 1099-R).
Asset Custodian: this party only custodies the underlying asset / investment. The asset could be self-custodied (e.g. gold, crypto in your private cold wallet) or with a financial institution (e.g. Fidelity, Schwab, Kraken, Coinbase, etc). In the case of an SD IRA, accounts opened at these financial institutions are opened in the name of the special purpose LLC. Asset Custodians (with the exception of self-custody) are responsible for tax reporting on the underlying asset / investment (e.g. Form 1099-MISC, DIV, B, INT, etc).

As you can see in the illustration below, these 3 groups of roles are all served by the same party in the case of Managed IRAs like at Schwab or Fidelity. But in the case of SD IRAs, these are typically 3 (or more) different parties. We discuss why this matters and why this causes unexpected Form 1099 reporting in the next section after first understanding a general concept of how tax reporting works.

How does Form 1099 tax reporting work?

Asset Custodians may have annual obligations to issue Forms 1099-DIV, MISC, INT or other forms where an asset / investment has paid investors some income during the year. When an investor makes a sale or exchange of their investment, that Asset Custodian may also have a Form 1099-B reporting obligation (and eventually, in the case of crypto, Form 1099-DA). IRA Custodians typically have an obligation to issue Forms 1099-R where an IRA has made a distribution to the taxpayer (e.g. in retirement) or rollover to another IRA Custodian.

During the annual reporting process, Asset Custodians typically evaluate a number of factors to determine which customers / accounts are reportable payees, and if they have reportable transactions. One of those factors is called the '“Exempt Payee Status” of the payee. In the Internal Revenue Code, the IRS has a list of so-called “Exempt Recipients” for which a Form 1099 is not required to be issued. This list of Exempt Recipients changes depending on the type of income or other payment being made (e.g. Corporations are typically Exempt Recipients for payments of dividends but they are not Exempt Recipients for payments of legal services). The regulations allow for the following:

Asset Custodians may choose not to exempt any payees. This means that if an Asset Custodian decides not to treat a payee as an Exempt Recipient then they are not in violation of the Internal Revenue Code and Form 1099 reporting rules.
Asset Custodians may collect an Exempt Payee Code from their payees in order to determine if they are Exempt Recipients or not. The codes can be found in the Instructions to IRS Form W-9. IRAs are Exempt Recipients for most payment types and their Exempt Recipient Code is “1”.
In the absence of an Exempt Payee Code, Asset Custodians can still treat a payee as an Exempt Recipient if certain factors are present. According to US Treasury Regulation 1.6049-4(c)(1)(C), in the absence of an Exempt Payee Code, an Asset Custodian may only treat an IRA as an Exempt Recipient where the Asset Custodian is also the IRA Custodian. Where the Asset Custodian is not the IRA Custodian, then they may only treat an IRA as an Exempt Recipient by collecting an Exempt Payee Code from the payee (i.e. reverts back to the previous point 2).

Bringing this all together:

We saw in the previous illustration that with Managed IRAs, the Asset Custodian and IRA Custodian are the same party. As such, the Asset Custodian can automatically exempt payments made to the IRA from annual Form 1099 reporting on income and trades of the underlying assets / investments. In this case, the Asset Custodian does not need to collect an Exempt Payee Code.
We also saw in the previous illustration that with SD IRAs, the Asset Custodian and IRA Custodian are not the same party. As such, the Asset Custodian can only exempt payments made to the IRA from annual Form 1099 reporting on income and trades of the underlying assets / investments by collecting and storing an Exempt Payee Code.

This is illustrated as follows:

We can now line up Managed IRAs (holding stocks) next to SD IRAs (holding crypto) in the below illustration. In both the Managed IRA and the SD IRA scenario, it is not the fact that crypto is involved which is causing the Form 1099 reporting on the underlying activities of the investment. It is the absence of an Exempt Payee Code for the LLC/SD IRA at the Asset Custodian. In both cases, the IRA Custodian will always issue Forms 1099-R to the end taxpayer for any distribution or rollover activities.

It is interesting to note that the Form 1099-MISC, DIV, B, etc reporting risk inside the SD IRA is also present with stocks, ETFs, etc but there is a work around that mitigates the risk. Taking a step back, people that only want to invest in stocks would simply open a Managed IRA and not take on the hassle of an SD IRA. But there are some cases where a person with an SD IRA has some cash to invest but it’s not enough for a larger deal (like real estate) so they may want to move smaller sums of cash into stocks in the interim. These people would only be able to make that investment by opening a brokerage account in the name of their LLC/IRA at an institution like Schwab or Fidelity (as example). Yet most of these institutions do not allow SD IRAs to open an account in this way and simply force you to open a Managed IRA with them for that portion of your portfolio. This is an acceptable work around for the portion of your portfolio allocated to stocks because you are allowed to hold stocks in a Managed IRA. But as of today, most (if not all) traditional Managed IRA brokerages do not allow you to hold crypto. You are then stuck trying to find an Asset Custodians that will allow you to open an account with them and that will collect, store, and apply Exempt Payee Codes for annual tax reporting processes.

Am I going to receive Forms 1099 for my SD IRA?

Crypto Asset Custodians may not yet support Exempt Payee Codes

Providers of Managed IRAs have been around for decades and have very advanced tax reporting infrastructure as a result. On the other hand, crypto exchanges have been around 10 years or less. The bigger crypto exchanges are furiously building out this infrastructure but some smaller or younger exchanges may not yet realize that they have tax reporting obligations to comply with. We then have some fintech players somewhere in the middle that have been around long enough to have advanced tax reporting infrastructure and have recently added crypto to their custody product offering.

What this practically means is that many crypto Asset Custodians simply do not have the infrastructure built yet to collect, store, and apply Exempt Payee Codes during annual Form 1099 reporting. If that is their case, and they are issuing Forms 1099 at year-end, then they will report all payees and exempt nothing.

Did you earn crypto income such as staking rewards, airdrops, etc in your SD IRA held at a crypto Asset Custodian ?

Here are a few questions to ask yourself:

Does the crypto Asset Custodian issue Forms 1099-MISC reporting for this type of income?
- If no, then you likely won’t receive a Form 1099 today but you could in the future (kicking the problem to another year).
- If yes, did you provide any Exempt Payee Code when you opened an account either on Form W-9 or through some other form options?
  - If no, then you will probably receive a Form 1099.
  - If yes, then you will likely not receive a Form 1099, but I of course can’t guarantee it.

Keep in mind that simply emailing a Form W-9 to a customer agent during the account opening process is not enough. Unless the crypto Asset Custodian has data systems that record that Exempt Payee Code during the onboarding process then whatever you send in over email or PDF is unlikely to be recorded and utilized at year-end. It just floats around in cloud storage not being used for any purpose. Don’t let flashy marketing materials convince you otherwise: if you did not type an Exempt Payee Code into a screen or drop down when you opened your account at the crypto Asset Custodian then there is a very high liklihood that you will receive a Form 1099.

Did you sell or exchange crypto in your SD IRA held at a crypto Asset Custodian?

Some crypto Asset Custodians are issuing Forms 1099-B today for sales or exchanges of crypto but in some cases the information is reported to the IRS and in other cases it is not (just provided as a customer service). This will all change when crypto reporting on Form 1099-DA is fully implemented in the coming years. As mentioned above, while you might not get a Form 1099 today for those transactions you could start receiving them in the future if the Exempt Payee Code problem isn’t resolved.

Other considerations

There are a handful of crypto Asset Custodians today that may let you contact them after they have issued a Form 1099 and request that they amend and cancel it by providing a signed Form W-9 with an Exempt Payee Code. Other crypto Asset Custodians may opt not to provide this service. Such a manual process will not be sustainable in the long run once crypto Asset Custodians are issuing millions of Forms 1099 every year for sales, exchanges, and transfers of crypto.
The world of crypto and tax is still wildly unsettled. It may not be clear today what activities in your crypto account are allowed or prohibited activities for an SD IRA to be compliant and maintain its tax deferred status. I have made reference to earning staking rewards in a crypto SD IRA but this is not to imply staking is or is not a prohibited transaction. It is just a matter of fact that some crypto holders are undertaking this activity in their SD IRAs.

The takeaway

Promoters / Administrators of SD IRAs cannot control the technology limitations of crypto Asset Custodians. Yet they might publish user guides for their customers on how to setup accounts on those platforms. Taxpayers / investors should be aware of the Form 1099 reporting that could land in their inbox and be prepared to manage the IRS audit risk. Alternatively, taxpayers can do their own due diligence when seeking out a crypto Asset Custodian and consider placing their funds at those crypto Asset Custodians which have 1) provided a box to enter your LLC/IRA Exempt Payee Code during onboarding and 2) have support pages that confirm that accounts established for SD IRAs will be exempted from Form 1099 reporting.

Crypto Asset Custodians are diligently working to build infrastructure to accommodate a wide range of US and non-US tax reporting, including support for Exempt Recipient Codes. Until then, holding crypto in your SD IRA on a centralized exchange / custodian may come with surprise Forms 1099.

How can Dune Consultants help?

Contact us today to discuss at info@duneconsultants.com. Or you can jump in the calendar for an introduction call.

Why crypto Self-Directed IRAs are getting 1099ed