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Legislation, a new Uniform Principal and Income Act and reminders to plan with caution were all issues in 2018.
The year 2018 saw a minor legislative change to individual retirement accounts in divorces, a significant change in trust accounting rules that states should adopt and a variety of court cases and private letter rulings. All are reminders of the need for attention to detail.
Bipartisan Budget Act of 2018
Authority for making an income tax-free direct transfer of an IRA in a divorce was moved from Internal Revenue Code Section 72 to IRC Section 408(d). That change was needed to preserve such transfers, because provisions permitting tax-free transfers between divorcing spouses, including IRAs, were struck.1
Roth IRA conversions occurring after Dec. 1, 2017 may no longer be recharacterized.2 However, no change was made to the rule that Roth IRA contributions may be recharacterized by making a direct transfer from the Roth IRA to a traditional IRA as late as the extended due date of the IRA owner’s income tax return (for individuals, that date is generally Oct. 15 of the year after the conversion).
Trust Accounting
Many states have adopted trust law provisions rooted in the Uniform Principal and Income Act (UPIA). UPIA amendments in 2018 significantly change trust accounting rules for receipts from an inherited IRA or from an inherited employer-sponsored defined contribution plan. Before the amendment, trust receipts from such accounts were arbitrarily allocated 10 percent to income and 90 percent to principal, unless an estate tax marital deduction would be defeated by following that rule.
Under the 2018 amendment, if the trustee can ascertain the retirement account’s income, payments received by the trust are classified as trust accounting income to the extent of the retirement account’s income. The balance of such receipts, if any, is classified as trust principal.
If the amount of income can’t be determined, trustees must use the unitrust method to classify receipts to income. Under that method, the value of the account determined as of the beginning of the accounting period is multiplied by a percentage between 3 percent and
5 percent.
Both methods appear to comply with the Internal Revenue Service’s definition of income.3
If neither method can be used, only then is the 90/10 rule applied.
Divorce Disaster
John Kirkpatrick, an IRA owner, was ordered by the court to make a direct transfer of $100,000 to an IRA of his wife, Christiana, and pay $40,000 of her costs. Instead of making any direct transfer, and in violation of the court order, he withdrew IRA funds, placed those funds in an ordinary (non-IRA) account and wrote a series of checks to Christiana, as well as to third parties. He made no direct transfers.
Because no direct transfers actually occurred, the Tax Court held that all $140,000 was gross income reportable by John.4
Excess Contributions
The Tax Court found that impermissible excess contributions to Roth IRAs occurred when payments from a family-controlled foreign sales corporation were made to Roth IRAs, in Mazzei, et ux v. Commissioner.5 An excise tax at the rate of 6 percent applies to “excess contributions” paid into Roth IRAs, as well as other types of retirement savings accounts. Such contributions occur when contribution limits are exceeded.6
The court said excess contributions occurred because it found payments into those Roth IRAs were made, in effect, by the Roth IRA owners, who controlled the foreign sales corporation. The court said it didn’t matter that a similar case was decided favorably for taxpayers in the U.S. Court of Appeals for the Sixth Circuit Court,7 because the instant case is appealable to a different court of appeal—the Ninth Circuit.
After the Mazzei decision was handed down, the First Circuit reversed the Tax Court’s adverse holding in Summa Holdings, Inc. v. Comm’r with respect to one of the individuals who was among the parties in the Tax Court proceedings.8 There, family-controlled businesses paid commissions to a domestic international foreign sales corporation that ultimately benefited Roth IRAs. The Sixth Circuit had previously overturned the Tax Court with respect to family members who were parties to Summa Holdings, but resided in that district. The Tax Court’s decision in Mazzei is thus arguably contrary to both the Sixth and First Circuits. If Mazzei is overturned in the Ninth Circuit, there will be taxpayer-favorable authority in three circuits.
Retirement Annuities
For income tax purposes, annuity payments are partly a nontaxable return of the annuitant’s investment in the annuity contract and partly ordinary income. The investment portion allocated to each year’s payment is based on the age of the annuitant on the annuity starting date. That portion is prescribed by statute and by regulation.9
In Oliver v. Comm’r,10 Albert Anthony Oliver retired from Castaic Lake Water Agency in 2007 at age 55. He argued that an accelerated method of recovering his investment in the annuity contract was justified because of his poor health.
But, for a person aged 55, the taxpayer’s investment in the contract is recovered ratably over 360 months, by statute.11
The Tax Court found there was no authority to accelerate recovery of Albert’s investment in the contract contrary to the taxing statute and so held for the government.
Prohibited Transaction
In Stacey S. Marks v. Comm’r,12 a prohibited transaction occurred when an IRA owner loaned the account’s funds to her father in 2005. In 2012, $60,000 of the account’s funds were loaned to a friend.
A prohibited transaction causes an IRA to terminate on the first day of the year when the prohibited transaction occurs.13 Termination results in a deemed distribution of the entire IRA and resultant realization of taxable income. But, because the IRS didn’t discover the loans until after the statute of limitation ran, the income tax on the deemed IRA termination couldn’t be collected.
Death Benefits
On death, a decedent’s employer-sponsored retirement plan became payable to the decedent’s surviving spouse. The surviving spouse designated a successor beneficiary, then died when there were still funds in the plan. In an information letter, the IRS National office advised that the successor beneficiary couldn’t establish an inherited IRA and transfer the funds from the employer-sponsored retirement plan account to that inherited IRA.14
Private Letter Rulings
Extension of time granted to complete rollover. In PLR 201807010 (Nov. 27, 2017), the IRS granted an extension of time to complete a rollover to an IRA. After a new investment advisor was hired, a taxpayer liquidated an individual retirement annuity, intending to roll over the proceeds to IRAs. The advisor opened non-IRAs instead of IRAs. That the IRA owner understood an IRA would be opened didn’t alter the result.
Valid rollover by surviving spouse. In PLR 201821008 (Feb. 22, 2018), an individual was a participant in a qualified retirement plan established by a state. When that individual died, his account was payable to his estate.
The decedent’s surviving spouse was the executor of his estate, as well as its sole beneficiary. The plan account funds were distributed to the estate, net of mandatory income tax withholdings.
Within 60 days of the distribution, the surviving spouse “promptly” took possession of the net distribution, established an IRA in her name and contributed to that IRA the amount of that net distribution, plus an amount equal to the withholdings.
The IRS confirmed that the surviving spouse’s IRA rollover was valid.
Proceeds of inherited IRA transferred to trust. In PLR 201822033 (March 5, 2018), a decedent’s IRA was payable to a revocable living trust established by the decedent’s surviving spouse. The proceeds of the IRA had been transferred from the decedent’s IRA directly to an inherited IRA set up for the benefit of the trust. The IRS held that the surviving spouse was eligible to roll over the IRA distribution to one or more IRAs established and maintained in her own name, provided that the rollover occurs within 60 days of the distribution. By so doing, no part of the IRA proceeds were required to be included in gross income for federal tax purposes.
IRA allocated to survivor trust. In PLR 201831004 (April 30, 2018), the IRS confirmed that a surviving spouse may roll over an IRA of a deceased spouse that was payable to a trust and was later distributed to that trust. The surviving spouse, acting as trustee, allocated, in a non pro rata allocation of community property, all of the IRA to a “Survivor’s Trust” established under the trust. Next, the surviving spouse exercised her power as trustee to allocate the IRA to the Survivor’s Trust. Lastly, within 60 days of the IRA distribution to the trust, the IRA proceeds were paid over to a rollover IRA held for the benefit of the surviving spouse alone, free of trust.
Trust severed in two. In PLR 201832003 (April 30, 2018), a trust established by a decedent was the beneficiary of an IRA. The trust provided that the surviving spouse was entitled each year to a percentage of the value of trust assets, payable quarterly. But, in any year when the IRA’s required minimum distribution (RMD) exceeds the unitrust amount, the surviving spouse is instead entitled to the IRA distribution.
A court order was obtained to sever the trust into two trusts: an IRA trust to hold the IRA and a non-IRA trust. The ruling notes that the purpose of the division was to qualify the non-IRA trust for qualified terminable interest property (QTIP) trust treatment.
The IRS granted extensions of time to sever the trust into an IRA trust and a non-IRA trust, effective as of the date of decedent’s death, and to make a QTIP election15 for estate tax purposes with respect to the assets of the non-IRA trust.
Wrong deadline information given to spouse. An IRA owner’s spouse was wrongly advised that a rollover of distributed IRA funds could be completed by the end of the year in PLR 201835017 (June 6, 2018). Because of that advice, the 60-day rollover deadline was missed. The IRS granted an extension of time to complete a rollover.
Children disclaimed their interests. In PLR 201839005 (June 25, 2018), a state government employee’s retirement account in a plan qualifying for income tax deferral of benefits under IRC Section 457(b) provided for designation of a beneficiary. The employee made no designation before the employee died. Under the plan, if no beneficiary was designated, death benefits are payable to the participant’s estate.
Pursuant to applicable state laws of intestacy, the estate’s property, including the retirement account death benefits, were payable to the deceased participant’s spouse and children. The children disclaimed their interests. As a result, their portion of the benefits passed to the surviving spouse.
The IRS held that the benefits that the spouse received in consequence of the disclaimers could be distributed to the spouse and, within 60 days, could then be rolled over to an IRA of the surviving spouse.
Eldest child was designated beneficiary. In PLR 201840007 (July 9, 2018), an employer-sponsored retirement account was payable to a trust. The IRS analyzed trusts formed for each of five surviving children of the deceased IRA owner and ruled that the decedent’s eldest child was the designated beneficiary over whose life expectancy RMDs could be made. Presence of a power of appointment didn’t adversely affect the outcome. Although it was exercisable in favor of all or any person, persons or charitable organizations or a combination thereof other than the beneficiary, the estate, the creditors or the creditors of the estate of the beneficiary, each beneficiary executed a partial release on Sept. 30 of the year after the year when the decedent died—in time to have effect on RMDs. The result of the partial releases was that appointment was restricted to individuals who weren’t older than the eldest child of the decedent.
This PLR points out the need for Treasury regulations to include a provision that excludes potential takers when the probability of receiving retirement account death benefits is so remote as to be negligible, meaning, a probability of 5 percent or less. There’s plenty of precedent for such rulemaking in other regulations, including ones in which there’s no statutory direction to promulgate such a rule. Such a rule would simplify application of the regulations relating to RMDs, create clarity and eliminate the need for many PLRs in this area.
IRA assets distributed from trust to spouse. In PLR 201844004 (Aug. 8, 2018), a trust was named as an IRA’s beneficiary and became entitled to that account when the owner died. The surviving spouse became trustee of the trust. The trust opened an inherited IRA, and the surviving spouse, acting as sole trustee of the trust, caused the assets of the decedent’s IRA to be transferred to the trust’s inherited IRA in a direct trustee-to-trustee transfer. The surviving spouse sought and obtained a PLR confirming that the assets of the IRA could be distributed by the trust to herself, as sole beneficiary of the trust, and could then be rolled over into one or more IRAs in her own name.
Here’s hoping the details of your 2019 adventures are anything but devilish.
Endnotes
1. Pub. L. 115-97 (Bipartisan Budget Act of 2018), Section 11051(b)(3)(G), striking Internal Revenue Code Section 72.
2. Pub. L. 115-97, Section 13611(a), adding IRC Section 408A(d)(6)(B)(iii).
3. Treasury Regulations Section 1. 643(b)-1.
4. Kirkpatrick v. Commissioner, T.C. 2018 (Feb. 22, 2018).
5. Mazzei, et ux v. Comm’r, 150 T.C. No. 7 (March 5, 2018).
6. Internal Revenue Code Section 4974.
7. Summa Holdings, Inc. v. Comm’r, No. 6476-12 (6th Cir. Feb. 16, 2017), rev’g T.C. Memo. 2015-119 (June 29, 2015).
8. Benenson v. Comm’r, No. 16-2066, 2018 BL 122523 (1st Cir. April 6, 2018), rev’g T.C. Memo. 2015-119 (June 29, 2015).
9. IRC Section 72(b); Treas. Regs. Section 1.72-4, relating to application of an exclusion ratio to determine the nontaxable return of a taxpayer’s investment in an annuity contract.
10. Oliver v. Comm’r, No. 25169-16S (Apr. 3, 2018).
11. IRC Section 72(d)(1)(B)(iii).
12. Stacey S. Marks v. Comm’r, T.C. Memo. 2018-49, No. 18520-16 (April 10, 2018).
13. IRC Sections 408(e)(2) and 4975(c)(1)(B).
14. IRC Information Letter 2017-0030 (Oct. 11, 2017).
15. IRC Section 2056((b)(7).