Its vastness was on display in 2017.
Last year’s developments serve to remind planners what can go wrong—and what can go right with planning.
Settlement Proceeds
In Ozimkoski v. Commissioner,1 Thomas W. Ozimkoski, Sr. died testate, and his individual retirement account was payable to his estate. A will contest between his widow, Suzanne, and his son from a prior marriage, Thomas Jr., ended in a settlement agreement. Under that agreement, Thomas Jr. became entitled to his father’s 1967 Harley-Davidson motorcycle and $110,000 cash, free of income taxes. Suzanne was entitled to the rest, except for some personal property.
Suzanne’s share included her husband’s IRA. In 2008, Suzanne transferred $235,495.46 into a rollover IRA titled in her name and treated it as her own IRA. Later that year, Suzanne withdrew $174,597.17 from her rollover and paid Thomas Jr. his $110,000 cash award out of the proceeds.
The IRA custodian reported to the Internal Revenue Service total 2008 IRA distributions to Suzanne of $174,597.17, coded as distributions before age 59½. Suzanne reported no IRA taxable income in her 2008 income tax return, wrongly believing that Thomas Jr. would have to pay income taxes on the $174,597.17.
Based on the IRA custodian’s reporting, the IRS assessed income taxes against Suzanne, along with late payment interest, a penalty for failing to timely file her income tax return and a penalty for substantial understatement of tax. Suzanne petitioned the Tax Court, claiming she didn’t owe the assessed additional income tax, interest and penalties.
Because Thomas Sr.’s IRA was transferred to Suzanne’s own IRA, the Tax Court found distributions to her were taxable. That Suzanne was required to pay $110,000 to Thomas Jr. couldn’t change that result. The court sustained the IRS’ claims.
Taxable Distributions
After serving as a mutual fund company’s call center manager for 23 years, Candice Elaine lost her job. A single mother with two daughters, she rolled over her retirement benefits to an IRA and was later compelled by financial hardship to make IRA withdrawals.
Because she was under age 59½, the IRS assessed Internal Revenue Code Section 72(t)’s 10 percent additional tax on early withdrawals, along with a 20 percent substantial income understatement penalty. Candice asked the Tax Court to reverse the penalty.
In Elaine v. Comm’r,2 the Tax Court noted that financial hardship isn’t among Section 72(t)’s enumerated exceptions and upheld the additional tax. But the court, observing that her error is commonplace, held that Candice’s error fell within the penalty tax’s reasonable cause exception and reversed the 20 percent substantial income understatement penalty.
In Kevin Cheves, et ux. v. Comm’r,3 economic hardship followed after the loss of Kevin’s job. Unfortunately, when Kevin’s IRA had to be tapped to make ends meet, he was under age 59½, causing imposition of the 10 percent early distributions tax. Adding insult to injury, his Form 1099-R underreported Kevin’s and his wife’s withdrawals by $15,221. As economic hardship isn’t listed in the IRC as an exception to the early distributions tax, the Tax Court found it couldn’t grant relief from that tax. However, it did grant relief from the substantial underpayment penalty because of Kevin’s reliance on a faulty Form 1099-R.
Roth IRAs
In Summa Holdings, Inc. v. Comm’r,4 the U.S. Court of Appeals for the Sixth Circuit overturned a Tax Court’s decision holding that excess contributions to Roth IRAs occurred. Family-controlled enterprises made payments to JC Export, a domestic international sales corporation (DISC). The DISC was owned by JC Holding, a taxable corporation. There were two equal owners of JC Holding: a Roth IRA of Clement C. Benenson and a Roth IRA of James Benenson III.
The Sixth Circuit found that because the DISC and the Roth IRAs were authorized by statute, the Tax Court erred in disregarding them for purposes of determining that the Roth IRA contribution limits were violated.
In contrast, the Roth IRAs in Block Developers, LLC v. Comm’r5 didn’t fare as well. Jan Jansson developed and obtained a patent on interlocking concrete blocks. He formed three corporations: Toy Rentals, to hold equipment; SR Products, for manufacturing and distribution; and SR designs, for sales. Jan continued to hold the patent. Block Developers LLC (Block) was formed to purchase the patents from Jan, securing his retirement and providing a source of cash replenishment for SR Products.
Jan, his wife and their two sons formed Roth IRAs, each funded with $2,000. Each Roth IRA bought a 23.75 percent interest in Block, and Jan’s attorney purchased the remaining 5 percent interest.
But, the Tax Court observed that $249,000 of the money that Block used to pay for the patents came from SR Products. Furthermore, SR Products allowed Block to offset that amount against its royalty payments owed to SR Products. The court also found that Block’s payments to SR Products weren’t consistent with billing statements. The end result was that SR Products provided all of the funds that found their way into the Roth IRAs, except for the initial Roth IRA contributions of $2,000 each. The court ultimately found “that Block Developers was just a conduit to shunt money to the Janssons’ Roth IRAs and was not engaged in any real business activity.” It therefore ruled that Block’s transfers to the Roth IRAs were excess contributions that triggered the excise tax the IRS was seeking.
Beneficiaries
An attempt to change a beneficiary of an employee stock ownership plan and 401(k) retirement accounts subject to the Employee Retirement Income Security Act of 1984 (ERISA) was challenged and ultimately set aside in Arlene Ruiz v. Publix Super Markets, Inc.6 The method for changing beneficiary designations was set forth in the retirement plan’s summary description, which the court found was part of the retirement plan documents.
In 2008, Irialeth Rizo named a nephew and two nieces as beneficiaries of her retirement accounts. In September 2011, she sent a letter and two cards in which she attempted to change the beneficiary to Arlene Ruiz. Written on the cards’ signature line was “as stated in letter.” The letter directed that Arlene be the beneficiary of 100 percent of the accounts. The letter was signed.
The court refused to read the documents together because, under ERISA, strict compliance, not substantial compliance, is required. The cards weren’t completed as required to change beneficiaries, and Arlene’s attempted change of beneficiaries therefore failed.
Late Rollovers
John C. Trimmer, et ux. v. Comm’r7 involved a New York City police officer who suffered from a major depressive disorder and retired. He could no longer conduct his and his wife’s financial affairs and as such, failed to make a timely IRA rollover of funds distributed to him in 2011 from the New York City Employees’ Retirement System and the New York City Police Pension Fund.
John’s wife had no involvement in the couple’s financial affairs. Although she was aware he’d received payments of his retirement funds, she wasn’t aware that an IRA rollover might be needed.
In 2012, John’s condition abated, and he met with his income tax preparer. Noting Form 1099-R reporting the distributions, the preparer advised John to open a rollover IRA and deposit the proceeds of his retirement distributions into that account.
Based on information reporting by the retirement plans’ administrator, the IRS assessed underpayment of income taxes for 2011. John responded by letter, explaining his condition and asking for additional time to make the rollover. The IRS denied his request.
Noting that the IRC grants the IRS authority to waive the 60-day rollover requirement “where the failure to waive such requirement would be against equity or good conscience, including casualty, disaster, or other events beyond the reasonable control of the individual subject to such requirement,”8 the Tax Court held that the rollover was valid and reversed the IRS’ assessment.
Disability Payments
Taylor v. Comm’r distinguishes taxable retirement income from non-taxable disability payments.9 Retired fireman Jack Howard Taylor served the City of Asheville, N.C. for nearly 24 years. After retiring because of disability, he began receiving payments from Local Governmental Employees’ Retirement System of North Carolina (LGERS). His payments were based on his age, length of service and average final compensation before his disability retirement occurred. After payments began, North Carolina Firemen and Rescue Squad Workers’ Pension Fund (FRSWPF) also began making pension payments to Jack.
Shortly after Jack turned 60, he was notified that, effective Sept. 1, 2004, he was being transferred from disability retirement to regular service retirement. Nevertheless, he continued to claim that his payments were exempt from income taxes as part of workmen’s compensation.10
During 2012, LGERS paid Jack $34,505; FRSWPF paid him $2,000. He characterized the payments as tax-free disability income, but the IRS disagreed.
The court concluded the payments made in 2012 weren’t excludible amounts received under IRC Section 104(a), relating to workmen’s compensation. Instead, the payments were taxable pension payments. The court took pains to acknowledge that, “[t]he fireman’s vocation is not an easy one. Petitioner fought fires for over 24 years and retired disabled. But Lady Justice is blind, and the tax law takes its toll without regard for sentiment.”
Spousal Rollovers
In Private Letter Ruling 201707001 (released Feb. 17, 2017), a deceased spouse’s IRAs and Roth IRAs were payable to a trust. The trust was to be divided between a survivor’s trust, holding property having a combined value of half of the couple’s assets, and two other trusts, together holding property having a combined value of half of the couple’s assets. One of those two other decedent’s share trusts, the bypass trust, was to be allocated the amount that could pass from the decedent free of estate taxes. The other decedent’s share trust, the marital trust, qualified for the estate tax marital deduction by making a qualified terminable interest property (QTIP) election. Provided an election was made to treat the marital share as a QTIP,11 no federal estate taxes would be payable on the death of the first spouse.
The surviving spouse, as trustee, could decide which trust got which assets. She also had the power to take personal possession of any survivor’s trust property, but not the other two trusts. That meant that she could allocate IRAs to the survivor’s trust—and she did so, as to four Roth IRAs and a traditional IRA. She proposed to roll those over to a traditional IRA and Roth IRAs held solely in her name, and the IRS confirmed she could do so.
As a result, beginning with the calendar year following the year of the rollover, required minimum distributions (RMDs) from her rollover traditional IRA and her Roth IRA would be determined under rules applicable to an IRA or Roth IRA owner instead of those that apply to an IRA beneficiary. Thus, no lifetime Roth IRA distributions will be required. Traditional IRA RMDs will be based each year on her attained age and the RMD Uniform Table. While the ruling doesn’t specifically say so, when the wife dies, RMDs will be based on her designated beneficiary’s age.
Sixty-Day Rollover Waived
PLR 201737016 (June 21, 2017) involved an IRA owner’s attorney who held himself out as a tax and real estate specialist. Acting on her attorney’s suggestion, the IRA owner authorized the attorney to use IRA funds to purchase real estate and hold it in an IRA. Relying on the attorney’s instructions, the IRA owner wired funds from her IRA into a non-IRA escrow account of a title company. The attorney owned the title company.
The title company established a new escrow account through Trust Company F, and the attorney then transferred funds from the title company account to the escrow account.
The attorney then assisted the IRA owner in purchasing real estate, but the IRA was never recorded on the title. In addition, the settlement papers listed the purchaser of the properties as “Trust Company F as Custodian” for the benefit of the IRA owner, rather than for the benefit of the IRA.
At that time, the IRA owner flew out of the country to help her ill mother. Between her “preoccupation with caring for her mother and her reliance on Attorney G,” the IRA owner wasn’t aware any issue had arisen until after the 60-day rollover period had lapsed. Sometime after that deadline, she became aware that there weren’t funds in the escrow account and that her attorney had been arrested and charged with multiple felonies for theft of trust assets. To make matters worse, the escrow company was insolvent.
The IRA owner requested an extension from the 60-day IRA rollover period, and the IRS granted that relief under IRC Section 408(d)(3)(I), because the funds withdrawn from the IRA had been used for no other purposes and because the failure to make a rollover within 60 days was due to mishandling of the transaction by her attorney.
Similarly, in PLR 201739017 (July 3, 2017), an IRA owner needed an extension of the 60-day IRA rollover period because three withdrawals were made without the IRA owner’s knowledge or consent. The thefts were committed by the IRA owner’s spouse.
On learning of the thefts, the IRA owner instituted criminal charges against her spouse. She also requested an extension of the 60-day IRA rollover period. Because the funds withdrawn from the IRA had been stolen, the IRS waived the 60-day rollover requirement under Section 408(d)(3)(I).
In PLR 201742034 (July 24, 2017), the IRS granted a wife’s request for waiving the 60-day rollover requirement. Both the wife and her husband worked in his medical practice; both participated in a SEP-IRA plan. The wife filed for divorce. In violation of an injunction issued during the divorce proceedings, her husband informed her that he was closing his medical practice, thus terminating her employment. Before mediation proceedings began, the husband promised to provide his wife with funds to buy a residence.
Believing that state law and her husband’s promise would result in a new residence, the wife withdrew IRA funds and purchased a residence with those funds. But, the husband didn’t fulfill his promise until a court issued an order requiring him to transfer funds from his SEP-IRA account to his wife’s account. By the time that transfer occurred, more than 60 days had lapsed. The wife sought and was granted a waiver of the 60-day rollover requirement.
Note that the husband didn’t get stuck with the tax bill. Although his transfer wasn’t a rollover to his own IRA, any transfer to a spouse or former spouse under a divorce or separation instrument isn’t a taxable distribution to the transferor.12
Death of Stretch Distributions?
As Congress looks for ways to finance tax reform, RMDs for non-spouse beneficiaries of employer-sponsored qualified retirement plans and IRAs could get curtailed or completely axed. That would do to America’s working middle class the very thing that many in Congress object to about the estate tax: reduce the value of inheritances.
Here’s a possible fix: Name a charitable remainder trust (CRT) as beneficiary of the retirement account. Funds held in a CRT aren’t subject to tax. Family members can then receive payments over their lifetimes, with income taxes being paid on each year’s distributions. But, to get those payments, at least 10 percent of the value passing to the CRT must pass to a qualifying charity.
For the charitably minded, it’s an easy move to make. Others may not find it as attractive. Advisors can make clients aware of the CRT opportunity and provide financial modeling comparing CRTs to the loss of RMDs. Remember to count the value passing to charity as money that isn’t going to the government.
Here’s a crude comparison. The value of a $500,000 IRA distributed immediately on death subject to 45 percent combined federal and state income taxes is worth $275,000. The value, net of 45 percent income taxes, of a lifetime unitrust interest paying 9.8 percent of the trust’s annual value to a beneficiary aged 50 is $247,129. The present value of the charity’s interest is $50,675. The combined value of the life beneficiary and the charity is $297,804.
But, if spreading the income over lifetime lowers the lifetime recipient’s effective income tax rate to, say, 33 percent, the present value of the lifetime payments is $301,048. The present value of the charity’s interest is still $50,675. The combined value of the life beneficiary and the charity is $351,723.
Endnotes
1. Ozimkoski v. Commissioner, T.C. Memo. 2016-228 (Dec. 19, 2016).
2. Elaine v. Comm’r, T.C. Memo. 2017-3 (Jan. 3, 2017).
3. Kevin Cheves, et ux. v. Comm’r, T.C. Memo. 2017-22 (Jan. 30, 2017).
4. Summa Holdings, Inc. v. Comm’r, CA-6, No. 6476-12 (Feb. 16, 2017), rev’g. T.C. Memo. 2015-119 (June 29, 2015).
5. Block Developers, LLC v. Comm’r, T.C. Memo. 2017-142 (July 18, 2017).
6. Arlene Ruiz v. Publix Super Markets, Inc., No. 8:17-cv-735-T-24 TGW, DC M.D. Florida (March 30, 2017).
7. John C. Trimmer, et ux. v. Comm’r, No. 27238-14, 148 T.C. No. 14 (May 9, 2017).
8. Internal Revenue Code Section 408(d)(3)(I).
9. Taylor v. Comm’r, T.C. Memo. 2017-132 (July 5, 2017).
10. IRC Section 104(a).
11. IRC Section 2056(b)(7).
12. IRC Section 408(d)(6).