In October 2019, the Internal Revenue Service issued Private Letter Ruling 201943020 (July 25, 2019), which concerns an individual retirement account left to a charity client of mine.
The amount remaining in the IRA was about $30,000, small enough for the client to decide to seek a PLR as it was willing to wait to get the distribution. Getting a PLR would delay a beneficiary distribution but that was tolerable for my client from a financial standpoint.
Custodian Insists on Inherited IRA
The custodian of the IRA is a major U.S. financial institution. The custodian insisted that my client set up what the custodian calls an “inherited IRA.” The custodian would make the beneficiary distribution only to the inherited IRA.
The custodian stated in emails it sent to my client that: (1) it will treat the inherited IRA as a new IRA, not as a continuation of the decedent’s IRA, and (2) my client will own the inherited IRA. My client furnished these emails to the IRS.1
My client will be able, if it creates the inherited IRA, to drain and collapse the inherited IRA immediately. The inherited IRA, therefore, will serve no substantive purpose.
What’s an inherited IRA? The tax law doesn’t define the term “inherited IRA.” The closest it comes is in Internal Revenue Code Section 408, which describes an IRA that’s “treated as inherited.”
IRC Section 408(d)(3)(C)(ii) provides:
(ii)...An individual retirement account or individual retirement annuity shall be treated as inherited if—
(I) the individual for whose benefit the account or annuity is maintained acquired such account by reason of the death of another individual, and
(II) such individual was not the surviving spouse of such other individual.
I argued that my client couldn’t set up an inherited IRA because the quoted IRC section requires that to be treated as inherited, the IRA must be acquired by reason of the death of an individual. The problem, I believed, was the word “acquired.” My client wouldn’t “acquire” an inherited IRA. My client would simply set up and own a new IRA.
IRS attorneys informed me that the only purpose of Section 408(d)(3)(C)(ii) is to describe the type of IRA to which a rollover contribution can’t be made. This section of the IRC, according to IRS attorneys, doesn’t define the term “inherited IRA.”
IRS Creates New Term
PLR 201943020 doesn’t define the term “inherited IRA” either. Instead, it creates and uses a new term: “transfer IRA.” This term isn’t defined anywhere. It’s de novo. The PLR says:
...Custodian requires that Taxpayer create a new IRA (‘Transfer IRA’) with Custodian to which Custodian would transfer assets from Original IRA directly in a trustee-to-trustee transfer. Distributions could then be made to Taxpayer from Transfer IRA.
Note carefully that this portion of the PLR acknowledges that the transfer IRA would be a new IRA (set up in the name of my client). The PLR avoids stating that my client would own the transfer IRA. As discussed below, a charity can’t own an IRA, according to a plain reading of Section 408. To “own” an IRA is to “establish” the IRA.
Terminology. At this point, three terms are in play: (1) IRA; (2) inherited IRA; and (3) transfer IRA. Of the three, only “IRA” is defined in the tax law.2 The IRC is largely a collection of definitions. Undefined terms such as “transfer IRA” are wild cards that can lead to arbitrary conclusions contrary to the tax law.
IRS Publication 590-B (Pub 590-B). Pub 590-B, which deals with IRA distributions, uses the term “inherited IRA.” In Pub 590-B, an inherited IRA is established by an IRA beneficiary in the name of a deceased IRA owner, not in the beneficiary’s name. So, Pub 590-B is factually at odds with the PLR request and is therefore irrelevant to the ruling request.
Initially, an IRS attorney told me the inherited IRA my client was being required to establish was just like the one described in Pub 590-B. IRS attorneys told me later that Pub 590-B is just someone’s opinion (meaning it’s not part of the tax law).
The first thing the IRS attorney told me was factually incorrect. The second thing other IRS attorneys told me, however, was legally correct because taxpayers can’t rely on IRS publications. IRS publications aren’t part of the tax law in the sense that they can’t properly be cited in a pleading submitted to a court and can’t, without peril, be relied on by taxpayers.3
Revenue Ruling 78-406. The PLR cites this revenue ruling as precedent. A revenue ruling is part of the tax law.
The facts in Rev. Rul. 78-406 are that in 1975, individual A established an IRA at Bank X. In 1976, A rolled money tax free from the IRA at Bank X to an IRA at Bank Y. In 1977, A caused money in the IRA at Bank Y to be transferred tax free to an IRA at Bank Z.
Rev. Rul. 78-406 is irrelevant to PLR 201943020, because all transfers were from one IRA owned by individual A to another IRA owned by individual A. In PLR 201943020, the transfer would be made from an IRA established by the decedent to a so-called IRA established by my client.
So, what’s the inherited IRA in PLR 201943020? In a telephone conversation, an IRS attorney confirmed that any IRA must meet the definition of IRA under Section 408. Whatever it is, it’s something that doesn’t correspond to a straightforward reading of Section 408.
Errors of Fact and Law
Factual errors. PLR 201943020 states:
[S]tatements from Custodian suggest that Taxpayer is the ‘owner’ of Transfer IRA....
A written communication from the IRA custodian to my client didn’t “suggest” that my client would be the owner of the inherited IRA. It flat-out stated that my client would be the owner of the inherited IRA. This is the first factual error.
The second factual error appears in this statement of the PLR:
Transfer IRA is merely a continuation in substance of the inherited IRA from which the transfer is accepted and is not established and maintained by Taxpayer as an original IRA to which Taxpayer can make contributions.
A written communication from the IRA custodian to my client states unequivocally that the inherited IRA will be a new IRA and not a continuation of the decedent’s IRA. An IRS attorney agreed in a telephone call that the inherited IRA wouldn’t be a continuation of the decedent’s IRA. The PLR takes the opposite position.
The only part of the quoted language that’s factually accurate is the part stating that my charity client may not make contributions to the inherited IRA, according to the governing instrument of the inherited IRA. This prohibition is meaningless, however, given that no charity would ever consider making a contribution to a so-called inherited IRA.4
Error of law. Section 408 states who may own (that is, establish and maintain) an IRA:
- an individual;
- an employer for the benefit of its employees; and
- an association of employees for the benefit of its members.
My client, a garden-variety charity, isn’t on this list. The PLR acknowledges this list but sidesteps it by stating incorrectly that the custodian merely suggested that my client would own the inherited IRA. Accordingly, the PLR states:
...Transfer IRA does not fail to be a type of IRA described in section 408....
Why My Client Refused
My client has refused to create the inherited IRA. Here’s why:
The Patriot Act. To create an inherited IRA, my client would become a “customer” of the custodial financial institution (not merely an IRA beneficiary), which would subject my client to Section 326 of the Patriot Act. Section 326 is a “know-your-customer” provision aimed at preventing money laundering. It allows a financial institution to ask intrusive questions of a customer. Such questions may cover a range of sensitive personal individual matters, such as the Social Security number of the charity’s business officer or intrusive questions about the charity beneficiary’s board members.5
Difficulty with forms. Setting up an inherited IRA requires the charity to fill out various forms, typically encountering delays from the custodian and often having to provide detailed personal information about officers or board members. The process is hugely time consuming. The individual who fills out the forms can never get help from the custodian, because no one the individual is able to reach at the custodial financial institution understands how to complete the forms.
The forms are confusing because they’re aimed at IRA beneficiary distributions made to individuals, not to charities. Charities routinely fill out the forms incorrectly from the custodian’s standpoint. This has led to inordinate delays in charities receiving IRA beneficiary distributions.
The experiences of other charities. One of my charity clients has a large number of high profile board members who are appointed by an elected officer of the federal government. To receive an IRA beneficiary distribution, this client was required to provide the IRA custodian with detailed personal financial affidavits prepared by each board member. As one might imagine, those affidavits weren’t provided, and the client didn’t receive its beneficiary distribution.
Another charity client had a longstanding relationship with a large New York City bank, which was the custodian of an IRA left to the charity. This client couldn’t get its beneficiary distribution from the bank without providing detailed information on each of its board members, who said “nothing doing.”
These two examples are typical of the kinds of problems charities across the United States face in trying to collect their IRA beneficiary distributions.
If a charity fails to comply with an IRA custodian’s demands and doesn’t receive its beneficiary distribution, eventually the money that should have been distributed to the charity becomes unclaimed property and escheats to the state.
Flawed Software
Why does the IRA custodian require the creation of a so-called inherited IRA? For some time, I believed it was a tax reporting problem. My belief was confirmed in a 2019 conference call with an assistant general counsel (AGC) of the IRA custodian involved in PLR 201943020. The AGC admitted over the phone that her employer requires the creation of an inherited IRA because it has flawed tax reporting software.
The software treats any IRA distribution as being made to the named owner of the IRA. The software works perfectly well for distributions made while the individual who established the IRA is living.6
If the individual dies having named a charity as beneficiary of his IRA, the software will report a distribution to the charity as a distribution to the decedent, who’s still the named owner of the IRA. This reporting, of course, would be incorrect.
Instead of fixing its tax reporting software, the custodian demands that the charity create an inherited IRA, which the charity will own. The custodian treats the distribution from the decedent’s IRA to the inherited IRA as a tax-free trustee-to-trustee transfer, and the custodian’s tax reporting software correctly reports the distribution from the inherited IRA to its charity owner.
In every situation with which I’ve dealt, the fact that the custodian’s software for reporting IRA beneficiary distributions is flawed is tightly held knowledge. It’s known only by a few key employees.
Recently, for example, my path crossed with that of the general counsel (GC) of a large east coast bank that serves as the broker for a decedent’s IRA left to a charity. The GC was unaware of the tax reporting software problem and the Patriot Act’s relevance. According to the GC, thousands of charities have set up inherited IRAs. His attitude was, what’s the problem? More to the point, the GC wasn’t one of the key employees who knew why his bank’s practices regarding IRA beneficiary distributions to charity were the way they were. For what it’s worth, I consider keeping a GC out of the loop on an issue like this to be contemptuous of the law.
IRA as Trust?
The tax law definition of an IRA is found in Section 408 and the corresponding Treasury regulations.
Section 408(a) provides:
(a) Individual retirement account. For purposes of this section, the term ‘individual retirement account’ means a trust created or organized in the United States for the exclusive benefit of an individual or his beneficiaries, but only if the written governing instrument creating the trust meets the following requirements....
It’s clear from this part of the definition that an IRA is a trust. A decision of the Massachusetts Supreme Judicial Court, however, held that an IRA was a custodial account and not a trust because the decedent who established the IRA didn’t intend to create a trust.7 The court took this position despite the fact that IRAs exist only by virtue of federal tax law, which provides that an IRA set up as a custodial account is a trust.8 The true significance of the court’s decision is that while a trustee would be subject to state law fiduciary duties, a mere custodian wouldn’t.9
The AGC for the IRA custodian in PLR 201943020, which is a Massachusetts corporation, also insisted that the IRA held by her employer was a custodial account, not a trust. The AGC maintained in addition that her employer owed no fiduciary duties to my client.
An issue PLR 201943020 doesn’t address is how it’s possible to have a tax-free trustee-to-trustee transfer when the recipient entity isn’t regarded as a trust under state law or under the recipient entity’s custodial agreement.
Further Details
My client argued in the ruling request that the inherited IRA wouldn’t be an IRA because it would be owned by my client in violation of Section 408 and Treasury Regulations Section 1.408(a). And, that for this reason, a distribution from the decedent’s IRA to the so-called inherited IRA would be a taxable distribution, causing federal income tax to be imposed on the inherited IRA.10
Early on, an IRS attorney agreed this was correct. Later, IRS attorneys told me that notwithstanding all the facts my client had presented, the IRS would issue an adverse ruling if the ruling request wasn’t withdrawn. My client refused to withdraw the ruling request, and the IRS issued the PLR described in this article.
As a reader of this piece, you may be scratching your head over what happened here. Keep in mind, however, that because a PLR isn’t a part of the tax law that can be cited in pleadings or relied on by third parties, the IRS is free to make any statement it chooses about either facts or law in a PLR.
In addition, practically speaking, the ruling request in PLR 201943020 could have adversely affected a large part of the financial industry. I don’t know whether this played a role in the outcome.
PLRs in Charitable Gift Planning
Notwithstanding the limitations of PLRs, they’re a rich source of information about charitable gift planning issues. This is mostly true for PLRs published in the 1970s through about 2010. In those years, the user fee for obtaining a PLR ranged from nothing to a rather modest amount, and a good number of valuable PLRs on charitable gift planning were issued.
These days, because the user fee is so high, it’s unusual to find a current PLR on a charitable gift matter. The user fee for seeking PLR 201943020 was almost $30,000. The money for the user fee was raised in a national effort from a number of prominent charities.
Endnotes
1. The writings were unequivocal emails sent in response to the charity client’s requests for clarification.
2. Internal Revenue Code Section 408 defines the term “individual retirement account.” The IRC doesn’t define the term “inherited IRA,” “transfer IRA” or “continuation IRA,” nor does any other part of the tax law do so. “Transfer IRA” and “continuation IRA” are terms not used in any Internal Revenue Service published guidance.
3. Taxpayers rely on IRS published guidance at their own peril. See Bobrow, T.C. Memo. 2014-21 (Jan. 28, 2014). This peril extends also, for example, to guidance provided on the IRS website and to written instructions on how to fill out federal tax forms.
4. No charity would ever consider making a contribution to an inherited IRA because a charity has no use whatsoever for an inherited IRA. An inherited IRA is simply the only way a charity can get its IRA beneficiary distribution.
5. The final rule on customer identification under IRC Section 326 is set forth in Office of the Comptroller of the Currency Bulletin 2003-22 (June 3, 2003). Many IRA custodians demand of charity IRA beneficiaries far more information than the minimum information required to be obtained under the final rule.
6. All distributions from an IRA during the IRA owner’s life, including qualified charitable distributions made pursuant to IRC Section 408(d)(8), are reported to the IRS on Form 1099-R as distributions to the IRA owner.
7. UBS Financial Services, Inc. v. Alberti (Supreme Judicial Court of Massachusetts (Oct. 22, 2019)). The court ignored the fact that the decedent did intend to establish an IRA, which federal tax law defines as a trust. Question: How many Americans who establish IRAs understand that federal tax law defines an IRA as a trust? When I established IRAs in the 1980s, I had no idea an IRA was a trust. Even then, I was an active member of four state Bars, had been widely published in peer-reviewed tax journals and had a national reputation as a charitable gift planning expert. I believe the Alberti decision represents the pinnacle of unreasonable judicial expectations. No one, in my estimation, intends to create a trust in establishing an IRA. An individual who establishes an IRA has two purposes: (1) saving for retirement, and (2) saving income taxes, neither of which have anything to do with the intent to create a trust. What the Alberti decision did, because it knocked out fiduciary responsibilities, was let an IRA custodian off the hook for grossly unreasonable and harmful behavior toward an individual IRA beneficiary.
8. Treasury Regulations Section 1.408-2(a) provides that an IRA must be a trust or a custodial account. Consistent with Section 408, Treas. Regs. Section 1.408-2(d) provides that any such a custodial account shall be treated as a trust. The logical conclusion is that an IRA is always a trust, although it may be labeled a custodial account.
9. Merely based on the differences between state law and federal tax law, I could buy the Alberti decision of the Massachusetts Supreme Judicial Court, which is a decision based on Massachusetts state law as to whether an entity is a trust. But, an IRA exists only under federal tax law and only as a trust. Nothing about the definition of an IRA depends on state law. Unlike a charitable remainder trust as defined in IRC Section 664, which must satisfy the requirements of applicable state law as to the creation of a trust, an IRA exists independent of state law. In my view, therefore, the Alberti decision is erroneous.
10. If the inherited IRA the custodian insisted my charity client establish wasn’t an IRA, it would be a taxable entity, because although it would be owned by a tax-exempt charity, it would have its own separate tax status and that status would be taxable because nothing in the IRC would confer on it tax-exempt status.