Sunday, June 29, 2014

What Happens To Inherited IRAs in Bankruptcy?

Let us discuss IRAs.

You may be aware that there is bankruptcy protection for IRAs. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 exempts up to $1 million in IRAs created and funded by the debtor. Employer plans have even more favorable protection.

Why? The government has expressed interest that citizens be able to save for their retirement. This diminishes the odds of future government assistance and deemed in the public interest.

Fair enough. But I have one more question.

Let us say that you inherited the IRA. Does the above protection still apply to you?

Why wouldn’t it, you might ask. It is like an ice cream bar. It is still an ice cream bar whether you or I take it from the freezer, right?

This very question made it to the Supreme Court in the recent case of Clark v Rameker. While a bankruptcy case, it does have tax implications.

In 2001 Ruth Heffron established a traditional IRA and named her daughter as beneficiary.

NOTE:  “Traditional” means the classic IRA: contributions to it are deductible and withdrawals from it are taxable. Contrast this with a “nondeductible” IRA (contributions are nondeductible and withdrawals are taxable, according to a formula) and Roths (contributions are nondeductible and withdrawals are nontaxable).

Mrs Heffron passed away a year later – 2001 – and left approximately $400,000 to her daughter in the IRA account. Inherited IRAs have special rules on distributions, and one has to take distributions over a life expectancy or withdraw the entire balance within five years. Her daughter – Ms. Heffron-Clark - elected to use life expectancy with monthly distributions.

Fast forward to 2010 and Ms. Heffron-Clark and her husband file for Chapter 7 bankruptcy. The IRA has approximately $300,000 remaining, and you can bet that the couple considered the IRA to be an exempt asset. The unsecured creditors of the bankruptcy estate disagreed, thus beginning the litigation.

·       The Bankruptcy Court said that the IRA was not exempt and could be reached by creditors.
·       The District Court reversed, saying that the IRA was exempt and could not be reached by creditors.
·       The Appeals Court for the Seventh Circuit reversed, saying that the IRA was not exempt and could be reached by creditors.

This set up disagreement between the Fifth and Seventh Circuits, so the Supreme Court agreed to hear the case.

Believe it or not, the Bankruptcy Code does not define the term “retirement funds,” resulting in the above courts drawing such different conclusions. The Supreme Court declared that the term must be defined in order to arrive at a correct conclusion. The Court looked a dictionary and saw that “retirement” is defined as …

       … withdrawal from one’s occupation, business or office.”

The Court wanted to look at the legal characteristics of funds set aside for the day one stops working. It focused on three:

(1)  One can put additional monies into a retirement account.

POINT: One cannot put additional monies into an inherited account. In fact, if one inherits again, one cannot mingle the two accounts. Each is to remain separate and unique.

COUNTERPOINT: One cannot put additional monies into an IRA after age 70 ½.

(2)  Holders of an inherited account are required to begin distributions in the year following the death.

POINT: There are no age 59 ½ or 70 ½ minimum distribution requirements here. It does not matter whether the beneficiary is three years old or ninety-three; distributions must begin in the year following death, unless one fully depletes the account over 5 years.

OBSERVATION: The Court asked obvious question: how does this distribution requirement tie-in to the beneficiary’s retirement in any way?

(3)  The beneficiary can withdraw the entire balance at any time, without penalty.

POINT: You and I cannot do that with our own IRA until we are age 59 ½. 

OBSERVATION”: The Court noted that there is a ‘stick” if one wants to access a traditional IRA early – the 10% penalty. That expresses Congress’ intent to discourage use of traditional IRA s for day-to-day non-retirement purposes. The inherited IRA has no such prohibition. What does that say about Congress’ intent with inherited IRAs?

Rest assured that Ms Heffron-Clark was arguing furiously that the funds in that inherited IRA are “retirement funds” because, at some point, they were set aside for retirement.

The Court looked at the three criteria above and said that the inherited IRA certainly constitutes “funds,” but it cannot see how they rise to the level of “retirement funds.” They simply do not have the characteristics of normal retirement funds.

The Supreme Court unanimously decided that an inherited IRA do not constitute “retirement funds” and are not exempt from bankruptcy claims. Ms. Heffron-Clark’s creditors could in fact reach that $300 grand.

Granted, this is a bankruptcy case, but I see two immediate tax consequences from this decision:
(1) First, a surviving spouse (that is, the widow or widower) has a tax  option offered no other IRA beneficiary.
The surviving spouse can take the IRA as an inherited IRA (and be subject to bankruptcy claims) or he/she can rollover the IRA to his/her own personal name.
In the past, this decision was sometimes made based on the survivor’s age. For example, if the surviving spouse thought he/she might need the money before age 59 ½, the tax planner would lean towards an inherited IRA. Why? Because there is no 10% penalty for early withdrawals from an inherited IRA. There would be penalties on early withdrawals from a rollover IRA.
This decision now gives planners another reason to consider a spousal rollover.
(2) Second, there may be increased attention to IRA accumulation trusts.
A trust is allowed to be an IRA beneficiary, but at the cost of some highly specific tax rules. There are two types of permitted trusts. The first is the conduit trust. The trust receives the annual minimum required distributions (MRDs) but is required to immediately pay them out to the beneficiary.  While you may wonder what purpose this trust serves, consider that the trust – while unable to protect the annual income – can still protect the principal of the trust.

The second type is the accumulation trust. It is eponymous: it accumulates. There are no required distributions to the beneficiaries. The tax cost for this can be enormous, however. A trust reaches the maximum federal tax rate at the insanely low threshold of approximately $12,000. Obviously, this strategy works best when the beneficiaries are themselves at the maximum tax bracket.

The other point that occurred to me is the future of stretch IRAs. There has been considerable discussion about imposing a five-year distribution requirement (with very limited exceptions) on inherited IRAs. This of course is in response to the popular tax strategy of “stretch” IRAs. The stretch is easy to explain: I leave my IRA to my granddaughter. The IRA resets its mandatory distributions, using her life expectancy rather than mine (which is swell, as I am dead). Say that she is age 11. Whereas there are mandatory distributions, those distributions are spread out over the life expectancy of an eleven-year-old girl. That is the purpose and use of the “stretch.”

Consider that the Court just decided that an inherited IRA does not constitute “retirement funds.” This may make it easier for Congress to eventually do away with stretch IRAs.

Friday, June 20, 2014

The Clintons And Their Residence Trusts

I am looking at a Bloomberg article titled” Wealthy Clintons Use Trusts to Limit Estate Tax They Back.”

I get the hypocrisy. There truly cannot be any surprises left with this pair, but I get it.

I also have no problem with the tax strategy. I would use it unapologetically, if I were within its wheelhouse.

This trust is known as a Qualified Personal Residence Trust (QPRT), pronounced “cue-pert.” I use to see more of them years ago, as this trust works better in a high interest rate environment. We haven’t had high interest rates for a while, so the trust is presently out of its natural element.

You can pretty much deduce that this trust is funded with a house. It can be funded with a main residence or a second home. I have seen it done with (very nice) vacation homes. There are income tax and gift tax consequences to a QPRT. 

Let’s go through an example to help understand the hows and whys of this thing.

Let’s say that we have a modestly successful, low-mileage, middle-aged tax CPA. We shall call him Steve. Steve owns a very nice second home in Hailey, Idaho. Word is he bought it from Bruce Willis. Steve and Mrs. Steve are meeting with their tax advisor, and they are discussing making gifts to their children. The advisor mentions gifting the Hailey residence, using a QPRT.

Mrs. Steve: How does that work?
Advisor:      The house is going to go the kids eventually, someday. We are just putting it in motion. We set up a trust. We put the house in the trust. We have the trust last a minimum number of years – in your case, maybe 15 years. At the end of the trust, the house belongs to the kids. Maybe it belongs to a trust set up for the kids. You can decide that.
Mrs. Steve: What’s the point? In any event the kids will wind up with house anyway.
Advisor:      The point is to save on estate and gift taxes. Someday this house will pass to the kids. If it happens while you are alive, we have to discuss gift taxes. If it happens at your or Steve’s death…
Steve:         I am right here, people.
Advisor:      Just explaining the process. If it happens at death, we have to discuss estate taxes.
Mrs. Steve: So, either way …
Advisor:      … you are hammered.
Mrs. Steve: How do I save money?
Advisor:      You continue to live in the house for a while, say fifteen years. The house is eventually going to the kids, so there is a gift. However the house is not going to the kids for fifteen years, so the value of the gift is the house fifteen years out.
Mrs. Steve: Wait. The house will be worth more fifteen years out. How is this possibly helping me?
Advisor:      I said it wrong. The IRS considers the gift to be made today for something to be delivered fifteen years out. That long wait reduces the value of the gift, which is what drives the gift tax planning with a QPRT.
Mrs. Steve: Should I just invite the IRS to an audit?
Advisor:      Not at all. We can find out what the house is worth today. The IRS has given us tables and interest rates to calculate the fifteen years wait. Since we are using their tables and their rates, it is fairly safe mathematics. There isn’t much to audit.
Steve:         I am stepping out to stretch my legs.
Mrs. Steve: Give me an example.
Steve:         Is there fresh coffee in the break room?
Advisor:      We have seen cases where someone has transferred a house worth $2 million in a ten-year QPRT and the IRS says the gift was only around $550 thousand.
Mrs. Steve: Which does what?             
Advisor:      You get to hold on to your lifetime gift tax exemption as long as possible. You can make more, or larger, gifts and not owe any gift tax as long as you have some lifetime exemption amount remaining.
Mrs. Steve: Who pays for the house; you know, the utilities, the maintenance, taxes and all that?
Advisor:      You do. And Steve, of course.
Steve:         (from outside the room) Did I hear my name?
Mrs. Steve: No! Go find your coffee.  
Mrs. Steve: Who gets to deduct the real estate taxes – the trust?
Advisor:      The trust is “invisible” for tax purposes. It is a “grantor” trust, which means that – to the IRS – there is no trust and it is just you and Steve. You get to deduct the real estate taxes.
Mrs. Steve: Wait a minute. If there is no trust, how can there be a gift?
Advisor:      This part gets confusing. For income tax purposes, the IRS says that there is no trust. For gift tax …
Steve:         (from outside the room) Where’s the cream?
Advisor:      For gift tax purposes, the IRS says there is a trust. Because there is a trust, you can make a gift.
Mrs. Steve: You are kidding.
Advisor:      No. Tax law can be crazy like that.
Mrs. Steve: What happens if after fifteen years I still want to live there? Does the trust boot me out?
Advisor:      Nope. You can rent the house, but you will have to pay fair market value, of course.
Mrs. Steve: Because I no longer own it.
Advisor:      Right. Also, since you do not own it, technically the kids could act against you and sell the house, even if against your will. That is a reason for keeping the house in some kind of trust, even after the QPRT term, as it allows for an independent trustee.
Mrs. Steve: What is the downside to this QPRT thing?
Steve:         (walking back into room, with coffee) We done yet?
Advisor:      You have to outlive the trust.
Steve:         I intend to. What are you talking about?
Advisor:      If the QPRT is for fifteen years, then you have to live at least fifteen years and a day for this thing to work.
Steve:         And if I don’t?
Advisor:      It will be as though no trust, no gift, no anything had ever happened. The house would be pulled back into your estate at its value when you die.
Steve:         Why do I keep dying with you two?
Mrs. Steve: OK. Steve dies before fifteen years. What can I do to minimize the risk to me of him dying….
Steve:         Risk to you?
Mrs. Steve:  … of him dying before his time?
Advisor:      Several things. You and Steve own the house jointly, right?
Mrs. Steve: Of course.
Steve:         (under his breath) As though there was a choice.
Mrs. Steve: What was that, dear?
Steve:         Just blowing on the coffee to cool it down, dear.
Advisor:      We set up two trusts. One for Steve and one for you. It helps with the odds.
Mrs. Steve: I like that.
Advisor:      We can even “supercharge” that by putting fractional interests in the trusts. Say you put a 1/3 fractional interest each. You and Steve would be able to fund six different trusts. We could vary the term of the trusts – say from ten to twenty years – again improving your odds.
Steve:         Are we still talking about me?
Mrs. Steve: It’s not about you, dear.

Believe it or not, this is pretty straightforward and well-marked tax planning for folks who know they will be subject to the estate tax. Few planners would describe QPRTs as aggressive. There are some twists and turns in there – say if the trust sells the house during the trust term, for example – but that can be a blog for another day.

How and why would the Clintons be pursuing this strategy? Remember that they own two houses: one in Washington (worth approximately $2 million) and another in Chappaqua, New York (worth approximately $5 million). They have quite a bit of money tied-up there. They are almost certain to face an estate tax some day, bringing them well within the wheelhouse of a QPRT.

Not bad for dead broke.

Friday, June 13, 2014

Z Street Decision Will Force IRS To Disclose How It Reviews – And Delays - Tax-Exempt Applications

I am reading things that make me wonder what is going on at the IRS. It repetitively appears that the agency – or at least influential partisan players – think that the job of the IRS is to take sides in political issues.

I am looking at Z Street v Shulman. It is a Court decision from the District of Columbia. There are some interesting points in here, embalmed in yawn-inducing legalese.

Let’s talk about this case.

Z Street is a non-profit corporation. It comes out of Pennsylvania, was organized in 2009 and immediately applied for tax-exempt status. Its purpose is to educate the public about Zionism; about facts on the formation of the Jewish state; and about Israel’s right to refuse to negotiate with terrorists.

We know about that the IRS instituted a policy of 501(c)(4) suppression prior to the 2012 presidential election. The 501(c)(4)s are a different animal from a (c)(3), the “traditional” charity. A (c)(4) may engage in an unlimited amount of lobbying, as long as it stays within the issues for which it was organized. If someone felt strongly about blue M&Ms, for example, I suppose that someone could organize a (c)(4) and lobby nonstop – as long as they stayed within the issues concerning blue M&Ms. A (c)(4) can also engage in some partisan political activity, as long as it does not become its primary activity. There is a price however for this freedom to till so close to political soil: deductions to a (c)(4) are not deductible.

Contrast that to a (c)(3), contributions to which are tax-deductible. As a trade-off, there are severe restrictions on lobbying activities of a (c)(3).

Anyway, Z Street applies for (c)(3) status. It wants that tax-deductible status, understandably. It is possible that – in the future – it will spin-off a (c)(4). 

Here are some quick dates:

·       12/29/09 - applies for exempt status with IRS
·       5/15/10 – IRS send a letter requesting additional information
·       6/7/10 – Z Street provides additional information to the IRS
·       7/10/10 – Z Street’s attorney tracks down the IRS person (Dianne Gentry) handling the file.  Agent Gentry tells the attorney that she has two reservations:

o   Z Street is engaged in “advocacy” activities that are not permitted under Section 501(c)(3)
o   The IRS has special procedures for applications from organizations whose activities relate to Israel, and whose positions with respect to Israel contradict the current policies of the U.S. government. She further stated, “these cases are being sent to a special unit in the D.C. office to determine whether the organization’s activities contradict the Administration’s public policies."

I am stunned.

I immediately pick up on the issue of a (c)(3) and advocacy. I expected that issue, and frankly, I wonder why Z Street didn’t organize a (c)(4) instead.

But “special procedures” and the “Administration’s” current policies? My tax-exempt application is to be judged on whether the Administration “likes” me and whether I say “politically correct” things? Good grief, bring on Kristallnacht.

Z Street brought a lawsuit. They alleged that the IRS maintains a special policy when it comes to Israel and to (c)(3)s whose stance does not agree with the Obama Administration, and that such applications are subject to special procedures not applied to other organizations. 

What does Z Street want?

·       A declaration that policy is unconstitutional, and
·       An injunction forcing the IRS to disclose the policy and barring the IRS from employing the same.

The IRS stalled this thing almost long enough to put your kid through college. I am disturbed that the IRS core argument seems to be “we can do whatever we want.” Here are their arguments:

(1)  The Anti-Injunction Act

The AIA was first enacted in 1867, and states that ”no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person, whether or not such person is the person against whom such tax is assessed.”

The IRS argued that the AIA barred the Court from granting injunctive relief.

(2)  Code Section 7428

Code Section 7428 already provides remedy for organizations that seek to challenge IRS determination of their (c)(3) status.

(3)  The IRS also argued that the case should be dismissed on “sovereign immunity” grounds.

The Court goes to work:

(1)  The D.C. Circuit had already decided a case (Cohen) rejecting  that the AIA’s “assessment and collection” language bars any and all lawsuits that might ultimately impact revenue to the Treasury. It has to be so, otherwise one could pass virtually any law and render it unreachable by calling it a “tax.”

(2)  By its terms, Section 7428 applies when there is controversy concerning qualification of an organization as a (c)(3). The only available remedy under Section 7428 is a “declaration with respect to … initial qualification or continuing qualification.”

The Courts points out that Z Street is not asking the Court for (c)(3) qualification. Rather it is asking the Court to force the IRS to follow a “constitutionally valid process” – nothing more and nothing less.

(3)  The Administrative Procedure Act expressly waived sovereign immunity for lawsuits such as this. The APA waives sovereign immunity for suits for nonmonetary damages that allege wrongful action by an agency or its officers or employees.

The Court points out the obvious: that is exactly what Z Street is doing.

Judge Ketanji Brown Jackson observed:

Defendant struggles mightily to transform a lawsuit that clearly challenges the constitutionality of the process that the IRS allegedly employs when it determines the tax-exempt status of certain organizations into a dispute over tax liability as a means of attempting to thwart this action’s advancement.”

In legalese, this is like being punched in the face.

The Court decided that the Z Street’s lawsuit could proceed. After the IRS files its response, the case will go to discovery. The IRS will have to pony up what it has been doing with tax-exempt applications these last few years. Anticipate that Z Street attorneys will seek depositions from other groups similarly treated by the IRS.  


If proven, this type of behavior by the IRS is thuggish and needs to be punished. People need to lose their jobs, if not their freedom for a while. Perhaps we could build a Lois Lerner wing at a prison somewhere. Perhaps somewhere near the District of Columbia so these people would not have to travel far.

Why do I say this? Our taxation system relies – to an overwhelming extent – on voluntary compliance. The function of the IRS is to administer and collect taxes and process records of the same. Whatever our political stance, we can have common ground on the assessment and collection of tax. We can all hate the IRS equally.

If we disagree on tax law, however, we take that disagreement into the legislative arena. Allow elected representatives to hash it out. At least the representatives have to run for reelection occasionally, so there is some chance for an accounting of their decisions and actions. This is greatly preferable – and healthier for our system of governance – than partisan berserkers bending whatever lever of government they can access to impose their dogma du jour.

Remember: there will be a future White House with very different attitudes and values than the present one. If this behavior goes unpunished, those now in power will then be out of power, and it will be their views and causes that will be handed to the tender mercies of the partisan berserkers then in power.

Don’t come crying then.