An Estate And An IRA Rollover

 

Retirement accounts can create headaches with the income taxation of an estate.

We know that – if one is wealthy enough – there can be an estate tax upon death. I doubt that is a risk for most of us. The new tax bill (the One Big Beautiful …), for example, increases the lifetime estate tax exclusion to $15 million, with future increases for inflation. Double that $15 million if you are married. Yeah, even with today’s prices $30 million is pretty strong.

What we are talking about is not estate tax, however, but income tax on an estate.

How can an estate have income tax, you wonder? The concept snaps into place if you think of an estate with will-take-a-while-to-dispose assets. Let’s say that someone passes away owning the following:

·       Checking and savings accounts

·       Brokerage accounts

·       IRAs and 401(k)s

·       Real estate

·       Collectibles

The checking and savings accounts are easy to transfer to the estate beneficiaries. The brokerage accounts are a little more work - you would want to obtain date-of-death values, for example – but not much more than the bank accounts. The IRAs and 401(k)s can be easy or hard, depending on whether the decedent left a designated beneficiary. Real estate can also be easy or hard. If we are selling a principal residence, then – barring deferred maintenance or unique circumstances – it should be no more difficult than selling any other house. Change this to commercial property and you may have a different answer. For example, a presently unoccupied but dedicated structure (think a restaurant) in a smaller town might take a while to sell. And who knows about collectibles; it depends on the collectible, I suppose.

Transferring assets to beneficiaries or selling assets and transferring the cash can take time, sometimes years. The estate will have income or loss while this is happening, meaning it will file its own income tax return. In general, you do not want an estate to show taxable income (or much of it). A single individual, for example, hits the maximum tax bracket (37%) at approximately $626,000 of taxable income. An estate hits the 37% bracket at slightly less than $16 grand of taxable income. Much of planning in this area is moving income out of the estate to the beneficiaries, where hopefully it will face a lower tax rate.

IRAs and 401(k)s have a habit of blowing up the planning.

In my opinion, IRAs and 401(k)s should not even go to an estate. You probably remember designating a beneficiary when you enrolled in your 401(k) or opened an IRA. If married, your first (that is, primary) beneficiary was probably your spouse. You likely named your kids as secondary beneficiaries. Upon your death, the IRA or 401(k) will pass to the beneficiary(ies) under contract law. It happens automatically and does not need the approval – or oversight – of a probate judge.

So how does an IRA or 401(k) get into your estate for income taxation?

Easy: you never named a beneficiary.

It still surprises me – after all these years - how often this happens.

So now you have a chunk of money dropping into a taxable entity with sky-high tax rates.

And getting it out of the estate can also present issues.

Let’s look at the Ozimkoski case.

Suzanne and Thomas Ozimkoski were married. He died in 2006, leaving a simple two-page will and testament instructing that all his property (with minimal exceptions) was to go to his wife. Somewhere in there he had an IRA with Wachovia.

During probate, his son (Ozimkoski Junior) filed two petitions with the court. One was for outright revocation of his father’s will.

Upon learning of this, Wachovia immediately froze the IRA account.

Eventually Suzanne and Junior came to an agreement: she would pay him $110 grand (and a 1967 Harley), and he would go away. Junior withdrew both petitions before the probate court.

Wachovia of course needed copies: of the settlement, of probate court approval, and so on). There was one more teeny tiny thing:

… Jr had called and told a different Wachovia representative that he did not want an inherited IRA.”

What does this mean?

Easy. Unless that IRA was a Roth, somebody was going to pay tax when money came out of the account. That is the way regular IRAs work: it is not taxable now but is taxable later when someone withdraws the money.

My first thought would be to split the IRA into two accounts: one remaining with the estate and the second going to Junior.

Junior however understood that he would be taxed when he took out $110 grand. Junior did not want to pay tax: that is what “he did not want an inherited IRA” means.

It appears that Suzanne was not well-advised. She did the following: 

·       Wachovia transferred $235 grand from the estate IRA to her IRA.

·       Her IRA then distributed $141 grand to her.

·       She in turn transferred $110 grand to Junior.

Wachovia issued Form 1099-R to Suzanne for the distribution. There was no 1099-R to Junior, of course. Suzanne did not report the 1099-R because some of it went (albeit indirectly) to Junior. The IRS computers hummed and whirred, she received notices about underreporting income, and we eventually find her in Tax Court.

She argued that the $110 grand was not her money. It was Junior’s, pursuant to the settlement.

The IRS said: show me where Junior is a beneficiary of the IRA.

You don’t understand, Suzanne argued. There is something called a “conduit” IRA. That is what this was. I was the conduit to get the money to Junior.

The IRS responded: a conduit involves a trust, with Junior as the ultimate beneficiary of the trust. Is there a trust or trust agreement we can look at?

There was not, of course.

Junior received $110 grand, and the money came from the IRA, but Junior was no more a beneficiary of that IRA than you or I.

Back to general tax principles: who is taxed on an IRA distribution?

The person who receives the distribution – that is, the IRA beneficiary.

What if that person immediately transfers the distribution monies to someone else?

Barring unique circumstances – like a conduit – the transfer changes nothing. If Suzanne gave the money to her church, she would have a charitable donation. If she gave it to her kids, she might have a reportable gift. If she bought a Mercedes, then she bought an expensive personal asset. None of those scenarios keeps her from being taxed on the distribution.

Here is the Court:

What is clear from the record before the Court is that petitioner’s probate attorney failed to counsel here on the full tax ramifications of paying Mr. Ozimkoski, Jr., $110,000 from her own IRA.”

While the Court is sympathetic to petitioner’s argument, the distributions she received were from her own IRA and therefore are considered taxable income to her …”

She was liable for the taxes and inevitable penalties the IRS piled on.

Was this situation salvageable?

Not if Junior wanted $110,000 grand with no tax.

It was inevitable that someone was going to pay tax.

If Junior did not want tax, the $110 grand should be reduced by taxes that either Suzanne or the estate would pay on his behalf.

If Junior refused, then the settlement was not for $110 grand; it instead was for $110 grand plus taxes. That arrangement might have been acceptable to Suzanne, but – considering that she went to Tax Court – I don’t think it was.

The Court noted that Suzanne was laboring.

… she was overwhelmed by circumstances surrounding the will contest.”

While the Court is sympathetic to petitioner’s situation …”

Let me check on something. Yep, this is a pro se case.

Suzanne was relying on her probate attorney for tax advice. It seems clear that her attorney did not spot the issue. I would say Suzanne’s reliance on her attorney was misplaced.

Our case this time was Suzanne D. Oster Ozimkoski v Commissioner, T.C. Memo 2016-228.

A Call From Chuck

I was speaking with a client this week. He told me that he recently retired and his financial advisor recommended he discuss a matter with me.

Me:              So, what are we going to talk about?”

Chuck:         I worked for Costco for many years.”

Me:              OK.”

Chuck:         I bought their stock all along.”

Me:              Not sure where this is going. Are you diversifying?”

Chuck:         Have you heard of Net Unrealized Appreciation?”

Me:              Sure have, but how does that apply to you?”

That was not my finest moment. I did not immediately register that Chuck had – for many years – bought Costco stock inside of his 401(k).

Take a look at this stock chart: 

Costco stock was at $313 on February 7, 2020. Five years later it is at $1,043.

It has appreciated – a lot.

I missed the boat on that one.

The appreciation is unrealized because Chuck has not sold the stock.

The difference between the total value of the Costco stock in his 401(k) and his cost in the stock (that is, the amount he paid over the years buying Costco) is the net unrealized appreciation, abbreviated “NUA” and commonly pronounced (NEW-AHH).

And Chuck has a tax option that I was not expecting. His financial advisor did a good job of spotting it.

Let’s make up a few numbers as we talk about the opportunity here.

Say Chuck has 800 shares. At a price of $1,043, the stock is worth $834,400.

Say his average cost is 20 cents on the dollar: $834,400 times 20% = cost of $166,880.

Chuck also owns stocks other than Costco in his 401(k). We will say those stocks are worth $165,600, bring the total value of his 401(k) to an even $1 million.

Chuck retires. What is the likely thing he will do with that 401(k)?

He will rollover the 401(k) to an IRA with Fidelity, T Rowe, Vanguard, or someone like that.

He may wait or not, but eventually he will start taking distributions from the IRA. If he delays long enough the government will force him via required minimum distributions (RMDs).

How is the money taxed when distributed from the IRA?

It is taxed as ordinary income, meaning one can potentially run through all the ordinary tax rates.

It was not that long ago (1980) that the maximum tax rate was 70%. Granted, one would need a lot of income to climb through the rates and get to 70%. But people did. Can you imagine the government forcing you to take a distribution and then taking seventy cents on the dollar as its cut?

Hey, you say. What about those capital gains in the 401(k)?  Is there no tax pop there?

Think of a 401(k) as Las Vegas. What happens in Las Vegas stays in Las Vegas. What leaves Las Vegas is ordinary income.

And that gets us to net unrealized appreciation. Congress saw the possible unfairness of someone owning stock in a regular, ordinary taxable brokerage account rather than a tax-deferred retirement account. The ordinary taxable account can have long-term capital gains. The retirement account cannot.

Back to NEW-AHH.

How much is in that 401(k)?

A million dollars.

How much of that is Costco?

$834,400.

Let’s roll the Costco stock to a taxable brokerage account. Let’s roll the balance ($165,600) to an IRA.

This would normally be financial suicide, as stock going to a taxable account is considered a distribution. Distributions from an IRA are ordinary income. How much is ordinary income tax on $834,400? I can assure you it exceeds my ATM withdrawal limit.

Here is the NUA option:

You pay ordinary tax on your cost - not the value - in that Costco stock.

OK, that knocks it down to tax on $166,880.

It still a lot, but it is substantially less than the general rule.

Does that mean you never pay tax on the appreciation – the $667,520?

Please. Of course you will, eventually. But you now have two potentially huge tax planning options.

First, hold the stock for at least a year and a day and you will pay long-term capital gains (rather than ordinary income tax) rates on the gain.

QUIZ: Let’s say that the above numbers stayed static for a year and a day. You then sold all the stock. How much is your gain? It is $667,520 (that is, $834,400 minus $166,880). You get credit (called “basis” in this context) for the income you previously reported.

What is the second option?

You control when you sell the stock. If you want to sell a bit every year, you can delay paying taxes for years, maybe decades. Contrast this with MRDs, where the government forces you to distribute money from the account.

So why wouldn’t everybody go NUA?

Well, one reason is that (in our example) you pony up cash equal to the tax on the $166,880. I suppose you could sell some of the Costco stock to provide the cash, but that would create another gain triggering another round of tax.

A second reason is your specific tax situation. If you just leave it alone, distributions from a normal retirement account would be taxable as ordinary income. If you NUA, you are paying tax now for the possibility of paying reduced tax in the future. Take two people with differing incomes and taxes and whatnot and you might arrive at two different answers.

Here are high-profile points to remember about net unrealized appreciation:

(1)  There must exist a retirement account at work.

(2)  There must be company stock in that retirement account.

(3)  There is a qualified triggering event. The likely one is that you retired.

(4)  There must be a lump-sum distribution out of that retirement account. At the end of the day, the retirement account must be empty.

(5)  The stock part of the retirement account goes one way (to a taxable account), and the balance goes another way (probably to an IRA).

(6)  The stock must be distributed in kind. Selling the stock and rolling the cash will not work.

BTW taking advantage of NUA does not have to be all or nothing. We used $834,400 as the value of the Costco stock in the above example. You can NUA all of that – or just a portion. Let’s say that you want to NUA $400,000 of the $834,400. Can you do that? Of course you can.

Chuck has a tax decision that I will never have.

Why is that?

CPA firms do not have traded stock.

Sonny Corleone’s IRA

I remember him as Sonny Corleone in The Godfather. He is James Caan, and he passed away in July 2022.

I am reading a Tax Court case involving his (more correctly: his estate’s) IRA.

There is a hedge fund involved.

For the most part, we are comfortable with “traditional” investments: money markets, CDs, stocks, bonds, mutual funds holding stocks and bonds and the mutual fund’s updated sibling: an ETF holding stocks and bonds.

Well, there are also nontraditional investments: gold, real estate, cryptocurrency, private equity, hedge funds. I get it: one is seeking additional diversification, low correlation to existing investments, enhanced protection against inflation and so forth.

For the most part, I consider nontraditional investments as more appropriate for wealthier individuals. Most people I know have not accumulated sufficient wealth to need nontraditional assets.

There are also tax traps with nontraditional assets in an IRA. We’ve talked before about gold. This time let’s talk about hedge funds.

James Caan had his cousin (Paul Caan) manage two IRAs at Credit Suisse. Paul wanted to take his career in a different direction, and he transferred management of the IRAs to Michael Margiotta. Margiotta left Credit Suisse in 2004, eventually winding up at UBS.

The wealthy are not like us. Caan, for example, utilized Philpott, Bills, Stoll and Meeks (PBSM) as his business manager. PBSM would:

·       Receive all Caan’s mail

·       Pay his bills

·       Send correspondence

·       Prepare his tax returns

·       Act as liaison with his financial advisors, attorneys, and accountants

I wish.

Caan had 2 IRAs at UBS. One was a regular, traditional, Mayberry-style IRA.

The second one owned a hedge fund.

The tax Code requires the IRA trustee or custodian to file reports every year. You probably have seen them: how much you contributed over the last year, or the balance in the IRA at year-end. Innocuous enough, except possibly for that year-end thing. Think nontraditional asset. How do you put a value on it? It depends, I suppose. It is easy enough to look up the price of gold. What if the asset is trickier: undeveloped land outside Huntsville, Alabama – or a hedge fund?

UBS had Caan sign an agreement for the IRA and its hedge fund.

The Client must furnish to the Custodian in writing the fair market value of each Investment annually by the 15th day of each January, valued as of the preceding December 31st, and within twenty days of any other written request from the Custodian, valued as of the date specified in such request. The Client acknowledges, understands and agrees that a statement that the fair market value is undeterminable, or that cost basis should be used is not acceptable and the Client agrees that the fair market value furnished to the Custodian will be obtained from the issuer of the Investment (which includes the general partner or managing member thereof). The Client acknowledges, understands and agrees that if the issuer is unable or unwilling to provide a fair market value, the Client shall obtain the fair market value from an independent, qualified appraiser and the valuation shall be furnished on the letterhead of the person providing the valuation.

Got it. You have to provide a number by January 15 following year-end. If it is a hassle, you have to obtain (and you pay for) an appraisal.

What if you don’t?

The Client acknowledges, understands and agrees that the Custodian shall rely upon the Client’s continuing attention, and timely performance, of this responsibility. The Client acknowledges, understands and agrees that if the Custodian does not receive a fair market value as of the preceding December 31, the Custodian shall distribute the Investment to the Client and issue an IRS Form 1099–R for the last available value of the Investment.

Isn’t that a peach? Hassle UBS and they will distribute the IRA and send you a 1099-R. Unless that IRA is rolled over correctly, that “distribution” is going to cost you “taxes.”

Let’s start the calendar.

March 2015		UBS contacted the hedge fund for a value.
June 2015		Margiotta left UBS for Merrill Lynch.
August 2015		Striking out, UBS contacted PBSM for a value.
October 2015		Hearing nothing, UBS sent PBSM a letter saying UBS was going to resign as IRA custodian in November.
October 2015		Margiotta had Caan sign paperwork to transfer the IRAs from UBS to Merrill Lynch.
		There was a problem: all the assets were transferred except for the hedge fund.
December 2015		UBS sent PBSM a letter saying that it had distributed the hedge fund to Caan.
January 2016		UBS sent a 1099-R.
March 2016		Caan’s accountant at PBSM sent an e-mail to Merrill Lynch asking why the hedge fund still showed UBS as custodian.
December 2016		Margiotta requested the hedge fund liquidate the investment and send the cash to Merrill Lynch.
November 2017		The IRS sent the computer matching letter wanting tax on the IRA distribution. How did the IRS know about it? Because UBS sent that 1099-R.

The IRS wanted taxes of almost $780 grand, with penalties over $155 grand.

That caught everyone’s attention.

July 2018

Caan requested a private letter ruling from the IRS.

Caan wanted mitigation from an IRA rollover that went awry. This would be a moment for PBSM (or Merrill) to throw itself under the bus: taxpayer relied on us as experts to execute the transaction and was materially injured by our error or negligence….

That is not wanted they requested, though. They requested a waiver of the 60-day requirement for rollover of an IRA distribution.

I get it: accept that UBS correctly issued a 1099 for the distribution but argue that fairness required additional time to transfer the money to Merrill Lynch.

There is a gigantic technical issue, though.

Before that, I have a question: where was PBSM during this timeline? Caan was paying them to open and respond to his mail, including hiring and coordinating experts as needed. Somebody did a lousy job.

The Court wondered the same thing.

Both Margiotta and the PBSM accountant argued they never saw the letters from UBS until litigation started. Neither had known about UBS making a distribution.

Here is the Court:

            We do not find that portion of either witness’ testimony credible.

Explain, please.

We find it highly unlikely that PBSM received all mail from UBS— statements, the Form 1099–R, and other correspondence—except for the key letters (which were addressed to PBSM). Additionally, the March 2016 email between Ms. Cohn and Mr. Margiotta suggests that both of them knew of UBS’s representations that it had distributed the P&A Interest. It seems far more likely that there was simply a lack of communication and coordination between the professionals overseeing Mr. Caan’s affairs, especially given the timing of UBS’s letters, Mr. Margiotta’s move from UBS to Merrill Lynch, and the emails between Mr. Margiotta and Ms. Cohn. If all parties believed that UBS was still the P&A Interest’s custodian, why did no one follow up with UBS when it ceased to mail account statements for the IRAs? And why, if everyone was indeed blindsided by the Form 1099–R, did no one promptly follow up with UBS regarding it? (That followup did not occur until after the IRS issued its Form CP2000.) The Estate has offered no satisfactory explanation to fill these holes in its theory.

I agree with the Court.

I think that PBSM and/or Merrill Lynch should have thrown themselves under the bus.

But I would probably still have lost. Why? Look at this word salad:

        408(d) Tax treatment of distributions.

         (3)  Rollover contribution.

An amount is described in this paragraph as a rollover contribution if it meets the requirements of subparagraphs (A) and (B).

(A)  In general. Paragraph (1) does not apply to any amount paid or distributed out of an individual retirement account or individual retirement annuity to the individual for whose benefit the account or annuity is maintained if-

(i)  the entire amount received (including money and any other property) is paid into an individual retirement account or individual retirement annuity (other than an endowment contract) for the benefit of such individual not later than the 60th day after the day on which he receives the payment or distribution; or

(ii)  the entire amount received (including money and any other property) is paid into an eligible retirement plan for the benefit of such individual not later than the 60th day after the date on which the payment or distribution is received, except that the maximum amount which may be paid into such plan may not exceed the portion of the amount received which is includible in gross income (determined without regard to this paragraph).

I highlighted the phrase “including money and any other property.” There is a case (Lemishow) that read a “same property” requirement into that phrase.

What does that mean in non-gibberish?

It means that if you took cash and property out of UBS, then the same cash and property must go into Merrill Lynch.

Isn’t that what happened?

No.

What came out of UBS?

Well, one thing was that hedge fund that caused this ruckus. UBS said it distributed the hedge fund to Caan. They even issued him a 1099-R for it.

What went into Merrill Lynch?

Margiotta requested the hedge fund sell the investment and send the cash to Merrill Lynch.

Cash went into Merrill Lynch.

What went out was not the same as what went in.

Caan (his estate, actually) was taxable on the hedge fund coming out of the UBS IRA.

Dumb. Unnecessary. Expensive.

Our case this time was Estate of James E. Caan v Commissioner, 161 T.C. No. 6, filed October 18, 2023.

Repaying a COVID-Related Distribution

Do you remember a tax break in 2020 that allowed you to take (up to) $100,000 from your IRA or your employer retirement plan? These were called “coronavirus-related distributions,” or CRDs in the lingo. In and of itself, the provision was not remarkable. What was remarkable is that one was allowed three years to return some, all, or none of the money to the IRA or employer plan, as one wished.

I was thinking recently that I do not remember seeing 2021 individual returns where someone returned the money.

Granted, we have a flotilla of returns on extension here at Galactic Command. I may yet see this beast in its natural state.

Let’s go over how this provision works.

To make it easy, let’s say that you took $100,000 from your 401(k) in 2020 for qualifying COVID-related reasons.

You had an immediate binary decision:

·      Report the entire $100,000 as income in 2020 and pay the taxes immediately.

·      Spread the reporting of the $100 grand over three years – 2020, 2021 and 2022 - and pay taxes over three years.

There was no early-distribution penalty on this distribution, which was good.

You might wonder how paying the tax immediately could be preferable to paying over three years. It could happen. How? Say that you had a business and it got decimated by COVID lockdowns. Your 2020 income might be very low – heck, you might even have an overall tax loss. If that were the case, reporting the income and paying the tax in 2020 might make sense, especially if you expected your subsequent years’ income to return to normal levels.

What was a COVID-related reason for a distribution?

The easy ones are:

·      You, a spouse or dependent were diagnosed (and possibly quarantined) with COVID;

·      You had childcare issues because of COVID;

·      You were furloughed, laid-off or had work hours reduced because of COVID.

Makes sense. There is one more:

·      You experienced other “adverse financial consequences” because of COVID.

That last one has an open-gate feel to me. I’ll give you an example:

·      You own rental cabins in Aspen. No one was renting your cabins in 2020. Did you experience “adverse financial consequences” triggering this tax provision?

You have – should you choose to do so – three years to put the money back. The three-year period starts with the date of distribution, so it does not automatically mean (in fact, it is unlikely to be) December 31^st three years later.

The money doesn’t have to return to the same IRA or employer plan. Any qualifying IRA or employer plan will work. Makes sense, as there is a more-than-incidental chance that someone no longer works for the same employer.

 Let’s say that you decide to return $50 grand of the $100 grand.

The tax reporting depends on how you reported the $100 grand in 2020.

Remember that there were two ways to go:

·      Report all of it in 2020

This is easy.

You reported $100 grand in 2020.

When you return $50 grand you … amend 2020 and reduce income by $50 grand.

What if you return $50 grand over two payments – one in 2021 and again in 2022?

Easy: you amend 2020 for the 2021 and amend 2020 again for the 2022.

Question: can you keep amending like that – that is, amending an amended?

Answer: you bet.

·       Report the $100 grand over three years.

This is not so easy.

The reporting depends on how much of the $100 grand you have left to report.

Let’s say that you are in the second year of the three-year spread and repay $30,000 to your IRA or employer plan.

The test here is: did you repay the includable amount (or less) for that year?

If yes, just subtract the repayment from the includable amount and report the difference on that year’s return.

In our example, the math would be $33,333 - 30,000 = $3,333. You would report $3,333 for the second year of the spread.

If no, then it gets ugly.

Let’s revise our example to say that you repaid $40,000 rather than $30,000.

First step: You would offset the current-year includable amount entirely. There is nothing to report the second year, and you still have $6,667 ($40,000 – 33,333) remaining.

You have a decision.

You have a year left on the three-year spread. You could elect to carryforward the $6,667 to that year. You would report $26,666 ($33,333 – 6,667) in income for that third and final year.

You could alternatively choose to amend a prior year for the $6,667. For example, you already reported $33,333 in 2020, so you could amend 2020, reduce income by $6,666 and get an immediate tax refund.

Which is better? Neither is inherently better, at least to my thinking. It depends on your situation.

There is a specific tax form to use with spreads and repayments of CRDs. I will spare us the details for this discussion.

There you have it: the ropes to repaying a coronavirus-related distribution (CRD).

If you reflect, do you see the complexity Congress added to the tax Code? Multiply this provision by however many times Congress alters the Code every year, and you can see how we have gotten to the point where an average person is probably unable to prepare his/her own tax return.

 

IRAs and Nonqualified Compensation Plans

Can an erroneous Form 1099 save you from tax and penalties?

It’s an oddball question, methinks. I anticipate the other side of that see-saw is whether one knew, or should have known, better.

Let’s look at the Clair Couturier case.

Clair is a man, by the way. His wife’s is named Vicki.

Clair used to be the president of Noll Manufacturing (Noll).

Clair and Noll had varieties of deferred compensation going on: 

(1)   He owned shares in the company employee stock ownership program (ESOP).

(2)   He had a deferred compensation arrangement (his “Compensation Continuation Agreement”) wherein he would receive monthly payments of $30 grand when he retired.

(3)   He participated in an incentive stock option plan.

(4)   He also participated in another that sounds like a phantom stock arrangement or its cousin. The plan flavor doesn’t matter; no matter what flavor you select Clair is being served nonqualified deferred compensation in a cone.

Sounds to me like Noll was taking care of Clair.

There was a corporate reorganization in 2004.

Someone wanted Clair out.

COMMENT: Let’s talk about an ESOP briefly, as it is germane to what happened here. AN ESOP is a retirement plan. Think of it as 401(k), except that you own stock in the company sponsoring the ESOP and not mutual funds at Fidelity or Vanguard. In this case, Noll sponsored the ESOP, so the ESOP would own Noll stock. How much Noll stock would it own? It can vary. It doesn’t have to be 100%, but it might be. Let’s say that it was 100% for this conversation. In that case, Clair would not own any Noll stock directly, but he would own a ton of stock indirectly through the ESOP.

If someone wanted him out, they would have to buy him out through the ESOP.

Somebody bought out Clair for $26 million.

COMMENT: I wish.

The ESOP sent Clair a Form 1099 reporting a distribution of $26 million. The 1099 indicated that he rolled-over this amount to an IRA.

Clair reported the roll-over on his 2004 tax return. It was just reporting; there is no tax on a roll-over unless someone blows it.

QUESTION: Did someone blow it?

Let’s go back. Clair had four pieces to his deferred compensation, of which the ESOP was but one. What happened to the other three?

Well, I suppose the deal might have been altered. Maybe Clair forfeited the other three. If you pay me enough, I will go away.

Problem:

         § 409 Qualifications for tax credit employee stock ownership plans

So?

        (p)  Prohibited allocations of securities in an S corporation

                      (4)  Disqualified person

Clair was a disqualified person to the ESOP. He couldn’t just make-up whatever deal he wanted. Well, technically he could, but the government reserved the right to drop the hammer.

The government dropped the hammer.

The Department of Labor got involved. The DOL referred the case to the IRS Employee Plan Division. The IRS was looking for prohibited transactions.

Found something close enough.

Clair was paid $26 million for his stock.

The IRS determined that the stock was worth less than a million.

QUESTION: What about that 1099 for the rollover?

ANSWER: You mean the 1099 that apparently was never sent to the IRS?

What was the remaining $25 million about?

It was about those three nonqualified compensation plans.

Oh, oh.

This is going to cost.

Why?

Because only funds in a qualified plan can be rolled to an IRA.

Funds in a nonqualified plan cannot.

Clair rolled $26 million. He should have rolled less than a million.

Wait. In what year did the IRS drop the hammer?

In 2016.

Wasn’t that outside the three-year window for auditing Clair’s return?

Yep.

So Clair was scot-free?

Nope.

The IRS could not adjust Clair’s income tax for 2004. It could however tag him with a penalty for overfunding his IRA by $25 million.

Potato, poetawtoe. Both would clock out under the statute of limitations, right?

Nope.

There is an excise tax (normal folk call it a “penalty”) in the Code for overfunding an IRA. The tax is 6 percent. That doesn’t sound so bad, until you realize that the tax is 6 percent per year until you take the excess contribution out of the IRA.

Clair never took anything out of his IRA.

This thing has been compounding at 6 percent per year for … how many years?

The IRS wanted around $8.5 million.

The Tax Court agreed.

Clair owed.

Big.

Our case this time was Couturier v Commissioner, T.C. Memo 2022-69.

Are Minimum Required Distribution Rules Changing Again?

I wonder what is going on at the IRS when it comes to IRA minimum required distributions.

You may recall that prior law allowed for something called a “stretch” IRA.  The idea was simple, but planners and advisors pushed on it so long and so hard that Congress changed the law.

An IRA (set aside Roth IRAs for this discussion) must start distributing at some point in time. The tax Code tells you the minimum you must distribute. If you want more, well, that is up to you and the tax Code has nothing further to say.  The minimum distribution uses actuarial life expectancies in its calculation. Here is an example:

                   Age of IRA Owner            Life Expectancy

                            72                                    27.4

                            73                                    26.5

                            74                                    25.5

                            75                                    24.6                                        

Let’s say that you are 75 years old, and you have a million dollars in your IRA. Your minimum required distribution (MRD) would be:

                  $1,000,000 divided by 24.6 = $40,650

There are all kinds of ancillary rules, but let’s stay with the big picture. You have to take out at least $40,650 from your IRA.

President Trump signed the SECURE Act in late 2019 and upset the apple cart. The new law changed the minimum distribution rules for everyone, except for special types of beneficiaries (such as a surviving spouse or a disabled person).

How did the rules change?

Everybody other than the specials has to empty the IRA in or by the 10^th year following the death.

OK.

Practitioners and advisors presumed that the 10-year rule meant that one could skip MRDs for years 1 through 9 and then drain the account in year 10. It might not be the most tax-efficient thing to do, but one could.

The IRS has a publication (Publication 590-B) that addresses IRA distributions. In March, 2021 it included an example of the new 10-year rule. The example had the beneficiary pulling MRDs in years 1 through 9 (just like before) and emptying the account in year 10.

Whoa! exclaimed the planners and advisors. It appeared that the IRS went a different direction than they expected. There was confusion, tension and likely some anger.

The IRS realized the firestorm it had created and revised Publication 590-B in May with a new example. Here is what it said:

For example, if the owner dies in 2020, the beneficiary would have to fully distribute the plan by December 31, 2030. The beneficiary is allowed, but not required, to take distributions prior to that date.”

The IRS, planners and advisors were back in accord.

Now I am skimming the new Proposed Regulations. Looks like the IRS is changing the rules again.

The Regs require one to separate the beneficiaries as before into two classes: those exempt from the 10-year rule (the surviving spouse, disabled individuals and so forth) and those subject to the 10-year rule.

Add a new step: for the subject-to group and divide them further by whether the deceased had started taking MRDs prior to death. If the decedent had, then there is one answer. If the decedent had not, then there is a different answer.

Let’s use an example to walk through this.

Clark (age 74) and Lois (age 69) are killed in an accident. Their only child (Jon) inherits their IRA accounts.

Jon is not a disabled individual or any of the other exceptions, so he will be subject to the 10-year rule.

One parent (Clark) was old enough to have started MRDs.

The other parent (Lois) was not old enough to have started MRDs.

Jon is going to see the effect of the proposed new rules.

Since Lois had not started MRDs, Jon can wait until the 10^th year before withdrawing any money. There is no need for MRDS because Lois herself had not started MRDs.

OK.

However, Clark had started MRDs. This means that Jon must take MRDs beginning the year following Clark’s death (the same rule as before the SECURE Act). The calculation is also the same as the old stretch IRA: Jon can use his life expectancy to slow down the required distributions – well, until year 10, of course.

Jon gets two layers of rules for Clark’s IRA:

·      He has to take MRDs every year, and

·      He has to empty the account on or by the 10^th year following death

There is a part of me that gets it: there is some underlying rhyme or reason to the proposed rules.

However, arbitrarily changing rules that affect literally millions of people is not effective tax administration.

Perhaps there is something technical in the statute or Code that mandates this result. As a tax practitioner in mid-March, this is not my time to investigate the issue.  

The IRS is accepting comments on the proposed Regulations until May 25.

I suspect they will hear some.