Using A Liquidating Trust

I am reading a case where the IRS wanted taxes of almost $1.5 million.

I am not surprised to read that it involved a real estate developer.

Part of tax practice is working within someone’s risk tolerance (including mine, by the way). Some clients are so risk adverse that an IRS notice – on any matter for any reason – can be interpreted as a mistake by the tax practitioner. Then you have the gunslingers at the other end of the spectrum. These are the clients you have to rope-in, for their own as well as your sake.

My experience has been that real estate developers seem to cluster around the gunslinger end of the spectrum. We have one who recently explained to me that “paying taxes means that the tax advisor made a mistake.” That, folks, is a lot of pressure … on my partner.

Jason Sage is a developer in Oregon. He represented several companies, including JLS Customs Homes. You may recall that 2008 – 2009 was a rough time for real estate, and JLS took it in the teeth. It had three projects, dragging behind approximately $18 million in debt.

Eventually the real estate market collapsed. Sage had to do something. He and his advisors decided to utilize liquidating trusts. The idea is that one transfers everything one has into a trust, which might be owned by one’s creditors; then again, it might not. The creditors might accept the settling of the trust (a fancy term for putting money and assets into a trust) as discharge of the underlying debt; then again, they might not. Each deal is its own story, and the tax consequences can vary depending on the telling.

Our story involves the transfer of three projects to three liquidating trusts. Since real estate had tanked, these transfers – treated for tax purposes as sales - threw off huge losses. These losses were so big they created overall losses - called “net operating losses” (NOLs). Tax law at the time allowed the net operating losses to travel back in time, meaning that Sage could recoup taxes previously paid.

COMMENT: I see nothing wrong with this. If the government wants to participate in one’s profits, then it can also participate in one’s losses. To do otherwise smacks more of robbery than taxation.

The IRS took a look at this arrangement and immediately called foul.

Trust taxation looks carefully at whether the trust is a separate tax entity from the person establishing the trust, funding the trust or benefiting from the trust.  There is a type called a “grantor trust” which is disregarded as a separate tax entity altogether. The most common type of grantor trust is probably the “living trust,” which has gained popularity as a probate-mitigating tool. The idea behind the grantor trust is that the grantor – say me, for example – is allowed to put money in, take money out, change beneficiaries, even terminate the trust altogether without anyone being able to gainsay my decision.

Tax law considers this to be too much control over the trust, so the trust and I are considered to be the same person for tax purposes. I would have a grantor trust. Its tax return is combined with mine.

How do I avoid this result? Well, I have to start with limiting my otherwise unrestricted control over the trust. Yield enough control and the IRS will respect the trust as separate from me.

The IRS argued that Sage’s liquidating trusts were grantor trusts. They were not separate tax entities, and one cannot sell and create a loss by selling to oneself. Without that loss, there was no NOL carryover and therefore no tax refund.

Sage had to persuade the Court that the trusts were in fact separate from him and his companies.

After all, the trusts were for the benefit of his creditors. One has to concede that creditors are an adverse party, and the existence of an adverse party is an indicator that the trust is a separate tax entity. Extrapolating, the existence of creditors means that someone with interests adverse to Sage’s own had sway over the trusts. It was that sway that made these non-grantor trusts.

Persuasive, except for one thing.

Sage had never involved the creditors when setting up the trusts.

It was hard for them to be adverse when they did not even know the trusts were there.

Our case this time was Sage v Commissioner.

Can Creditors Reach The Retirement Account Of A Divorced Spouse?

Let’s say that you divorce. Let say that retirement savings are unequal between you and your ex-spouse. As part of the settlement you receive a portion of your spouse’s 401(k) under a “QDRO” order.

COMMENT: A QDRO is a way to get around the rule prohibiting alienation or assignment of benefits under a qualified retirement plan. I generally think of QDROs as arising from divorce, but they could also go to a child or other dependent of the plan participant.

Your QDRO has (almost) the same restrictions as any other retirement savings. As far as you or I are concerned, it IS a retirement account.

You file for bankruptcy.

Can your creditors reach the QDRO?

Sometimes I scratch my head over bankruptcy decisions. The reason is that bankruptcy – while having tax consequences – is its own area of law. If the law part pulls a bit more weight than the tax part, then the tax consequence may be nonintuitive.

Let’s segue to an inherited IRA for a moment. Someone passes away and his/her IRA goes to you. What happens to it in your bankruptcy?

The Supreme Court addressed this in Clark, where the Court had to address the definition of “retirement funds” otherwise protected from creditors in bankruptcy.

The Court said there were three critical differences between a plain-old IRA and an inherited IRA:

(1)  The holder of an inherited IRA can never add to the account.

(2)  The holder of an inherited IRA must draw money virtually immediately. There is no waiting until one reaches or nears retirement.

(3)  The holder of an inherited IRA can drain the account at any time – and without a penalty.

The Court observed that:

Nothing about the inherited IRA’s legal characteristics would prevent (or even discourage) the individual from using the entire balance of the account on a vacation home or sports car immediately after bankruptcy proceedings are complete.”

The Court continued that – to qualify under bankruptcy – it is not sufficient that monies be inside an IRA. Those monies must also rise to the level of “retirement funds,” and – since the inheritor could empty the account at a moment’s notice - the Court was simply not seeing that with inherited IRAs.

I get it.

Let’s switch out the inherited IRA and substitute a QDRO. With a QDRO, the alternate payee steps into the shoes of the plan participant.

The Eighth Circuit steps in and applies the 3-factor test of Clark to the QDRO. Let’s walk through it:

(1)  The alternate payee cannot add to a QDRO.

(2)  The alternate payee does not have to start immediate withdrawals – unless of required age.

(3)  The alternate payee cannot – unless of required age - immediately empty the account and buy that vacation home or sports car.

By my account, the QDRO fails the first test but passes the next two. Since there are three tests and the QDRO passes two, I expect the QDRO to be “retirement funds” as bankruptcy law uses the term.

And I would be wrong.

The Eighth Circuit notes that tests 2 and 3 do not apply to a QDRO. The Court then concludes that the QDRO has only one test, and the QDRO fails that.

The Eighth Circuit explains that Clark:

… clearly suggests that the exemption is limited to individuals who create and contribute funds into the retirement account.”

It is not clear to me, but there you have it – at least if you live in the Eighth Circuit.

No bankruptcy protection for you.

Our case this time for the home gamers was In re Lerbakken.

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.

Losing Bankruptcy Protection On Your IRA

You probably know that monies in your IRA are protected from bankruptcy. No one intends to go there, but it’s nice to know that you have that safeguard.

What do you have to do to void that protection?

Enter Ernest Willis and his IRAs (Willis v Menotte).

Willis opened a self-directed IRA with Merrill Lynch in March, 1993. On December 20, 1993 he withdrew $700,000to help him with a real estate transaction. On February 22, 1994 he put the $700,000 back in the IRA.

NOTE: Let’s count the days… 12 + 31 +22 = 65 days. You may remember that you can withdraw money from your IRA and not have it count as a distribution IF you replace it within 60 days. Looks like Willis missed his count.

In January, 1997 Willis had problems with the stock market. He had to put money into his brokerage account (I presume he was on margin), so he wrote checks back and forth between his IRA and the brokerage account. The settlement takes a few days, so he could keep the brokerage account afloat by swapping checks. Since he was replacing the IRA monies within 60 days, he did not have a distribution.

Somewhere in here Willis partially rolled-over his Merrill Lynch account to AmTrust and Fidelity.

In February, 2007 Willis filed for bankruptcy. The creditor wanted his IRA. Willis said NO NO and NO. The IRA is protected by Bankruptcy Code Section 522(b) (4) (A). “Go away” says Willis.

The bankruptcy court takes a look at the IRA transactions. An IRA is not allowed to participate in certain transactions (called “prohibited transactions”) with its fiduciary. Guess what? If you direct a self-directed IRA, you are a “fiduciary.” Willis tapped into his IRA and did not replace the money within 60 days. The 60 days is not a suggestion; it is the statute. He didn’t make it. He put the money back in there, but this was not horseshoes. This was a prohibited transaction.

The court was also not too amused with the check swapping scheme and his brokerage account. The court observed that this had the effect of a loan between Willis and his IRA. An IRA cannot loan money, and it especially cannot loan money to its fiduciary. This was a prohibited transaction.

The bankruptcy court held against Willis. He appealed to the district court. That court sustained. Willis next appealed to the Eleventh Circuit, and the circuit court has just sustained the district court. Willis has lost.

How much money was in these IRAs? The Merrill Lynch account alone was over $1.2 million.

I have known clients to “borrow” from their IRA, and I especially remember one doing this while Rick and I worked together at another firm a few years ago. I remember counting down and sweating the 60 days. This was a sensitive client, and – if it blew up – I was going to take massive damage. Willis unfortunately did not keep it to 60 days. He must have been strapped, because he wound up borrowing from friends and family. He put the money back into the IRA, but he had missed the window. The later episode with the check swapping was just icing on the cake.

The court pointed out that once the IRA was tainted, the taint followed the partial rolls to the other two IRAs. His three IRAs were unprotected and could be actioned by his bankruptcy creditors.

Willis thought he was clever. He got schooled, and the tuition was expensive.