Becoming Personally Liable For An Estate’s Taxes

 

I had lunch with a friend recently. He is executor for an estate and was telling me about some … questionable third-party behavior and document discoveries. I left the conversation underwhelmed with his attorney and recommending a replacement as soon as possible. There are two other beneficiaries to this estate, and he has a fiduciary responsibility as executor.

Granted, all are family and get along. The risk - it seems to me - is minimal.

It is not always that way. I have a client whose family was ripped apart by an inheritance. I shake my head, as there was not enough money there (methinks) to spat over, much less exact lifelong grudges. However, he was executor and so-and-so received such-and-such back when Carter first started making liver pills and he should have offset someone for … oh, who knows.

Being executor can be a thankless job.

It can also get one into trouble.

Let’s take a look at the Lee estate.

Kwang Lee died testate in September, 2001.

         COMMENT: Testate means someone died with a will.

A municipal court judge was named executor.

The judge filed the estate return in May, 2003.

COMMENT: The return was late, but there was some complexity as both spouses died within six months. There was language in the will about a-spouse-is-considered-to-survive-if that created some confusion.

COMMENT: It doesn’t matter. You know the IRS is coming in with penalties.

The IRS audited the return.

 In April 2006 the IRS issued a Notice of Deficiency for over $1,000,000. 

COMMENT: The IRS also wanted a penalty over $255 grand for late filing.

The executor filed with the Tax Court.

 In February, 2007 the executor distributed $640,000 to the beneficiaries.

COMMENT: Pause on what happened here. The IRS wanted additional tax and penalties. The executor was contesting this in Tax Court. The issue was live when the executor distributed the money.

Is there a risk?

You bet.

What if the estate lost its case and did not have enough money left to pay the tax and penalties?

The Tax Court gave the executor a partial win: the estate owed closer to a half million dollars than a million. The Court also waived the penalties.

The estate did not have a half million dollars. It did have $182,941.

The estate submitted an offer in compromise to the IRS for $182,941.

The IRS looked at the offer and said: are you kidding me? What about that $640,000 you distributed before its time?

The IRS pointed out this bad boy:

31 U.S. Code § 3713.Priority of Government claims

(a)

(1) A claim of the United States Government shall be paid first when—

(A) a person indebted to the Government is insolvent and—

(i) the debtor without enough property to pay all debts makes a voluntary assignment of property;

(ii) property of the debtor, if absent, is attached; or

(iii) an act of bankruptcy is committed; or

(B) the estate of a deceased debtor, in the custody of the executor or administrator, is not enough to pay all debts of the debtor.

(2) This subsection does not apply to a case under title 11.

(b) A representative of a person or an estate (except a trustee acting under title 11) paying any part of a debt of the person or estate before paying a claim of the Government is liable to the extent of the payment for unpaid claims of the Government. 

The effect of Section 3713 is to make the executor personally liable for a debt to the U.S. when: 

o  The estate was rendered insolvent by a distribution, and

o  The executor had knowledge or notice of the government’s claim at the time of the distribution.

The judge/executor did the only thing he could do: he challenged the charge that he had actual knowledge of a deficiency when he distributed the $640,000.

The executor was hosed. I am not sure what more of a wake-up-call the executor needed than an IRS Notice of Deficiency. For goodness’ sake, he filed a petition with the Tax Court in response.

Maybe he thought that he would win in Tax Court.

He did, by the way, but partially. The tax was cut in half, and the penalties were waived.

Notice that the estate would not have had enough money had it lost the case in full. The tax would have been over a million, with additional penalties of a quarter million. Under the best of circumstances, the estate would have had cash of approximately $822 thousand and unable to pay in full.

In that case I doubt Section 3713 would have applied. The estate would have conserved its cash upon receiving a Notice of Deficiency.

But the estate did not conserve its cash upon receiving a Notice of Deficiency.

The executor became personally liable.

Mind you, this may work out. Perhaps the beneficiaries return the cash; perhaps there is a claim under a performance bond.

Still, why would an executor – especially a skilled attorney and municipal judge – go there?

Our case this time was Estate of Lee v Commissioner, T.C. Memo 2021-92.

Exceptions to Early Distribution Penalties

 

What caught my eye about the case was the reference to an “oral opinion.”

Something new, methought.

Better known as a “bench opinion.’

Nothing new, methinks.

What happened is that the Tax Court judge rendered his/her opinion orally at the close of the trial.

Consider that a tax case will almost certainly include Code section and case citations, and I find the feat impressive.

Let’s talk about the case, though, as there is a tax gotcha worth discussing.

Molly Wold is a licensed attorney. She was laid-off in 2017. Upon separation, she pulled approximately $86 grand from her 401(k) for the following reasons:

(1)  Pay back a 401(k) loan

(2)  Medical expenses

(3)  Student loans

(4)  Mortgage and other household expenses

You probably know that pulling money from a 401(k) is a taxable event (set aside a Roth 401(k), or we are going to drive ourselves nuts with the “except-fors”).

Alright, she will have income tax.

Here is the question: will she have an early distribution penalty?

This is the 10% penalty for taking money out from a retirement account, whether a company plan (401(k), 403(b), etc) or IRA and IRA-based plans (SIMPLE, SEP, etc). Following are some exceptions to the penalty:

·      Total and permanent disability

·      Death of the account owner

·      Payments over life expectancy; these are sometimes referred to as “Section 72(t)” payments.

·      Unreimbursed medical expenses (up to a point)

·      IRS levy

·      Reservist on active duty

Then it gets messy, as some exceptions apply only to company-based plans:

·      Leaving your job on reaching age 55 (age 50 if a public safety employee)

Is there a similar rule for an IRA?

·      Withdrawals after attaining age 59 ½.

Why age 55 for a 401(k) but 59 ½ for an IRA?

Who knows.

Molly was, by the way, younger than age 55.

There are exceptions that apply only to a company-based plan:

·      A qualified domestic relations order (that is, a divorce)

·      Dividends from an ESOP

There are exceptions that apply only to an IRA and IRA-based plans:

·      Higher education expenses

·      First-time homebuyer (with a maximum of $10,000)

Yes, Congress should align the rules for both company, IRA and IRA-based plans, as this is a disaster waiting to happen.

However, there is one category that all of them exclude.

Ms Wold might have gotten some pop out of the exception for medical expenses, but that exclusion is lame. The excluded amount is one’s medical expenses exceeding 7.5% of adjusted gross income (AGI). I suppose it might amount to something if you are hit by the proverbial bus.

The rest of the $86 grand would have been for general hardship.

Someone falls on hard times. They turn to their retirement account to help them out. They take a distribution. The plan issues a 1099-R at year-end. Said someone says to himself/herself: “surely, there is an exception.”

Nope.

There is no exception for general hardship.

10% penalty.

Let’s go next to the bayonet-the-dead substantial underpayment penalty. This penalty kicks-in when the additional tax is the greater of $5,000 or 10% of the tax that should have been shown on the return.

Folks, considering the years that penalty has been around, you would think Congress could cut us some slack and at least increase the $5 grand to $10 grand, or whatever the inflation-adjusted equivalent would be.

Ms Wold requested abatement of the penalty for reasonable cause.

Reasonable cause would be that this area of the Code is a mess.

You know who doesn’t get reasonable cause?

An attorney.

Here is the Court:

So I will hold her as a lawyer and as a highly intelligent person with a good education to what IRS instructions that year showed.”

Our case this time was Woll v Commissioner, TC Oral Order.

Abandoning A Partnership Interest

I suspect that most taxpayers know that there is a difference between long-term capital gains and ordinary income. Long-term capital gains receive a lower tax rate, incentivizing one to prefer long-terms gains, if at all possible.

Capital losses are not as useful. Capital losses offset capital gains, whether short-term or long-term. If one has net capital losses left over, then one can claim up to $3,000 of such losses to offset non-capital gain income (think your W-2).

That $3,000 number has not changed since I was in school.

And there is an example of a back-door tax increase. Congress has imposed an effective tax increase by not pegging the $3,000 to (at least) the rate of inflation for the last how-many decades. It is the same thing they have done with the threshold amount for the net investment income or the additional Medicare tax. It is an easy way to raise taxes without publicly raising taxes.

I am looking at a case where two brothers owned Edwin Watts Golf. Most of the stores were located on real estate also owned by the brothers, so the brothers owned two things: a golf supply business and the real estate it was housed in.

In 2003 a private equity firm (Wellspring) offered the brothers $93 million for the business. The brothers took the money (so would I), kept the real estate and agreed to certain terms, such as Wellspring having control over any sale of the business. The brothers also received a small partnership position with Wellspring.

Why did they keep the real estate? Because the golf businesses were paying rent, meaning that even more money went their way.

The day eventually came when Wellspring wanted out; that is what private equity does, after all. It was looking at two offers: one was with Dick’s Sporting Goods and the other with Sun Capital.  Dick’s Sporting already had its own stores and would have no need for the existing golf shop locations. The brothers realized that would be catastrophic for the easy-peasy rental income that was coming in, so they threw their weight behind the offer by Sun Capital.

Now, one does not own a private equity firm by being a dummy, so Wellspring wanted something in return for choosing Sun Capital over Dick’s Sporting.

Fine, said the brothers: you can keep our share of the sales proceeds.

The brothers did not run the proposed transaction past their tax advisor. This was unfortunate, as there was a tax trap waiting to spring.  

Generally speaking, the sale or exchange of a partnership interest results in capital gain or loss. The partners received no cash from the sale. Assuming they had basis (that is, money invested) in the partnership, the sale or exchange would have resulted in a capital loss.

Granted, one can use capital losses against capital gains, but that means one needs capital gains.   What if you do not have enough gains? Any gains? We then get back to an obsolete $3,000 per year allowance. Have a big enough loss and one would need the lifespan of a Tolkien elf to use-up the loss.

The brothers’ accountant found out what happened during tax season and well after the fact. He too knew the issue with capital losses. He played a card, in truth the only card he had. Could what happened be reinterpreted as the abandonment of a partnership interest?

There is something you don’t see every day.

Let’s talk about it.

This talk gets us into Code sections, as the reasoning is that one does not have a “sale or exchange” of a partnership interest if one abandons the interest. This gets the tax nerd away from the capital gain/loss requirement of Section 741 and into the more temperate climes of Section 165. One would plan the transaction to get to a more favorable Code section (165) and avoid a less favorable one (741). 

There are hurdles here, though. The first two are generally not a problem, but the third can be brutal.

The first two are as follows:

(1) The taxpayer must show an intent to abandon the interest; and

(2)  The taxpayer must show an affirmative act of abandonment.

This is not particularly hard to do, methinks. I would send a letter to the tax matters or general partner indicating my intent to abandon the interest, and then I would send (to all partners, if possible) a letter that I have in fact abandoned my interest and relinquished all rights and benefits thereunder. This assumes there is no partners’ meeting. If there was a meeting, I would do it there. Heck, I might do both to avoid all doubt.

What is the third hurdle?

There can be no “consideration” on the way out.

Consideration in tax means more than just receiving money. It also includes someone assuming debt you were previously responsible for.

The rule-of-thumb in a general partnership is that the partners are responsible for their allocable share of partnership debt. This is a problem, especially if one is not interested in being liable for any share of any debt. This is how we got to limited partnerships, where the general partner is responsible for the debts and the limited partners are not.

Extrapolating the above, a general partner in a general partnership is going to have issues abandoning a partnership interest if the partnership has debt. The partnership would have to pay-off that debt, refinance the debt from recourse to nonrecourse, or perhaps a partner or group of partners could assume the debt, excluding the partner who wants to abandon.

Yea, the planning can be messy for a general partnership.

It would be less messy for a limited partner in a limited partnership.

Then we have the limited liability companies. (LLCs). Those bad boys have a splash of general partnership, a sprinkling of limited partnership, and they can result in a stew of both rules.

The third plank to the abandonment of a partnership interest can be formidable, depending on how the entity is organized and how the debts are structured. If a partner wants an abandonment, it is more likely than not that pieces on the board have to be moved in order to get there.   

The brothers’ accountant however had no chance to move pieces before Wellspring sold Edwin Watts Golf. He held his breath and prepared tax returns showing the brothers as abandoning their partnership interests. This gave them ordinary losses, meaning that the losses were immediately useful on their tax returns.

The IRS caught it and said “no way.”

There were multiple chapters in the telling of this story, but in the end the Court decided for the IRS.

Why?

Because the brothers had the option of structuring the transaction to obtain the tax result they desired. If they wanted an abandonment, then they should have taken the steps necessary for an abandonment. They did not. There is a long-standing doctrine in the Code that a taxpayer is allowed to structure a transaction anyway he/she wishes, but once structured the taxpayer has to live with the consequences. This doctrine is not tolerant of taxpayer do-overs.

The brothers had a capital and not an ordinary loss. They were limited to capital gains plus $3 grand per year. Yay.

Our case this time for the home gamers was Watts, T.C. Memo 2017-114.

Another IRA-As-A-Business Story Gone Wrong

 

I am not a fan.

We are talking about using your IRA to start or own a business. We are not talking about buying stock in Tesla or Microsoft; rather we are talking about opening a car dealership or rock-climbing facility with monies originating in your retirement account. The area even has its own lingo – ROBS (Rollover for Business Start Ups), for example - of which we have spoken before.

Can it be done correctly and safely?

Probably.

What are the odds that it will not be done – or subsequently maintained - correctly?

I would say astronomical.

For the average person there are simply too many pitfalls.

Let’s look at the Ball case. It is not a standard ROBS, and it presents yet another way how using an IRA in this manner can blow up.

During 2012 Mr Ball had JP Morgan Chase (the custodian of his SEP-IRA) distribute money.

COMMENT: You have to be careful. The custodian can send the money to another IRA. You do not want to receive the money personally.

Mr Ball initiated disbursements requests indicating that each withdrawal was an early disbursement ….

         COMMENT: No!!!

He further instructed Chase to transfer the monies to a checking account he had opened in the name of a Nevada limited liability company.

         COMMENT: That LLC better be owned by the SEP-IRA.

Mr Ball was the sole owner of the LLC.

         COMMENT: We are watching suicide here.

Mr Ball had the LLC loan the funds for a couple of real estate deals. He made a profit, which were deposited back into the LLC.

At year-end Chase issued Forms 1099 showing $209,600 of distributions to Mr Ball.

         COMMENT: Well, that is literally what happened.

Mr Ball did not report the $209,600 on his tax return.

COMMENT: He wouldn’t have to, had he done it correctly.  

The IRS computers caught this and sent out a notice of tax due.

COMMENT: All is not lost. There is a fallback position. As long as the $209,600 was transferred back into an IRA withing 60 days, Mr Ball is OK.

ADDITIONAL COMMENT: BTW, if you go the 60-day route – and I discourage it – it is not unusual to receive an IRS notice. The IRS does not necessarily know that you rolled the money back into an IRA within the 60-day window.

This matter wound up in Tax Court. Mr Ball had an uphill climb. Why? Let’s go through some of technicalities of an IRA.

(1) An IRA is a trust account. That means it requires a trustee. The trustee is responsible for the assets in the IRA.

Chase was the trustee. Guess what Chase did not know about? The LLC owned by Mr Ball himself.

Know what else Chase did not know about? The real estate loans made by the LLC upon receipt of funds from Chase.

If Chase was the trustee for the LLC, it had to be among the worst trustees ever. 

(2)  Assets owned by the IRA should be named or titled in the name of the IRA.

Who owned the LLC?

Not the IRA.

Mr Ball’s back was to the wall. What argument did he have?

Answer: Mr Ball argued that the LLC was an “agent” of his IRA.

The Tax Court did not see an “agency” relationship. The reason: if the principal did not know there was an agent, then there was no agency.

Mr Ball took monies out of an IRA and put it somewhere that was not an IRA. Once that happened, there was no restriction on what he could do with the money. Granted, he put the profits back into the LLC wanna-be-IRA, but he was not required to. The technical term for this is “taxable income.”

And – in the spirit of bayoneting the dead – the Court also upheld a substantial underpayment penalty.

Worst. Case. Scenario.

Is there something Mr Ball could have done?

Yes: Find a trustee that would allow nontraditional assets in the IRA. Transfer the retirement funds from Chase to the new trustee. Request the new trustee to open an LLC. Present the real estate loans to the new trustee as investment options for the LLC and with a recommendation to invest. The new trustee – presumably more comfortable with nontraditional investments – would accept the recommendation and make the loans.

Note however that everything I described would take place within the protective wrapper of the IRA-trust.

Why do I disapprove of these arrangements?

Because – in my experience – almost no one gets it right. The only reason we do not have more horror stories like this is because the IRS has not had the resources to chase down these deals. Perhaps some day they will, and the results will probably not be pretty. Then again, chasing down IRA monies in a backdrop of social security bankruptcy might draw the disapproval of Congress.

Our case this time was Ball v Commissioner, TC Memo 2020-152.

No Required Minimum Distributions For 2020

There is a tax deadline coming up. It may matter to those who are taking required minimum distributions (MRDs) from your IRAs and certain employer-based plans.

You may recall that there is a trigger concerning retirement plans when one reaches age 72.

COMMENT: The trigger used to be age 70 ½ for tax years before 2020.

The trigger is – with some exception for employer-based plans – that one has to start withdrawing from his/her retirement account. There are even IRS-provided tables, into which one can insert one’s age and obtain a factor to calculate a required minimum distribution.

COMMENT: There are severe penalties for not withdrawing a minimum distribution. Fortunately, the IRS is fairly lenient in allowing one to “catch-up” and avoid those penalties. At 50% of the required distribution, the MRD penalty rate is one of the most severe in the tax Code.

Let’s say that you are in the age range for MRDs. You have, in fact, been taking monthly MRDs this far into 2020.

There has been a law change: you can take 2020 distributions if you wish, but distributions are not mandatory or otherwise required. That is, there are no MRDs for 2020. This means that you can take less than the otherwise-table-calculated amount (including none, if you wish) and not taunt that 50% penalty.

Why the change in tax law?

The change is related to the severe economic contractions emanating from COVID and its associated lockdowns and stay-at-home restrictions. Congress realized that there was little financial sense in forcing one to sell stocks and securities into a bear market to raise the cash necessary to pay oneself MRDs.

Hot on the heels of the change is the fact that different people take MRDs at different times. Some people take the distribution early in the year, others late, and yet others take distributions monthly or quarterly. There is no wrong answer; it just depends on one’s cash flow needs.

Let’s take the example we started with: monthly distributions.

Well, it’s fine and dandy that I do not have to take any more distributions, but what about the amount I took in January -before the law change? And February – before …., well, you get the point.

You can put the money back into the IRA or retirement account.

Think of it as a mulligan.

But you have to do this by a certain date: August 31, 2020.

You have approximately another month to get it done.

Here are some questions you may have:

(1)  Does this change apply to 401(k)s, 403(b)s, 457(b)s?

Answer: Yes.

(2)  How about inherited accounts?

Answer: Yes. You have to put it back in the same (that is, the inherited) account, of course.

(3)  What if I was having taxes withheld?

Answer: You are going to have reach into your pocketbook temporarily. Say that you took a $25,000 distribution with 20% federal withholding. You never spent any of it, so you have $20,000 sitting in your bank account. If you want to unwind the entire transaction, you are going to have to take $5,000 from somewhere, add it to the $20,000 you already have and put $25,000 back into your IRA or retirement account.

You may wonder what happened to the $5 grand that was withheld. It will be refunded to you – when you file your 2020 tax return.

(4)  Continuing with Example (3): what if I don’t have the $5 grand?

Answer: Then put back the $20,000 you do have. It’s not 100%, but you put back most of it. You will have that gigantic withholding when you finally file your 2020 taxes.

(5)  What if I turned 70 ½ last year (2019) and HAVE TO take a MRD in 2020?

Answer: The answer may surprise you. The downside to waiting is that you would (normally) have to take a distribution for 2019 (you turned 70 ½, after all) and another for 2020 itself. This means that you are taking two MRDs in one tax year. Under the new 2020 tax law, you do not have to take EITHER (2019 or 2020) distribution. Your first distribution would be in 2021, and you would have had no distributions for 2019 or 2020.

(6)  Does this change apply to pensions?

Answer: No. Pensions are “defined benefit” plans, whereas IRAs, 401(k)s and so on are “defined contribution” plans. The change is only for defined contribution plans.

(7)  Does this change apply to Roths?

Answer: Roths do not have minimum required distributions, so this law change means bupkis to them.

(8)  What if I went the other way: I withdrew from my traditional IRA and would like to put it back as a Roth?

Answer: Normally one cannot do this, as MRDs do not qualify for a Roth conversion. With no MRDs for 2020, however, you have a one-time opportunity to flip some of your traditional IRA into a Roth. Remember that you will have to pay tax on this, though.  

(9)  How does this law change interact with the qualified charitable distribution rules?

Answer: A qualified charitable distribution (QCD) is when you have your IRA custodian issue a check directly to a charity. You do not get a deduction for the contribution, but the upside is that you do not have to report the distribution as income. If you do not itemize deductions, this technique is – by far – the most tax-efficient way to go. The QCD rules are independent of the MRD 2020 rule change. If you want to donate via charitable distributions in 2020, then go for it!

If you are already into your MRD for 2020 and do not need the money – some or all of it – remember that you have approximately another month to put it back.

IRA Changes For 2020

 The issue came up last week with a retired client, so let’s talk about it.

What is going on in 2020 with your IRAs?

There are several things here, so let’s go step-by-step:

(1)  Do you have to take a minimum required distribution (MRD) if you turned 70 1/2 in 2020?

ANSWER: No. The new age requirement is age 72.

(2)  What if I turned 70 ½ in 2019 and delayed my initial MRD until 2020?

ANSWER: Thanks to the CARES Act, that initial MRD is delayed one more year – until 2021.

(3)   I am well over 70 ½.  Do I have a MRD for 2020?

ANSWER: No. You can take money out, but you are not required to.

(4)  What if I already took out my MRD?

ANSWER: There are two answers, depending on when you took the MRD.

(a) If you took the MRD in January 2020, there is nothing you can do at this point.

(b)  If you took the MRD after January 31, 2020, you have until July 15, 2020 to return the money.

BTW there is a possible tax trap here. You are allowed only one non-trustee-to-trustee rollover (meaning you received and cashed the check with the intent of paying it back within 60 days) within a rolling 12-month period. If you did this in 2019, you need to check whether you are caught within this 12-month dragnet.

(5)  I have an inherited IRA account. Is there any change for me?

ANSWER: If the decedent passed away before 2020, you do not have an MRD for 2020.

There is a technical point in here if one was waiting five years before emptying the inherited IRS account: 2020 will not be counted as a year. In effect, you now have six years to empty the account rather than five.

(6)  I am having cash-flow issues as a consequence of the virus-related lockdown. I am thinking about tapping my IRA in order to get through. Is there something for me?

ANSWER: There are several changes.

(1) The 10% penalty for pre-age-59 ½ payouts for COVID-related reasons is waived on distributions up to $100,000.

(2) The income tax on the distribution still applies, but the tax can be paid over three years.

(3) And you also have 3 years to put the money back in the IRA. If you do, the money restored will be treated like a qualified rollover.

a.    Remember, this is taking place over 3 years. It is possible that you will have paid income tax on some or all of the money you restore in your IRA. If so, you can file an amended return and get your income tax back.

(7)  I am taking “substantially equal periodic payments” from my IRA. I am under age 59 ½ and needed the money. Is there a break for me?

ANSWER: A SEPP program allows one to avoid the penalty for early withdrawals, but it comes at a price: on has to take withdrawals over a given period of time.

A SEPP is not the same as a MRD, so the new rules do not apply to you.

(8)  Is it too late to fund my IRA for 2019?

ANSWER: Normally, you have until April 15 of the following year to fund an IRA. For 2019, that deadline has been extended to July 15, 2020.