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.
