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.

Use Of Wrong Form Costs A Tax Refund

Let’s talk about the following Regulation:

26 CFR § 301.6402-2

Claims for credit or refund

(b) Grounds set forth in claim.

(1) No refund or credit will be allowed after the expiration of the statutory period of limitation applicable to the filing of a claim therefor except upon one or more of the grounds set forth in a claim filed before the expiration of such period. The claim must set forth in detail each ground upon which a credit or refund is claimed and facts sufficient to apprise the Commissioner of the exact basis thereof. The statement of the grounds and facts must be verified by a written declaration that it is made under the penalties of perjury. A claim which does not comply with this paragraph will not be considered for any purpose as a claim for refund or credit.

That last sentence is critical and – potentially – punishing.

I suspect the most common “claim for refund” is an amended return. There are other ways to claim, however, depending on the tax at issue. For example, businesses requested refunds of federal payroll taxes under the employee retention credit (“ERC”) program by filing Form 941-X. You or I would (more likely) file our claim for refund on Form 1040-X. 

File a 1040-X and the tax “variance doctrine” comes into play. This means that the filing must substantially inform the IRS of the grounds and reasons that one is requesting a refund. Both parties have responsibilities in tax administration. A taxpayer must adequately apprise so the IRS can consider the request without further investigation or the time and expense of litigation.

Here is a Court on this point in Charter Co v United States:

The law requires a taxpayer “to do more than give the government a good lead based on the government’s ability to infer interconnectedness.”

Another way to say this is that the IRS is not required to go all Sherlock Holmes to figure out what you are talking about. 

Let’s look at the Shleifer case.

Scott Shleifer was a partner in an investment firm. He travelled domestically and abroad to investigate new and existing investment opportunities. Scott was not a fan of commercial airfare, so he used his personal plane. He waived off reimbursement from the partnership for his air travel.

COMMENT: Scott is different from you or me.

The Shleifers filed their 2014 joint individual tax return. Whereas it is not stated in the case, we can assume that their 2014 return was extended to October 15, 2015.

In October 2018 they filed an amended return requesting a refund of almost $1.9 million.

COMMENT: And there you have your claim. In addition, notice that the two Octobers were three years apart. Remember that the statute of limitations for amending a return is three years. Coincidence? No, no coincidence.

What drove the amended return was depreciation on the plane. The accountant put the depreciation on Schedule C. It was – in fact – the only number on the Schedule C.

In July 2020 the IRS selected the amended return for audit.

COMMENT: A refund of almost $1.9 million will do that.

The Shleifer’s accountant represented them throughout the audit.

In March 2022 the IRS denied the refund.

Why?

Look at the Schedule C header above. It refers to a profit or loss “from business.” Scott was not “in business” with his plane. It instead was his personal plane. He did not sell tickets for flights on his plane. He did not rent or lease the plane for other pilots to use. It was a personal asset, a toy if you will, and perhaps comparable to a very high-end car. Granted, he sometimes used the plane for business purposes, but it did not cease being his toy. What it wasn’t was a business.

The accountant put the depreciation on the wrong form.

As a partner, Scott would have received a Schedule K-1 from the investment partnership. The business income thereon would have been reported on his Schedule E. While the letters C and E are close together in the alphabet, these forms represent different things. For example:

·       There must be a trade or business to file a Schedule C. Lack of said trade or business is a common denominator in the “hobby loss” cases that populate tax literature.

·       A partnership must be in a trade or business to file Schedule E. A partner himself/herself does not need to be active or participating. The testing of trade or business is done at the partnership - not the partner - level.

·       A partner can and might incur expenses on behalf of a partnership. White there are requirements (it’s tax: there are always requirements), a partner might be able to show those expenses along with the Schedule K-1 numbers on his/her Schedule E. This does have the elegance of keeping the partnership numbers close together on the same form.   

After the audit went south, the accountant explained to the IRS examiner that he was now preparing, and Scott was now reporting the airplane expenses as unreimbursed partner expenses. He further commented that the arithmetic was the same whether the airplane expenses were reported on Schedule C or on Schedule E. The examiner seemed to agree, as he noted in his report that the depreciation might have been valid for 2014 if only the accountant had put the number on the correct form.

You know the matter went to litigation.

The Shleifers had several arguments, including the conversation the accountant had with the examiner (doesn’t that count for something?); that they met the substantive requirements for a depreciation deduction; and that the IRS was well aware that their claim for refund was due to depreciation on a plane.

The Court nonetheless decided in favor of the IRS.

Why?

Go back to the last sentence of Reg 301.6402-2(b)(1):

A claim which does not comply with this paragraph will not be considered for any purpose as a claim for refund or credit.

The Shleifers did not file a valid refund claim that the Court could review.

Here is the Court:

Although the mistake was costly and the result is harsh …”

Yes, it was.

What do I think?

You see here the ongoing tension between complying with the technical requirements of the Code and substantially complying with its spirit and intent.

I find it hard to believe that the IRS – at some point – did not realize that the depreciation deduction related to a business in which Scott was a partner. However, did the IRS have the authority to “move” the depreciation from one form to another? Then again, they did not have to. The accountant was right: the arithmetic worked out the same. All the IRS had to do was close the file and … move on.

But the IRS also had a point. The audit of Schedule C is different from that of Schedule E. For example, we mentioned earlier that there are requirements for claiming partnership expenses paid directly by a partner. Had the examiner known this, he likely would have wanted partnership documents, such as any reimbursement policy for these expenses. Granted, the examiner may have realized this as the audit went along, but the IRS did not know this when it selected the return for audit. I personally suspect the IRS would not have audited the return had the depreciation been reported correctly as a partner expense. 

And there you have the reason for the variance doctrine: the IRS has the right to rely on taxpayer representations in performing its tax administration. The IRS would have relied on these representations when it issued a $1.9 million refund – or selected the return for audit.

What a taxpayer cannot do is play bait and switch.

Our case this time was Shleifer v United States, U.S. District Court, So District Fla, Case #24-CV-80713-Rosenberg.

Blowing An Estate Tax Deduction

 

Let’s talk about the Estate of Martin W. Griffin.

Martin Griffin (Martin) was married to Maria Creel.

Martin created a revocable trust known as the Martin W. Griffin Trust.

COMMENT: A revocable trust means that the settlor (Martin in this case) can undo the trust. When that happens, the trust is disregarded and Martin and his revocable trust are considered the same person for tax purposes. The classic revocable trust is a “living trust,” which has no effect until one dies. Its purpose is not tax-driven at all and is instead to avoid probate.

Martin next created the MCC Irrevocable Trust.

COMMENT: Irrevocable means that Martin cannot undo the trust. He might be able to tweak a thing or two at the edges, but he cannot do away with the trust itself.

The Irrevocable Trust had the following language in the trust agreement:

The trust shall distribute the sum of Two Million Dollars ($2,000,000) to the trustee then serving …. for the benefit of Maria C. Creel. From this bequest, the trustee … shall pay to Maria C. Creel a monthly distribution, as determined by Maria and Trustee to be a reasonable amount, not to exceed $9,000 ….”

You see the word “Estate” in the case name. The issue in this case is estate tax, and it involves passing assets at death to one’s surviving spouse. There are two general ways to do this:

·       You simply transfer the asset to the surviving spouse.

An example here is a principal residence. The deed is in both spouse’s names. When you die, the house transfers directly to her (I am assuming you are the husband). She can then do what she wants: she can keep the house, sell the house, rent it or whatever. She has unfettered control over the house.

·       You transfer a right – but not all the rights – to the asset.

Let’s stay with the above example. You instead transfer a life estate to your wife. Upon her death the house goes to your children from your first marriage. She no longer has unfettered control over the asset. She cannot sell the house, for example. She has some – but not all – incidents of ownership.

The reason this is important is that the estate tax will allow you to deduct category (1) assets from your taxable estate, but category (2) assets have to go through an additional hoop to get there.

Here is the relevant Code section:

26 U.S. Code § 2056 - Bequests, etc., to surviving spouse

(7) Election with respect to life estate for surviving spouse  

(A) In general In the case of qualified terminable interest property—  

(i) for purposes of subsection (a), such property shall be treated as passing to the surviving spouse, and

(ii) for purposes of paragraph (1)(A), no part of such property shall be treated as passing to any person other than the surviving spouse.  

(B) Qualified terminable interest property defined For purposes of this paragraph—  

(i)In general The term “qualified terminable interest property” means property—

(I) which passes from the decedent,

(II) in which the surviving spouse has a qualifying income interest for life, and

(III) to which an election under this paragraph applies.

Section 2056 addresses the hoops we are talking about. If you are transferring less than total and unfettered rights to an asset, you want to make sure that you are transferring enough to qualify the asset as “qualified terminable interest property.” If you do, you get a subtraction for estate tax purposes. If you do not, there is no subtraction. 

It takes a lot to get to an estate tax in 2025 (given the lifetime exemption), but – if you do – the rate ramps to 40% rather quickly.  

Back to Martin.  

The Irrevocable Trust transferred enough to qualify as qualified terminable interest property.

Here is the Court:

The $2 million bequest is not QTIP. It is terminable interest property that does not qualify for the marital deduction and is includible in the estate.”

Huh? What happened?

Go back to (B)(iii) above:

(III) to which an election under this paragraph applies.

How do you make the election?

You include the asset on Schedule M of Form 706 (that is, the estate tax return):

That’s it. It is not complicated, but it must be done. The Code requires it.

Someone missed this while preparing Martin W Griffin’s estate tax return.

Yep, I expect a malpractice suit.

The Importance of Marking A Return As “Final”

I have worked tax controversy for many years now. I have seen the system work well; I have seen the system work poorly. I would say – with some generosity – that the system has been on the downslope for several years now.

It may be as simple as a tax notice.

It may be – even more simply – failing to indicate that a particular tax filing is a “Final.” Perhaps the business has been sold or closed. Maybe the company discontinued a line of business and will no longer have that specific filing. Maybe the company is reorganizing to another state and will not have the origin state’s filing anymore. There can be a host of reasons for a final.

I am looking at one involving Albertina Camaclang doing business as “Europa Guest Home,” which we will abbreviate as “EGH.”

EGH was a small residential care facility in California. She sold the business in 2002. She however never marked “final” on her Form 941, which is the form to report (and remit) federal withholding and social security payroll taxes.

Sixteen years later (16, you read that correctly) there was a dispute. The IRS said they mailed a notice to EGH informing that they had never received Forms 941 for 2008.

COMMENT: Six years after the sale.

EGH said it never received the IRS notice.

And the IRS could not produce a copy of the letter nor proof that it was mailed.

But the IRS did kindly prepare Forms 941 showing unpaid liabilities of over $600 thousand. These are referred to a “substitutes for return” or “SFRs.” It is generally preferable to file a return rather than allow the IRS to prepare an SFR. The IRS is not concerned with deductions, for one thing. We are not told what EGH’s annual 941 liability was back in the day, a useful bit of information as we weigh the $600 grand.

The IRS filed liens.

COMMENT: Yep, predictable.

Off to Tax Court.

We are now in 2019. EGH hired a tax lawyer. The lawyer requested a Collection Due Process or Equivalent Hearing. EGH’s defense was straightforward: the business was sold long before 2008.

Go to 2020, and a settlement officer (SO) was assigned to the case.

And there was this:

The settlement officer learned of a parallel criminal investigation into petitioner, which delayed further work into the case. On February 15, 2023, the IRS lifted the suspension, and the settlement officer resumed work on the matter.”

OK then.

The SO wanted to schedule a conference with EGH on March 24, 2023. The SO also wanted paperwork to substantiate the sale of the business as well as original tax returns (meaning the 941s) for 2008.

COMMENT: Easiest tax returns ever: zero all the way down.

EGH requested access to its administrative file. This delayed the conference to June 5, 2023.

Which the IRS wanted later to reschedule. How about July 13^th?

EGH responded on July 19^th, explaining that it had received the notice that very day.

Back to rescheduling.

Mind you, EGH still had not provided documentation on the sale of the business.

COMMENT: I would have led with that documentation. I cannot help but wonder if something was afoot, which is how IRS CID had gotten involved.

The attorney finally provided the SO with a grant deed showing sale of the real estate.

COMMENT: What about the business located on that real estate, counselor?

The SO wanted to know why EGH filed Forms 941 for 2004 and 2005 if it was sold in 2002.

COMMENT: So do I.

The attorney argued that the IRS prepared these returns fraudulently.

COMMENT: Interesting persuasion skills being flashed there.

In the alternative, the attorney argued that the accountant was an idiot and incorrectly filed another entity’s return as EGH.

And here is an understated sentence:

While discussing these discrepancies, there was a ‘breakdown’ in communication between petitioner’s counsel and the settlement officer.”

To be a fly on the wall.

On August 29, 2023, a new settlement officer ….

I will interrupt here. I have practiced procedure for decades. I have never – barring illness or something like that – replaced an SO midstream. I am getting the impression that the most interesting parts of the story were not written down.

On August 29, 2023, the new SO reached out to explain why the IRS had filed SFRs and liens to back them up.

COMMENT: Self-serving, but OK.

The new SO requested new signed returns reporting zero liability filed by September 5,2023.

COMMENT: I would file them that very afternoon and end this nightmare.

On August 30, 2023, the IRS sent a letter acknowledging receipt of the returns. The IRS also enclosed Form 12257 Summary Notice of Determination and Waiver of Judicial Review.

EGH declined to sign the 12257.

The SO said fine. The IRS would nonetheless issue a notice of determination indicating a zero balance.

The IRS closed the file on September 1, 2023.

The IRS released the liens on October 27,2023.

The Tax Court closed the case.

COMMENT: I do not understand the reluctance to sign the 12257. Granted, one would lose certain procedural rights (such as the right to appeal), but EGH got everything it wanted: tax reduced to zero, interest and penalties likewise reduced to zero, liens released. What was left to fight over?

On October 6, 2023, EGH filed with the Tax Court for a review of the notice of determination.

COMMENT: Why? Let me keep reading…. EGH wanted reimbursement of approximately $50,000 for its litigation costs.

Folks, it does not work this way. The Tax Court had already decided and closed the case. EGH now wanted the Tax Court to resurrect the matter (the word is “vacate.”). Please stop already.

Would you believe that the Tax Court agreed to vacate?

EGH got its day. It now had to prove certain things – including being the prevailing party – to obtain reimbursement of its litigation costs.

EGH had pushed too far.

Remember: EGH had delayed at every turn. 

Here is the Court:

Petitioner is not the prevailing party. Accordingly, we need not consider whether petitioner unreasonably protracted proceedings or claimed ‘reasonable costs.’ Petitioner is not entitled to administrative or litigation costs.”

Our case this time was Albertina Camaclang d.b.a Europa Guest Home, Docket No. 15761-23L, filed April 23, 2025.