Rolling Over An Inherited IRA

I am not a fan of the 60-day IRA rollover.

I admit that my response is colored by being the tax guy cleaning-up when something goes awry. Unless the administrator just refuses a trustee-to-trustee rollover, I am hard pressed to come up with a persuasive reason why someone should receive a check during a rollover.

Let’s go over a case. I want you to guess whether the rollover did or did not work.

Taxpayer’s mom died in 2008.

Mom had two IRAs. She left them to her daughter, who received two checks: one for $2,828 and a second for $35,358.

The daughter rolled over $35,358 and kept the smaller check.

On her tax return, she reported gross IRA distributions of $38,194 (there is a small difference; I do not know why) and taxable distributions of $2,828.

She did not have an early distribution penalty, as that penalty does not apply to inherited accounts.

The IRS flagged her, saying that the full $38,194 was taxable.

What do you think?

Let’s go over it.

There is no question she was well within the 60-day period.

The money went into an IRA account. This is not a case where monies erroneously went into something other than an IRA.

This was the daughter’s only rollover, so we are not triggering the rule where one can only roll IRA monies in this manner once every twelve months.

The Court decided that the daughter was taxable on the full amount.

Why?

She ran face-first into a sub-rule: one cannot rollover an inherited account, with the exception of a surviving spouse.

The daughter argued that she intended to roll and also substantially complied with the rollover rules.

Here is the Tax Court:

The Code’s lines are arbitrary. Congress has concluded that some lines of this kind are appropriate. The judiciary is not authorized to redraw the boundaries.”

This is a polite way of saying that tax rules sometimes make no sense. They just are. The Tax Court, not being a court of equity, cannot decide a case just because a result might be viewed as unfair.

The Court did not address the point, but there is one more issue at play here.

There are penalties for overfunding an IRA.

Say that you can put away $6,500. You instead put away $10,000. You have overfunded by $3,500.

So what?

You have to get the excess money out of there, that’s what.

Normally I recommend that the $3,500 be moved as a contribution to the following year, nixing the penalty issue.

Let’s say that you do not do that. In fact, you do not even know to do that.

For whatever reason, the IRS examines your return five years later. Say they catch the issue. You now owe a 6% penalty on the overfunding.

That’s not bad, you think. You will pay $210 and move on.

Nope.

It is 6% a year.

And you still have to get the $3,500 out.

Except it is now not $3,500. It is $3,500 plus any earnings thereon for five years.

Say that amount is $5,500, including earnings.

You take out $5,500.

You have five years of 6% penalties. You also have tax on $2,000 (that is, $5,500 minus $3,500).

If you are under 59 ½ you probably have an early-distribution penalty on the $2,000.

Plus penalties and interest on top of that.

I like to think that the Tax Court cut the taxpayer a break by not spotlighting the overfunding penalty issue.

Our case this time was Beech v Commissioner.

Would You Believe?

It is a specialized issue, but I am going to write about it anyway.

Why?

Because I believe this may be the only time I have had this issue, and I have been in practice for over thirty years. There isn’t a lot in the tax literature either.

As often happens, I am minding my own business when someone – someone who knows I am a tax geek – asks:

          “Steve, do you know the tax answer to ….”

For future reference: “Whatever it is - I don’t. By the way, I am leaving the office today on time and I won’t have time this weekend to research as I am playing golf and sleeping late.”

You know who you are, Mr. to-remain-unnamed-and-anonymous-of-course-Brian-the-name-will-never-pass-my-lips.

Here it is:

Can a trust make a charitable donation?

Doesn’t sound like much, so let’s set-up the issue.

A trust is generally a three-party arrangement:

·      Party of the first part sets up and funds the trust.

·      Party of the second part receives money from the trust, either now or later.

·      Party of the third part administrates the trust, including writing checks.

The party of the third part is called the “trustee” or “fiduciary.” This is a unique relationship, as the trustee is trying to administer according to the wishes of the party of the first part, who may or may not be deceased. The very concept of “fiduciary” means that you are putting someone’s interest ahead of yours: in this case, you are prioritizing the party of the second part, also called the beneficiary.

There can be more than one beneficiary, by the way.

There can also be beneficiaries at different points in time.

For example, I can set-up a trust with all income to my wife for her lifetime, with whatever is left over (called the “corpus” or “principal”) going to my daughter.

This sets up an interesting tension: the interests of the first beneficiary may not coincide with the interests of the second beneficiary. Consider my example. Whatever my wife draws upon during her lifetime will leave less for my daughter when her mom dies. Now, this tension does not exist in the Hamilton family, but you can see how it could for other families. Take for example a second marriage, especially one later in life. The “steps” my not have that “we are all one family” perspective when the dollars start raining.

Back to our fiduciary: how would you like to be the one who decides where the dollars rain? That sounds like a headache to me.

How can the trustmaker make this better?

A tried-and-true way is to have the party of the first part leave instructions, standards and explanations of his/her wishes. For example, I can say “my wife can draw all the income and corpus she wants without having to explain anything to anybody. If there is anything left over, our daughter can have it. If not, too bad.”

Pretty clear, eh?

That is the heart of the problem with charitable donations by a trust.

Chances are, some party-of-the-second-part is getting less money at the end of the day because of that donation. Has to, as the money is not going to a beneficiary.

Which means the party of the first part had better leave clear instructions as to the who/what/when of the donation.

Our case this week is a trust created when Harvey Hubbell died. He died in 1957, so this trust has been around a while. The trust was to distribute fixed amounts to certain individuals for life. Harvey felt strongly about it, because - if there was insufficient income to make the payment – the trustee was authorized to reach into trust principal to make up the shortfall.

Upon the last beneficiary to die, the trust had 10 years to wrap up its affairs.

Then there was this sentence:

All unused income and the remainder of the principal shall be used and distributed, in such proportion as the Trustees deem best, for such purpose or purposes, to be selected by them as the time of such distribution, as will make such uses and distributions exempt from Ohio inheritance and Federal estate taxes and for no other purpose.”  

This trust had been making regular donations for a while. The IRS picked one year – 2009 – and disallowed a $64,279 donation.

Here is IRC Sec 642(c):

(c)Deduction for amounts paid or permanently set aside for a charitable purpose

(1)General rule

In the case of an estate or trust (other than a trust meeting the specifications of subpart B), there shall be allowed as a deduction in computing its taxable income (in lieu of the deduction allowed by section 170(a), relating to deduction for charitable, etc., contributions and gifts) any amount of the gross income, without limitation, which pursuant to the terms of the governing instrument is, during the taxable year, paid for a purpose specified in section 170(c) (determined without regard to section 170(c)(2)(A)). If a charitable contribution is paid after the close of such taxable year and on or before the last day of the year following the close of such taxable year, then the trustee or administrator may elect to treat such contribution as paid during such taxable year. The election shall be made at such time and in such manner as the Secretary prescribes by regulations.

The key here is the italicized part:        

“which pursuant to the terms of the governing instrument…”

The Code wants to know what the party of the first part intended, phrased in tax-speak as “pursuant to the terms of the governing instrument.”

The trustees argued that they could make donations via the following verbiage:

in such proportion as the Trustees deem best, for such purposes or purposes, to be selected by them as the time of such distribution….”

Problem, said the IRS. That verbiage refers to a point in time: the time when the trust enters its ten-year wrap-up and not before then. The trustees had to abide by the governing instrument, and said instrument did not say they could distribute monies to charity before that time.

The trustees had to think of something fast.

Here is something: there is a “latent ambiguity” in the will. That ambiguity allows for the trustees’ discretion on the charitable donations issue.

Nice argument, trustees. We at CTG are impressed.

They are referring to a judicial doctrine that cuts trustees some slack when the following happens:

(1) The terms of the trust are crystal-clear when read in the light of normal day: when it snows in Cincinnati during this winter, the trust will ….

(2) However, the terms of the trust can also be read differently in the light of abnormal day: it did not snow in Cincinnati during this winter, so the trust will ….

The point is that both readings are plausible (would you believe “possible?”).

It is just that no one seriously considered scenario (2) when drafting the document. This is the “latent ambiguity” in the trust instrument.

Don’t think so, said the Court. That expanded authority was given the trustees during that ten-year period and not before.

In fact, prior to the ten years the trustees were to invade principal to meet the annual payouts, if necessary. The trustmaker was clearly interested that the beneficiaries receive their money every year. It is very doubtful he intended that any money not go their way.

It was only upon the death of the last beneficiary that the trustees had some free play.

The Court decided there was no latent ambiguity. They were pretty comfortable they understood what the trustmaker wanted. He wanted the beneficiaries to get paid every year.

And the trust lost its charitable deduction.

For the home gamers, our case this time was Harvey C. Hubbell Trust v Commissioner.

IRA Rollover Decision Stuns Advisors

There was a recent Court decision that stunned and upset a number of tax and financial advisors. It has to do with IRA rollovers.

We need to be clear, though, on the type of rollover that we are talking about. There are two ways to rollover an IRA:

(1)  You have the trustee presently handling your IRA transfer the funds to another trustee. This is done trustee-to-trustee, and you never see the money. Let’s call this “Type 1.”

(2)  You have the trustee presently handling your money send you a check. You then have 60 days to transfer it to another trustee. If you go past the 60 days – say 61 – you have income, and possibly penalties. Let’s call this “Type 2.”

We are talking today about Type 2.

The IRS Publication on this matter is Publication 590, and here is its explanation on rollovers from one IRA to another. For those playing the home game, the following is from page 21:

Generally, if you make a tax-free rollover of any part of a distribution from a traditional IRA, you cannot, within a 1-year period, make a tax-free rollover of any later distribution from that same IRA. You also cannot make a tax-free rollover of any amount distributed, within the same 1-year period, from the IRA into which you made the tax-free rollover.

Example: You have two traditional IRAs, IRA-1 and IRA-2. You make a tax-free rollover of a distribution from IRA-1 into a new traditional IRA (IRA-3). You cannot, within 1 year of the distribution from IRA-1, make a tax-free rollover of any distribution from either IRA-1 or IRA-3 into another traditional IRA.

However, the rollover from IRA-1 into IRA-3 does not prevent you from making a tax-free rollover from IRA-2 into any other traditional IRA. This is because you have not, within the last year, rolled over, tax free, any distribution from IRA-2 or made a tax-free rollover into IRA-2."

So the IRS is saying that the one-year rollover limitation applies on an IRA-per-IRA basis.

How did tax pros work with this? Let’s say that someone has $1.05 million in an IRA. You have him/her split this (likely trustee-to-trustee) into seven IRAs, each with $150,000. You then have him/her roll $150,000 from IRA-1. Sixty days later, he/she draws $150,000 from IRA-2 to repay IRA-1, thereby resetting the 60-day clock. When that expires, he/she borrows from IRA-3 to repay IRA-2. And so on.

I have seen this done. I have never liked it. However Publication 590 said you could, so it was considered tax legitimate.

Now we look at Bobrow v Commissioner.

Here is the setup:

·       Bobrow received a $65,064 distribution from an IRA on April 14, 2008

·       Bobrow received a $65,054 distribution from an IRA on June 10, 2008

·       Bobrow’s wife received a $65,054 distribution from her IRA on July 31, 2008

Once you know the technique, it is easy to see it in practice.

The IRS said that the Bobrows had income for 2008, and it wanted taxes of $51,298, as well as penalties of $10,260.

The IRS laid-in with Section 408(d)(3)(B)(the bolding is mine):

408(d)(3)(B) LIMITATION.— This paragraph does not apply to any amount described in subparagraph (A)(i) received by an individual from an individual retirement account or individual retirement annuity if at any time during the 1-year period ending on the day of such receipt such individual received any other amount described in that subparagraph from an individual retirement account or an individual retirement annuity which was not includible in his gross income because of the application of this paragraph.

Did you notice the “an?” The Code does not refer to IRA-1 or IRA-2. Granted, the last sentence goes on to say “an” IRA not includible in gross income because of the application of this paragraph. I can see an interpretation limiting the rule to the IRA involved in the roll and not other IRAs the taxpayer may have. Apparently that was also the IRS’ reading in Publication 590.

The Tax Court said no. Its reading was one roll per year – that’s it, period. It does not matter how many IRAs the taxpayer has. The limit applies on a per-taxpayer and not a per-IRA basis. The Court held for the IRS, even for the penalties.

Now think about this for a second.

The Code outranks any IRS Publication in the hierarchy of tax authority. It has to, obviously. If an IRS publication misinterprets the Code, it is the Publication that has to step aside. It is unfortunate for those who relied on the Publication, but I understand the tax side of this.

But I do not understand the penalties. The IRS could have granted reasonable cause to the Bobrows and abated the penalties. Bobrow would present a good reason for his tax position in order to obtain abatement. Here is a good reason: relying on IRS Publication 590. The IRS nonetheless assessed penalties, and the Tax Court sustained the IRS.

And that to me is abusive tax practice. Good grief, this is like a game of three-card monte.

The decision surprised many advisors. It has certainly done away with serial Type-2 IRA rollovers. The IRS and the Tax Court have ended the technique of using multiple IRAs as bridge loan money. 

My advice? Make your rollovers trustee-to-trustee and this issue will not affect you.

An S Corporation and a Bankruptcy Trustee

The Kenrob case is a bankruptcy case and not a tax case. It presented such an unusual argument, though, that it caught my eye and my disbelief. Let’s talk about it.

Kenrob Information Technology Solutions, Inc. (Kenrob) was an S corporation. By agreement between the shareholders and the corporation, the corporation was obligated to reimburse the shareholders for the additional taxes attributable to its pass-through income. This is extremely common, although many times the agreement is not reduced to writing. The corporation distributed in April, 2007.  It did so again in April, 2008.

Kenrob goes into bankruptcy. The bankruptcy trustee wants the shareholders to pay the monies back, arguing that the disbursements were a fraudulent conveyance.

The trustee argues the following:

(1)   The only agreement that can be found between the corporation and the shareholders is a redlined agreement. A finalized, signed and dated copy cannot be found.

(2)   There was no consideration given by the shareholders for the distributions.

(3)   The value of the S election cannot be accurately measured. Had Kenrob been taxed as a C corporation, it may have taken different tax positions and strategies.

(4)   The agreement, if agreement there is, was made years before and is not binding.

The court decides the following:

(1)   The corporation and the shareholders have always followed an agreement. That it cannot be found does not mean that the agreement did not exist, especially since it has been fully performed on a continuous basis.

(2)   There was consideration to the corporation, as the shareholders did not take out all the distributable income. Rather they took out enough to pay taxes, leaving the excess with the corporation. This was of value to the company.

(3)   The court refused to engage in "what if” over corporate taxes.

(4)   There is no need for the agreement to be contemporaneous. The agreement was continuous and of lasting benefit.

The bankruptcy court decided in favor of the shareholders and that there was no fraudulent conveyance.

My take: A fraudulent conveyance. Really? As though the corporation would have paid no tax, or less tax, had it been taxed as a C rather than an S? The charge is so outlandish I have to wonder whether there were other factors – perhaps personal dislike – at play here. Otherwise that trustee’s driveway doesn’t quite reach the street.