Estimated Taxes Matter

Sometimes I read a case and I wonder if the most interesting part was not included.

There is a couple – a doctor and a financial consultant - who are not keen on paying their taxes. Here is a quick recap:

          Year            Tax           Withheld         Due

          2014         $70,018      $24,148         $45,870

          2015         $58,293      $11,677         $45,995

          2016         $52,474      $20,230         $32,244

          2017         $37,001      $11,720         $25,281

This is not rocket science. Chances are that one person has withholdings and the other person is supposed to pay estimated taxes. No estimated taxes were paid. The solution? Simple: (1) pay estimated taxes, or (2) increase the other spouse’s withholdings to compensate for the lack of estimated taxes.

On November, 2016 the IRS sent a Notice of Intent to Levy.

COMMENT: This tells you the taxpayers had been in the system for a while.

The taxpayers requested for a Collection Due Process Hearing.

COMMENT: Good step. The CDP is a chance to halt the IRS automated machinery and allow the taxpayers an opportunity to speak with an Appeals Officer about their specific situation.

The taxpayers were interested in collection alternatives, including:

(a)  an installment agreement

(b)  an offer in compromise

(c)  a “cannot pay balance” status

Seems to me they covered the bases.

They did not submit financial data with the CDP request, but they did later when the Appeals Officer requested. Their information showed monthly income of $25,317 and monthly living expenses of $17,217, leaving a monthly net of $8,100.

The IRS wanted the $8,100.

Surprise factor: zero.

The taxpayers balked, arguing that it was beyond their means.

COMMENT: How can the $8,100 be beyond their means, if that is the amount they calculated? The likely reason is that the IRS has tables for certain expense categories, such as transportation. Say that you have an expensive monthly car payment. You will bump up against that limit, and good luck getting the IRS to spot you more. Mind you, the IRS says that it will consider specific circumstances, but they do not consider them for long. You may find yourself having to trade-down on your car or pulling your kid from private school.

The taxpayers indicated they were going to file an offer in compromise.

They did – eight months later.

COMMENT: Folks, seriously, do not do this. If you are hip deep in a CDP hearing with the IRS, it is a very poor decision to stall.

The Appeals Officer – not willing to wait the better part of a year – sustained the proposed levy.

Next stop: Tax Court.

From the Court we learn that the taxpayers withdrew the offer in compromise because they were “unable” to make estimated tax payments.

Huh?

Folks, this act is fatal. Here is a requirement for an offer:

“Proof of sufficient withholding or estimated tax payments”

The Tax Court’s purview can be broad or narrow, depending on the issue. If there is an issue of tax law, the Court generally has broad powers. This case was not an issue of tax law; rather it was an issue of IRS procedure. Did the IRS follow its own rules? To phrase it another way, did the IRS abuse its authority?

This narrows the Court’s reach – a lot.

It means the Court is not reviewing whether the taxpayers should have received an installment plan, an offer in compromise or whatnot. Rather, the Court is reviewing whether the IRS abused its authority by not allowing said installment plan, offer in compromise or whatnot.

The Court decided the IRS had not.

Why?

“Proof of sufficient withholding or estimated tax payments”

To me, the take-away question is: what are these people doing with their money?

Our case this time was Reid v Commissioner.

The Parking Lot Tax

Last year’s Tax Cuts and Jobs Act created a 21% tax on transportation-related fringe benefits provided by nonprofits.

That does not sound so bad until you consider that qualified transportation fringe benefits include:

1.    Transit passes or reimbursement for the same

2.    Use of a commuter highway vehicle or reimbursement for the same

3.    Qualified bicycle commuting reimbursement

4.    Qualified parking expenses or reimbursement for the same

That last one proved to be a shocker.

What started the issue was the new deduction disallowance for qualified transportation fringe benefits paid by taxable employers. For example, if the employer pays for employee parking, up to $260 per month can be excluded from the employee’s 2018 W-2. In the past the employer could deduct that $260 on its tax return. Now it could not. Congress felt that – if taxable employers were to be affected – then nonprofit employers should also be affected.

But how does a nonprofit even pay tax?

It can happen, and it is called unrelated business income. In general, it means that the nonprofit is veering away from its charitable mission and is conducting an activity that is virtually indistinguishable from a for-profit business next door.

The nonprofit has to separately account for this activity. The IRS then spots it a $1,000 exemption. If it has more than a $1,000 in profit then it has to pay tax at the corporate rate – which is now 21%.

This change entered the tax Code in December, 2017 via Code Section 512(a)(7):

      (7)  Increase in unrelated business taxable income by disallowed fringe.

Unrelated business taxable income of an organization shall be increased by any amount for which a deduction is not allowable under this chapter by reason of section 274 and which is paid or incurred by such organization for any qualified transportation fringe (as defined in section 132(f) ), any parking facility used in connection with qualified parking (as defined in section 132(f)(5)(C) ), or any on-premises athletic facility (as defined in section 132(j)(4)(B) ).

There are three things to note here:

(1)  Congress is treating these disallowed deductions as if they were income to the nonprofit.

(2)  We have to track down the meaning of “qualified parking,” and

(3)  The phrase “deduction is not allowable” has a meaning that is not immediately apparent.

Let’s start with qualified parking, defined as:

… parking provided to an employee on or near the business premises of the employer or on or near a location from which the employee commutes to work …. 

Qualified parking does not include parking provided near the employee’s residence. 

Employer-provided parking includes parking on property an employer owns or leases, parking for which the employer pays, or parking for which an employer reimburses an employee.

So we know that qualified parking is provided near the employer and the employer pays for, reimburses, leases or owns the parking facility.

This makes sense if there is a public garage across the street and the employer pays the garage directly or reimburses an employee who paid the garage. However, how does this work if the employer owns the parking lot?  More specifically, how does this work if the parking lot is available to employees, customers – that is, to everyone and for free?

There is (what appears to be) a Congressional mistake when drafting Code Section 512(a)(7).

In 1994 the IRS published a rule in Notice 94-3, conveniently titled “IRS Explains Rules For Qualified Transportation Fringe Benefits.” Here is Question 10 and its example:

EXAMPLE. Employer Z operates an industrial plant in a rural area in which no commercial parking is available. Z furnishes ample parking for its employees on the business premises, free of charge. The parking provided by Z has a fair market value of $0 because an individual other than an employee ordinarily would not pay to park there.

The answer makes sense. Anyone can park on that lot for free. If an employee parks there, it seems reasonable that the value of the parking would be zero (-0-).

That is not what Code Section 512(a)(7) did:

Unrelated business taxable income of an organization shall be increased by any amount for which a deduction is not allowable ….

There is no reference here to value. To the contrary, the reference is to a deduction – which to an accountant means cost. Parking may be free to the user, but it will cost something to maintain that parking facility. The cost may be a lot or a little, but there is a cost.

The Notice 94-3 rule that tax practitioners had gotten used to was overturned.

Needless to say, there were many questions on what the new rules meant and how to apply them. Consider that a nonprofit is supposed to make quarterly estimated tax payments against any expected unrelated-business-income tax, and guidance was needed sooner rather than later. On December 10, 2018 the IRS published interim guidance (Notice 2018-99) on qualified transportation fringe benefits. 

It started with the easiest example:

A taxable employer pays a garage $12,000 annually so that its employees can park. None of this exceeds the $260 monthly threshold per employee for 2018. The entire $12,000 is non-deductible by the employer.

Introduce any complexity and there are steps to the calculation:   

(1)  Calculate the cost for reserved employee spots.

a.     These costs are disallowed.

(2)  Calculate the primary use of the remaining spots.

a.     If more than 50% is for customers, clients and the general public, the calculation ends.

                                                             i.     Any remaining cost is fully deductible.

b.    If more than 50% is for employees, there is math:

                                                             i.     Calculate the cost for reserved nonemployee parking; these costs are allowed.

                                                           ii.     Calculate the cost for nonreserved employee parking; these costs are disallowed.

Let’s go through an example from the Notice.

An accounting firm leases a parking lot for $10,000 next to its office. The lot has 100 spaces, used by clients and employees. The firm has 60 employees.

(1)  There are no reserved employee parking spaces

a.     We have zero (-0-) from this step.

(2)  The primary use is for employees (60/100).

a.     We have math.

(3)  There are no reserved nonemployee parking spaces (think visitor parking).

a.     We have zero (-0-) from this step.

(4)  One must use a reasonable allocation method. The accounting firm determines that employee use constitutes 60% (60/100) of parking lot use during business days, with no adjustment for evenings, weekends or holidays. The disallowance is $6,000 ($10,000 times 60%).

An accounting firm is a taxable entity, so the $6,000 is not deductible on its return.

What if we were talking about a nonprofit? Then the $6,000 magically “transforms” into unrelated business taxable income. The IRS spots $1,000 exemption, so the taxable amount is $5,000. Apply a 21% tax rate and the tax on the parking lot is $1,050.

What if the employer owns the parking lot? What costs could there be to a parking lot?

The IRS thought of this:

For purposes of this notice, “total parking expenses” include, but are not limited to, repairs, maintenance, utility costs, insurance, property taxes, interest, snow and ice removal, leaf removal, trash removal, cleaning, landscape costs, parking lot attendant expenses, security, and rent or lease payments or a portion of a rent or lease payment (if not broken out separately). A deduction for an allowance for depreciation on a parking structure owned by a taxpayer and used for parking by the taxpayer’s employees is an allowance for the exhaustion, wear and tear, and obsolescence of property, and not a parking expense for purposes of this notice.

At a minimum, I anticipate that one is allocating insurance and taxes.

So a nonprofit can have tax because it provides parking to its employees. You may have heard this referred to as the “church parking lot tax.” Yes, churches are 501(c)(3)s, meaning they are nonprofits just like the March of Dimes. Granted, there are additional tax breaks to being a church, such as not having to file a Form 990. The unrelated business income tax is not filed on a Form 990, however; it is filed on a Form 990-T. They both have “990” in their name, but they are separate tax forms. Who knows how many churches will have to file a Form 990-T for the first time for 2018, even though their board has never filed – or even seen - a Form 990.

How can a church have income from its parking lot?

If it charges for parking, obviously. That however is a low probability event.

Another way would be to have reserved employee parking spaces. Those are allocated cost (which morphs into income) immediately.

A third way is the employee:nonemployee calculation. That calculation would be tricky because of the uneven use of a church over an average week. One would somehow weight the use of the parking lot. Church employees are there Monday through Friday. The congregation is there on Sunday and (maybe) one night during the week. Perhaps employee parking is weighted using a factor of eight (hours) and congregational use is weighted using a factor of 2.5 (hours). Hopefully the result is to get congregational use above 50%. Why?

Remember: if nonemployee use at step (2) is more than 50%, the calculation ends. All the church would have to pay tax on is income from reserved employee parking. If that is below $1,000, there is no tax.

There is an effort to include a repeal of Code Section 512(a)(7) on any extender or other bill that Congress may pass, but that would require Congress to be able to pass a bill – any bill – in the near future.

The Notice also has one of the more unusual “make-up” provisions I have seen. Say that you want to do away reserved employee parking (that is, step (1)) because the tax gets expensive. It is way too late to do anything for 2018, as the guidance came out in December. The Notice allows you to make the change by March 31, 2019 and consider it retroactive to January 1, 2018.

Our church would have no step (1) income as long as it did away with reserved employee parking by March 31, 2019. That would mean taking down the sign saying “Pastor Parking Only,” but that may be the best alternative until Congress can correct this mess.

We Recently Lost An Employee

What I do for a living can be demanding.

I am thinking about it because we have lost another employee.

Mind you, there is always a good reason to leave: a larger firm, a smaller firm, someone wants to go private and get away from any firm, more predictable hours, a geographic move, … it is endless.

The auditors complain about the insane paper chase that has become their corner of the profession. They spend as much time completing checklists as actually doing any meaningful work. It truly takes an idiot to think that we can prevent the next Enron by checking a box on page 64 of a 98-page checklist.

Let me clue you in: by page 64 the auditor has zoned out.

The key to audit fraud is experience – the one thing the giant firms are not geared to provide. Their economics are based on 1 to 4-year accounting graduates. That is no country for old men. Or women.

Tax has fared no better.

It used to be that accountants would stagger year-ends for their business clients. Some would be June, some would be October. This helped to balance the workload and keep accountants from being crushed. Congress – reminding us that the truly useless become politicians – decided years ago that calendar year-ends were the way to go. They allowed a few exceptions, but the majority of closely-held businesses were herded to a calendar year-end.

BTW individuals also end their tax year on December.

So we have this insane crowding of work into two or so months. Granted, much is extended, meaning that the crowding occurs again when the extensions run out. There is no real reason for it, other than government whim and profligacy.

Why, no … gasp! We cannot possibly allow other-than-December year-ends because that would cause a one-time hit to the Treasury. Ignore the fact that there previously was a one-time boon to the Treasury when businesses went to December. The very pillars of society would fall!

Uh huh.

Congress continues its quest to have every economic transaction in American society reported to the government via a Form 1099 or its equivalent. Oh, and if you would be so considerate to do all this by January 31.

We tie-up at least three paraprofessionals for a good chunk of January with 1099s and payroll reporting. Let’s not go Boston University stupid and pretend this is not an indirect (but substantial) tax on business activity. A tax heaved on us by sociopaths who make $174,000 annually, live in one of the most expensive cities in the country but somehow become multimillionaires on a routine basis.

Uh huh.

Take an IRS that has sought for years to do more with less, meaning that more and more of what it does is automated. This returns us to all those 1099s the government wants, with its computer matching and automated notices.

I would be curious to know how many millions of man-hours are wasted every year by BS notices the IRS sprays out. Some of this used to be resolved internally before mailing a notice, as an IRS employee maybe … just maybe … actually looked at the file. Ah, how innocent we were then.

There are consequences to all this nonsense.

I had a conversation very recently with a CPA firm owner. We are similar in age and background. He was telling me how it is becoming almost impossible to hire, as there either is no one available or what is available is simply not hireable. Given our immediate needs, this was not good news.

Our conversation then expanded to the question of why a young person would pursue the career we ourselves chose years ago. There are so many more career paths now providing competitive income levels without depriving someone of 4 to 5 months of their life. Every year.

He did not want his kids to be accountants. They didn’t.

It is showing up in different ways. Accountancy, for example, remains a popular college major and graduation rates are strong. However, interest in pursuing a CPA credential is declining.

The CPA credential of course is closely associated with a CPA firm. When I was coming through there was a career point one could not pass if one did not have his/her CPA. One could make senior accountant, for example, but not manager without the certificate.

My CPA was not optimistic, arguing that our generation – his and mine – might be the last of its kind. 

I am hearing this opinion repeated by more and more practitioners. It is not uniform, mind you, but it is common.

I do not do gloom, but I also believe that the next generation of accountants will demand more life balance that we - the 50-and-60-year-old crowd – did when it was our turn.

Good for them.

What will it do to the giant CPA firms and their churn-and-burn business models? What will it do to the accounting governing bodies, who seem to represent the largest while seemingly having little interest in entrepreneurial and closely-held businesses the vast majority of CPAs – me included - represent? How about Congress? What if they passed a tax law in December and CPAs refused to work 24/7 for their incompetence?

I wish some of this had happened earlier in my career.

New York And State Donation Programs

You may have read that the new tax law will limit your itemized tax deduction beginning this year (2018).

This is of no concern to you if you do not itemize deductions on your personal return.

If you do itemize, then this might be a concern.

Here is the calculation:

        *  state income taxes plus

        *  local income taxes plus

        *  real estate taxes plus

        *  personal property taxes

There is a spiff in there if you live in a state without an income tax, but let’s skip that for now.

You have a sum. You next compare that sum to $10,000, and

… you take the smaller number. That is the maximum you can deduct.

Folks, if you live in New Jersey odds are that real estate taxes on anything is going to be at least $10 grand. That leaves you with no room to deduct New Jersey income taxes. You have maxed.

Same for New York, Connecticut, California and other high tax states.

Governor Cuomo said the new tax law would “destroy” New York.

Stepping around the abuse of the language, New York did put out an idea – two, in fact:

·       Establish a charitable fund to which one could make payments in lieu of state income taxes. When preparing one’s individual tax return, one could treat contributions to that fund as state taxes paid. To make this plausible, New York would not make the ratio one-to-one. For example, if you paid $100 to the charitable fund, your state tax credit might be $90. Surely no one would then argue that you had magically converted your taxes into a charitable deduction. The only one on the short end is the IRS, but hey … New York.

·      Have employers pay a new payroll tax on employee compensation, replacing employee withholding on that compensation.  Of course, to get this to work the employee would probably have to reduce his/her pay, as the employer is not going to keep his/her salary the same and pay this new tax.

Other states put out ideas, by the way. New York was not alone.

I somewhat like the second idea. I do however see the issue with subsequent raises (a smaller base means a smaller raise), possibly reduced social security benefits, possible employer reluctance to hire, and the psychological punch of taking a cut in pay. Ouch.

The first idea however has a sad ending.

You see, many states for many years thought that there were good causes that they were willing to subsidize.

·       Indiana has the School Scholarship Credit. You donate to a scholarship-granting charity and Indiana gives you a tax credit equal to 50% of the donation on your personal return.

·       South Carolina has something similar (the Exceptional SC), but the state tax credit is 100%.

New York and its cohorts saw these and said “What is the difference between what Indiana or South Carolina is doing and what we are proposing?”

Well, for one thing money is actually going to a charitable cause, but let’s continue.

This past summer the IRS pointed out the obvious: there was no charity under New York’s plan., The person making the “donation” was simultaneously receiving a tax benefit. That is hardly the hallmark of a charitable contribution.

Wait, wait, New York said. We are not giving him/her a dollar-for-dollar credit, so …..

Fine, said the IRS. Here is what you do. Subtract the credit from the “donation.” We will allow the difference as a deductible contribution.

In fact, continued the IRS, if the spread is 15% or less, we will spot you the full donation. You do not have to reduce the deduction for the amount you get back. We can be lenient.

So what have New York and cohorts done to Indiana, to South Carolina and other states with similar programs?

You got it: they have blown up their donation programs.

Way to go.

Why did the IRS not pursue this issue before?

Well, before it did not matter whether one considered the donation to be a tax or a deductible contribution. Both were deductible as itemized deductions. There was no vig for the IRS to chase.

This changed when deductible taxes were limited to $10,000. Now there was vig.

There are about 30 states with programs like Indiana and South Carolina, so do not be surprised if this reaches back to you.

A College Student and Ethereum

I have passed on Bitcoin and other cryptocurrencies.

I do not quite understand them, nor am I a Russian oligarch or Chinese billionaire trying to get money out of the country.

I certainly do not think of them as money.

The IRS agrees, having said that cryptos are property, not money.

This has very significant tax consequences.

I can take $100 out of my bank and pay cash at the dry cleaners, Starbucks, Jimmy John’s and Kroger without triggering a tax event.

Do that with a crypto and you have four taxable events.

That is the difference between property and money.

COMMENT: To be fair, money (that is, currency) can also be bought and sold like property. That is what the acronym “forex” refers to. It happens all the time and generally is the province of international companies hedging their cash exchange positions. Forex trading will trigger a tax consequence, but that is not what we are talking about here.

I am reading about a college student who in 2017 invested $5,000 in Ethereum, a cryptocurrency.

Within a few months his position was worth approximately $128,000.

He diversified to other cryptos (I am not sure that counts as diversification, truthfully) and by the end of the year he was closing on $900 grand.

Wow!

2018 has not been kind to him, however, and now he is back to around $125 grand.

Do you see the tax problem here?

Yep, every time he traded his crypto the IRS considered it taxable as a “sale or exchange” of property.

Maybe it is not that bad. Maybe he only traded two or three times and can easily pay the taxes from his $125 grand.

He estimates his 2017 taxes to be around $400 grand.

Seems a bit heavy to me, but let’s continue.

Does the IRS know about him?

Yep. Coinbase issued him a 1099-K reporting his crypto trades. Think of a 1099-K as the equivalent of a broker reporting your stock trades on a 1099-B.

He argues that he reinvested all his trades. He never took a personal check.

I don’t think he quite understands how taxes work. Try telling the IRS that you did not have taxable income upon the sale of your Apple stock because you left all the money in your brokers’ account.

He says that he reached out to a tax attorney – one who specializes in crypto.

I am glad that he sought professional help, whether attorney, CPA or EA.

I however doubt that the attorney’s crypto expertise is going to move the needle much. What he needs is a someone with expertise in IRS procedure, as he is rushing toward an installment plan, a partial pay or offer in compromise.

After all, he is not paying the $400 grand in taxes with what he has left.

Happy Thanksgiving!

Blade’s Offer In Compromise

I am enough of a nerd to say that I enjoyed the Blade movies. I am a fan of Wesley Snipes, who played the half-vampire vampire hunter in the series.

You may recall that he got into big-time tax trouble several years ago. He bought into tax protestor arguments, such as being an ambassador from the planet Naboo or some similar nonsense. He spent three years in prison.

When he came out of prison the IRS wanted over $23 million in taxes, penalties and interest.

He went to a Collections Due Process hearing. The purpose of a CDP is to tamp-down IRS aggressiveness in separating you from your money. The CDP has limited range, but sometimes that range makes all the difference.

So he goes and requests collection alternatives.

Perfect. Exactly what a CDP is designed to do.

He proposes an installment agreement.

There are flavors of these, and one of the flavors is called a “partial pay.” For a partial, you have to convince the IRS that you are unable to fully pay your taxes over the period the IRS can collect from you. You almost have to provide photos of Bigfoot to persuade the IRS to go along.

Alternatively, he proposes an offer in compromise (OIC).

In some cases, the difference between a partial pay and an OIC can be slight, except for maybe at the edges. For example, enter a partial pay and the IRS may request payment adjustment if your income goes up. That is a risk you do not have with an OIC.

Right there you can anticipate that an OIC is harder to obtain than a partial pay.

And an OIC for an actor who has made millions from movies is going to be harder still.

OICs are the “pennies on the dollar” tripe you hear on radio or late-night commercials. Those “pennies” OICs are few and far between, and usually involve some or all of the following factors:

·      Someone was injured and will never work again

·      Someone has retired and will never work again

·      Someone owns next to nothing

·      Someone owes the IRS money   

The key theme here is that someone is broke, and there is little likelihood that condition will ever change.

Folks, that is not tax planning. That is bad luck in life, very poor life choices, or both.

Wesley Snipes put in an OIC of $842,061.

Out of $25 million plus.

Heck, even I don’t believe him.

Let’s begin with personal financials. You know the IRS is going to check him out, especially with such a lowball offer.

·      Snipes owns real estate and other assets through a series of related companies.

OK. The IRS is going to have to look at this.

·      Snipes argued that some of this real estate had been sold or went missing.

OK. The IRS is going to have to look at this.

·      Snipes argued that his financial advisor had “diverted” his assets and money without his knowledge or consent.

OK. The IRS is going to have to look at this.

·      Snipes requested that his tax liability be “transferred” to his advisor, as the advisor had conveniently “transferred” Snipe’s assets to himself. This would require an investigation, of course, and perhaps the IRS could place his account in “currently not collectible” status during the investigation.

I suspect there is or will be a lawsuit here. I would have hired an attorney and filed papers already.

The problem is that Appeals (where Snipes was at the moment) is not built for this. Snipes is requesting an audit, and audits are done by Examination. Given what was alleged, this matter could even go to the Criminal Division of the IRS. While Appeals can review the work of the field (Examination) division, they cannot perform the field investigation themselves.

·      He has one more argument: economic hardship.

Problem: the normal indicia of economic hardship include illness, disability, or exhaustion of income or assets providing for oneself or dependents. These do not apply in his case.

That leaves an argument that he is unable to borrow against assets, and the forced sale of said assets would leave him unable to meet basic expenses.

This argument may have traction. He is – after all – asserting that assets have disappeared and he doesn’t know when or where.

But he failed to provide enough financial information to allow the IRS to evaluate the matter. The IRS and the Court kept circling on this point. Could it be that he truly could not sherlock what happened to his money?

However, not providing information in an OIC tends to be fatal.

Still, the IRS was moved. They agreed to reduce the settlement to $9,581,027.

Snipes’ team said: No. It is $842,061 or nothing.

The Court said: Then nothing it is.

I suspect the most interesting part of the story is the part that was not provided: what happened to the real estate and other money?

I also wonder if there is a certain schadenfreude here.

Tax protestors sometimes use unnecessarily complicated structures (trusts, for example) to distance, obscure and possibly hide the ultimate control of money or assets. A protestor would not own real estate directly, for example. Rather an entity would own the real estate and the protestor would control the entity. Or there would be an intermediate entity owned by yet another entity controlled by the protestor.

What if the protestor goes to prison? The protestor might then cede a certain amount of authority over the entity/entities to someone – like an advisor - while incarcerated.

What happens if that advisor does not have the protestor’s best interest at heart?

Might sound a lot like what we read here.

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.