Using An Annuity To Teach Tax

I intend someday to return to college and teach tax. It would be an adjunct position, as I have no intention of taking up another full-time job after this. One tax CPA career is enough.

I have previously taught accounting but not tax. There is some order to accounting: debits and credits, recording transactions and reconciling accounts. Tax and accounting may be siblings, but the tax Code does not purport to show anyone’s net income according to “generally accepted accounting principles.” It may, mind you, but that would be a coincidence.

Sometimes there are jagged edges to tax accounting. Have Johnson & Johnson issue financial statements pursuant to the tax Code and they would likely find themselves in front of the SEC.   

Let's say you are taking your first tax course. The syllabus includes:

·        What is income?

·        What is deductible?

·        Why doesn’t the answer make sense?

I am looking at Tobias v Commissioner. I give the taxpayers credit, as they were thinking outside the box. They knew they hadn’t made any money, irrespective of what the IRS said.

Edward Tobias was an attorney and kept an inactive CPA license. His wife was a school administrator. They had bought a variable annuity in 2003 for almost $230,000. In order to free up the cash, they sold stock at a loss of approximately $158,000. They put another $346,000 into the annuity over the years.

Fast forward to 2010. They withdrew $525,000 to buy and improve a residence. At that point in time, the deferred income (that is, the inside buildup) in the annuity policy was approximately $186,000. They insurance company sent them a Form 1099 for $186,000.

But they left the $186,000 off their 2010 tax return. They did attach an explanation, however:

The … account was funded with after-tax funds and all withdrawals have been made prior to annuitization. Accordingly, any potential gains should be applied to the prior capital loss carryforward, which is approximately $148,000. Additionally, this account has not recouped losses incurred in prior years and has incurred substantial withdrawal penalties; the calculation made by … is incorrect and is contested.”

You know the IRS was going to match this up.

The Tobias’ had a remaining capital loss of $148,000 from stock they sold to buy the annuity. In addition they had already put approximately $576,000 into the annuity, an amount less than the withdrawal. They were just getting their money back, even without taking that capital loss into consideration. 

The IRS on the other hand said they had $186,000 in income. The IRS also wanted an early distribution penalty of almost $19,000.

Who is right?

When the Tobias’ withdrew $525,000, they took deferred income with it. This is the “income first” rule of Code Section 72(e), and the rule has been there a long time. It says that – upon taking money from an annuity – the inside income is the first thing to come out. Like the fable of the frog and scorpion, that is what annuities do.

What about the $148,000 capital loss? A capital loss has a separate set of rules. Capital losses offset capital gains dollar-for-dollar. Past that they offset non-capital-gain income up to $3,000 per year. Annuity income however is not capital gain income, so we are stuck at $3,000.

But the economics were interrelated, argued the Tobias’. They sold the stock to buy the annuity. The loss on that should offset the income from the annuity, right?

No, not right.

When these transactions hit the tax return, each took on its own tax attribute. One attribute went to house Gryffindor, another to house Hufflepuff. They are all in Hogwarts, but they have been separated by the tax Sorting Hat. You cannot just mix them together - unless the Code says you can mix them together. Unfortunately, the Code does not say that.

So you have the odd result that the Tobias’ owed tax and penalty on more money than they made from the deal.

The answer makes sense to a tax guy.

It may just be a bit hard to teach.

Does A Charitable Remainder Trust Have To Be Charitable?

Over the years I have been able to work with very wealthy people. That level of wealth allows the tax attorneys and CPAs to bring out their toys. Granted, there may not be as many toys as when I came out of school, but the toys can still be impressive.

A favorite is the charitable remainder trust.

The concept is simple: you transfer money or other assets to a charity. They in turn agree to pay you an amount for a number of years, which may be the rest of your life. When you pass away, the balance of the trust (the remainder) goes to the charity.

Let’s add some horsepower under the hood:

(1)   You fund the trust with appreciated assets: real estate or stocks, for example. Odds are the trustee will sell the assets, either immediately or over time, to free-up the cash with which to pay your annuity.

Here is the tax gimmick: if you sold the stock or real estate, you would have a big tax bill. The trust sells the stock or real estate and you have … nothing. It’s like a Penn and Teller show!

(2)   Since the trust does not pay tax, more money is left to invest. This could allow larger annual payouts to you, a larger donation at the end, or a combination of the two.

(3)   I exaggerated a bit. While the trust does not pay tax, you will pay tax every year as you receive your payment. Still, you are paying over a period of years, likely a better result than paying immediately in the year of sale.

(4)   You get an immediate tax deduction for the part of the trust that will go to charity. Even if that is decades off, you get a tax deduction today.  

There are some crazy mathematics when working with this type of trust. The answer can vary wildly depending upon age, assumed rates of return (for the invested assets), discount rates (for the passage of time), whether you take an dollar annuity or a percentage annuity, the amount of the annuity and so on.

And then advisors have added bells and whistles over the years. For example, it is possible to put a “limit” on the annual annuity. How? One way is to restrict the annuity to the “income” of the trust. If the income exceeds the annuity, then the annuity is paid in full. If the annuity exceeds the income, then the annuity gets reduced.

Add one more bell and whistle: let’s say that the annuity gets a haircut. Can that reduction accumulate and be carried-over to be paid in the future, or is it forever lost? You can design the trust either way.

A charitable remainder trust with this income limit is referred to as a “NIMCRUT.” Yes, the “NI” stands for net income. Working in this area is like learning a foreign language.

Now, let’s talk about the Estate of Arthur Schaefer. We said the mathematics are crazy, as each piece can move the answer and there seems to be an endless supply of pieces. That “NI” we talked about is itself a piece. Can “NI” blow up our trust?

Mr. Schaefer settled two charitable remainders trusts during his lifetime, one for each son. He made them “NIMCRUTS,” with the provision that any income limitation would carryover and be payable in a later year, if able. Schaefer of course took a tax deduction for the charitable part.

OBSERVATION: These two trusts would also be gifts (to the sons) and trigger a gift tax return.

But he included one more thing: he set the annuity payouts fairly high – 10% for one trust and 11% for the other.

That creates a problem. If you expect the trust to pay out 10% (or 11%) a year, you better invest in stocks that are going to go exponential or you will eventually run out of money. There will be nothing left for the charity. Heck, there may not be anything left for the two sons.

No problem, said the trustee. You see, if the trusts do not have enough income (remember: NIMCRUT), then the 10% or 11% will never be paid. Those trusts can never run out of money. 

Problem, said the IRS. Throwing that NIMCRUT in there is fancy shoes and all, but you cannot take the NIMCRUT limit into account when that is the only way that the charity will ever receive a penny. Maybe Schaefer should have toned-down the 10% or 11% thing a bit and not put so much pressure on the NIMCRUT limit to get these trusts to work.

The matter wound up in Tax Court.

NOTE: Schaefer passed away and it was his estate that was litigating with the IRS. This happened because of the way the estate tax and the gift tax overlap, but we will spare ourselves the tortuous details.

It appears that there was a very sharp tax attorney behind these two trusts, looking at quotes by the Court:

            “We find the text of section 664(e) ambiguous.”

            “The regulations are less clear.”

But there is danger when a tax attorney walks out on a narrow ledge:

“… where a statute is ambiguous, the administrative agency can fill gaps with administrative guidance to which we owe the level of deference appropriate under the circumstances.”

Oh, oh. “Administrative” here means the IRS.

            “… we find the Commissioner’s guidance to be persuasive.”

And so the estate lost, meaning that somewhere in here the charitable donations were lost. Someone was writing the IRS a check.

Charitable remainder trusts are great tax vehicles. I have worked with them to a greater or lesser degree for over two decades, but one has to have some common sense. It is a “charitable” remainder trust. Something has to go to charity. Granted, the mathematics may border on Big Bang Theory, but the overall concept still applies. If it takes a high-powered attorney to parse the tax Code to the Tax Court, the deal may not be for you.

Using a 401(k) to Supercharge a Roth

Let’s talk this time about a tax trick that may be available to you if you participate in a 401(k). The reason for the “may” is that – while the tax Code permits it – your individual plan may not. You have to inquire.

Let’s set it up.

How much money can you put into your 401(k) for 2015?

The answer is $18,000. If you are age 50 or over you can contribute an additional $6,000, meaning that you can put away up to $24,000.

Most 401(k)’s are tax-deductible. There are also Roth 401(k)’s. You do not get a tax break like you would with a regular 401(k), but you are putting away considerably more than you could with just a Roth IRA contribution.

Did you know that you might be able to put away more than $18,000 into your 401(k)?

How?

It has to do with tax arcana. A 401(k) is a type of “defined contribution” (DC) plan under the tax Code. One is allowed to contribute up to $53,000 to a DC plan for 2015. 

What happens to the difference between the $18,000 and the $53,000?

It depends. While the IRS says that one can go up to $53,000, your particular plan may not allow it. Your plan may cut you off at $18,000.

But there are many plans that will allow.  

Now we have something - if you can free-up the money.

Let’s say you max-out your 401(k). Your company also contributes $3,000. Combine the two and you have $21,000 ($18,000 plus $3,000) going to your 401(k) account. Subtract $21,000 from $53,000, leaving $32,000 that can you put in as a “post-tax” contribution. 

Did you notice that I said “post-tax” and not “Roth?” The reason is that a Roth 401(k) is limited to $18,000 just like a regular 401(k). While the money is after-tax, it is not yet “Roth.”

How do you make it Roth?

Prior to 2015, there had been much debate on how to do this and whether it could even be done. The issue was the interaction of the standard pro-rata rules for plan distributions with the unique ordering rule of Code Section 402(c)(2).

In general, the pro-rata rule requires you to calculate a pre- and post-tax percentage and then multiply that percentage times any distribution from a plan.

EXAMPLE: You have $100,000 in your 401(k). $80,000 is from deductible contributions, and $20,000 is from nondeductible. You want to roll $20,000 into a Roth account. You request the plan trustee to write you a $20,000 check, which you promptly deposit in a newly-opened Roth IRA account. 

           Will this work?

Through 2014 there was considerable doubt. It appeared that you were to calculate the following percentage: $20,000/$100,000 = 20%. This meant that only 20% of the $20,000 was sourced to nondeductible contributions. The remaining $16,000 was from deductible contributions, meaning that you had $16,000 of taxable income when you transferred the $20,000 to the Roth IRA. 

I admit, this is an esoteric tax trap.

But a trap it was. 

There were advisors who argued that there were ways to avoid this result. The problem was that no one was sure, and the IRS appeared to disagree with these advisors in Notice 2009-68. Most tax planners like to keep their tires on the pavement (so as not to get sued), so there was a big chill on what to do.

The IRS then issued Notice 2014-54 last September.

The IRS has clarified that the 401(k) can make two trustee-to-trustee disbursements: one for $80,000 (for the deductible part) and another of $20,000 (for the nondeductible). No more of that pro-rata percentage stuff.

There is one caveat: you have to zero-out the account if you want this result.

Starting in 2015, tax planners now have an answer.

Let’s loop back to where we started this discussion.

Let’s say that you make pretty good money. You are age 55. You sock away $59,000 in your 401(k) for five years. Wait, how did we get from $53,000 to $59,000? You are over age 50, so your DC limit is $59,000 (that is, $53,000 plus the $6,000 catch-up). Your first $24,000 is garden-variety deductible, as you do not have a Roth option. The remaining $35,000 is nondeductible. After 5 years you have $175,000 (that is, $35,000 times 5) you can potentially move to a Roth IRA. You may have to leave the company to do it, but that is another discussion.

Not a bad tax trick, though.

Ohio Residency: Bright-Line and Common-Law Tests

How does one become an Ohio resident?

It’s not hard, I suppose. One could just buy a house in Ohio and live there.

How does one stop being an Ohio resident?

That one is a bit trickier. I would probably start by selling that same house and moving. It is a simple solution, but not one tailored to the needs of the snowbirds. I would not mind being a snowbird. Call me crazy, but I could separate myself from Cincinnati winters and spend that time in better weather.

Let’s say that you live in Cincinnati. You have a second home in Ft. Myers, Florida and a great deal of discretion as to how much time you spend in each state. You would like to move your “residency” to Florida, as Florida does not have an income tax. You still have friends and family in Cincinnati, however, so you intend to keep your house here. Can you do so and still be considered a Florida resident?

Of course you can.

Ohio is not one of those states that will chase you down to the ends of the earth to tax you years after you have left.

But that doesn’t mean there aren’t rules to follow.

And someone recently thought that those rules did not apply to them. The case is Cunningham v Testa. Let’s talk about it.

We have talked before about the idea of “domicile” in state taxation. Domicile is easy for the vast majority of us. We have one house, and we live there with our family. We have one house, one abode, one domicile. A house gives one an “abode,” and if one is fortunate one can afford more than one abode. Domicile rises above that. Domicile wants to know which abode is one’s true home: the one with the pencil markings measuring the kids’ height over the years, the squeaky floorboard at the top of the steps, the cold corner in the living room that never really warms up no matter how one sets the thermostat.

Domicile wants to know which abode is that house. You know - your home. The concept borders on the mystical.

Ohio is one the states that looks at domicile when determining whether one is a resident or nonresident. Ohio doesn’t care about that house in Florida. That is just an abode until one raises it to the level of domicile.

Remember that Ohio has a tremendous number of snowbirds. In years past the state expended a not-insignificant amount of resources reading tea lives and consulting Tarot cards to figure-out whether or not someone was an Ohio resident. Ohio needed something less employee-intensive.

Ohio decided to use a “bright-line” test and would henceforth look at “contact periods.” If one had enough contact periods it would consider one a resident. If not, it would consider one a nonresident … unless there were other factors indicating that one was a resident.  

For the most part it was now an arithmetic exercise. The “… unless” part was there to prevent one from gaming the count.

COMMENT: A contact period occurs if (1) one is away from his/her domicile (2) overnight and (3) is in Ohio for all or part of two consecutive days.  It is not the same as sleeping overnight in Ohio, as the test is not where one sleeps. One could book a hotel in Covington, Kentucky for example, and cross the bridge into Ohio in the morning. If one crossed the bridge for two consecutive days, there would be a contact period.

Ohio added up the contact periods. If there were at least 183, then Ohio considered one a resident.

            NOTE: Starting in 2015 that count has been raised to 213.

Back to the Cunninghams.

He filed an “Affidavit of Non-Ohio Domicile” for tax year 2008, using his name, social security number and Cincinnati address. She did not file anything.

COMMENT: Mrs. Cunningham is immediately out-of-the-game.

He declared he was a resident of Tennessee, although he did not give an address.   

            COMMENT: That did not help.

Nonetheless, filing the Affidavit shifted the burden to Ohio.

And Ohio responded by issuing a notice and then an assessment.

The Cunninghams appealed.

Time to show your cards, Ohio.

(1)   Cunningham and his wife were raised in Ohio and raised their children there.

COMMENT: Fail. What else do you have, Ohio?

(2)   He listed his Ohio address on his tax return.

COMMENT: Dumb but not fatal.

(3)   He had his Tennessee utility bills forwarded to Cincinnati for payment.

COMMENT: Same as (2), although I am wondering who was in Cincinnati to pay the bills if they were in Tennessee.

(4)   He maintained an Ohio driver’s license.

COMMENT: That guy, he is such a procrastinator …

(5)   He voted in Ohio during the year.

COMMENT: Did no one advise this guy?

(6)   He did not present a calendar of contact periods.

COMMENT: He’s got this ADD thing with paperwork …

(7)   He filled-out paperwork to obtain homestead exemption on his Cincinnati residence.

COMMENT: Really?! I mean it, REALLY???

Let’s just say that the Tax Commissioner persuaded the Ohio Supreme Court that any affidavit Cunningham filed was bunkum. Cunningham was an Ohio resident under common-law tests. The bright lines rules – while invaluable – are not an absolute defense against the common-law tests for residency.

There has been some hyperventilation in the wake of this decision. Here is an example from the Ohio Society of CPAs:

This ruling will encourage even more litigation whenever the commissioner decides to challenge an affidavit as ‘false,’ and will render almost meaningless the recent increase in allowable contact periods from 182 to 212.”  

No, no it doesn’t, and I greatly doubt that Ohio wants to get into repetitive shootouts with taxpayers on this issue. That is why Ohio moved to a bright-line standard in the first place.

Just have some common sense out there, folks.