Wiping Out An Inherited IRA

I came across an unfortunate tax situation this week.

It has to do with IRAs and trusts.

More specifically, naming a trust as a beneficiary of an IRA.

This carried a bit more punch before the tax law change of the SECURE Act, effective for 2020. Prior to the change, best planning for an inherited IRA frequently included a much younger beneficiary. This would reset the required distribution table, with the result that the monies could stay in the IRA for decades longer than if the original owner had lived. This was referred to as the “stretch” IRA. The SECURE Act changed that result for most beneficiaries, and now IRAs have to distribute – in general – over no longer than 10 years. 

Trusts created a problem for stretch IRAs, as trusts do not have an age or life expectancy like people do. This led to something called the “look-through” or “conduit” trust, allowing one to look-through the trust to its beneficiary in arriving at an age and life expectancy to make the stretch work.

The steam has gone out of the conduit trust.

One might still want to use a trust as an IRA beneficiary, though. Why? Here is an example:

The individual beneficiary has special needs. There may be income and/or asset restrictions in order to obtain government benefits.

What is the point, you ask? Doesn’t the IRA have to distribute to the individual over no more than 10 years?

Well … not quite. The IRA has to distribute to the trust (which is the IRA beneficiary) over no more than 10 years. The trust, in turn, does not have to distribute anything to its individual beneficiary.

This is referred to as an accumulation trust. Yes, it gets expensive because the trust tax rates are unreasonably compressed. Still, the nontax objectives may well outweigh the taxes involved in accumulating.

There is something about an inherited IRA that can go wrong, however. Do you remember something called a “60-day rollover?” This is when you receive a check from your IRA and put the money back within 60 days. I am not a fan, and I can think of very few cases where I would use or recommend it.

Why?

Because of Murphy’s Law, what I do and have done for over 35 years.

You know who can do a 60-day rollover?

Only a surviving spouse can use a 60-day rollover on an inherited IRA.  

You know who cannot do a 60-day rollover on an inherited IRA?

Anyone other than a surviving spouse.

It is pretty clear-cut.  

I am looking at someone who did not get the memo.

Here are the highlights:

·      Husband died.

·      The wife rolled the IRA into her own name (this is a special rule only for surviving spouses).

·      The wife died.

·      A trust for the kids inherited the IRA.

No harm, no foul so far.

·      The kids wanted to trade stocks within the IRA.

So it begins.

·      The IRA custodian told the kids that they would have to transfer the money someplace else if they wanted to trade.

No prob. The kids should have the IRA custodian transfer the money directly to the custodian of a new IRA that will let them trade to their heart’s content.

·      The kids had the IRA custodian transfer the money to a non-IRA account owned by the trust.

And so it ends.

The kids were hosed. They tried a Hail Mary by filing a private letter request with the IRS, asking for permission to put the money back in the IRA. The IRS looked at the tax law for a split second … and said “No.”

The IRS was right.

And, as usual, I wonder what happened with calling the tax advisor before moving around not-insignificant amounts of money.  

One can point out that taxes would have been payable as the kids withdrew money, and an inherited IRA has to distribute. If mom died in 2020 or later, the IRA would have to be distributed over no more than 10 years anyway.

Still, 10 years is 10 years. If nothing else, it would have given the kids the opportunity to avoid bunching all IRA income into one taxable year.

Not to mention paying for a private letter ruling, which is not cheap.

I hope they enjoy their stock trading.

The cite for the home gamers is PLR 202125007.

Taxation of Olympic Winnings

The summer Olympics are going on in Tokyo. I have watched little of the competitions. As I have gotten older, I watch less and less television, Olympics included. My heaviest TV consumption is just around the corner, when the NFL season begins. I am an unabashed NFL junkie.

Let’s discuss the taxation of Olympic awards, including medals.

In general, the law taxes all awards and prizes. There are exceptions, of course, but for years there was no exception for Olympic medals and prize money.

This means that if someone won a gold medal, for example, Uncle Sam was standing on the podium with the athlete waiting for his cut.

Can you imagine having to pay tax on a gold medal?

Although a gold medal is not pure gold. The last pure gold medal was awarded in 1912, and today’s gold medals are over 90% silver. Gold medals at the 2012 London Olympics were less than 2% gold, for example.

Then there is the issue that a medal – once awarded – can be worth more than the weight of the metals that went into its manufacture. Boxing fans may remember the boxer Wladimir Klitschko from the 1996 Atlanta games. He sold his gold medal in 2012 for $1 million, donating the proceeds to charity.  

There may also be cash winnings. The U.S. Olympic and Paralympic Committee (USOPC) will pay a winning athlete approximately $37,000 per gold medal. While not bad, it pales in comparison to some other countries. Singapore will pay over $730 thousand for a gold medal, by comparison.

The real money of course is in endorsements. Usain Bolt receives $4 million per year from Puma as a brand ambassador, even after retirement. Not bad work if you can get it.

Back to tax. The general rule is that all prizes and awards are taxable, unless the Code allows an exception.

In 2016 lawmakers decided that it was a bad look to assess tax on Olympic winners. Two senators – John Thune, a Republican from South Dakota and Chuck Schumer, a Democrat from New York – submitted a bill to change this situation. Here is a joint statement, something we are unlikely to see again in the near to intermediate political future:

It’s no secret that athletes don’t become Olympians overnight. For many of the competitors who’ve been fortunate enough to earn a spot on an Olympic or Paralympic podium, it’s a lifetime’s worth of work that has come with years of blood, sweat and tears.

It’s a patriotic endeavor that often has a large price tag affiliated with it, too.

Under the current tax code, medals and any associated prize stipend are considered taxable income.

Tax policy is too often complicated and partisan, which makes the bill we introduced this year unique. Our bill passed the Senate without a dissenting vote, and is about as simple as they come. The bill, which awaits action in the House, would bar the IRS from leveeing a victory tax on Olympic and Paralympic medalists.

Preventing the IRS from taxing medals and modest cash incentive prizes sends the right message to present and future members of Team USA: Rather than viewing Olympic success as another chance to pay Uncle Sam, it’s a special opportunity to celebrate American patriotism and the Olympic tradition.

The tax on Olympic winnings was called the “victory tax,” and President Obama signed the United States Appreciation for Olympians and Paralympians Act into effect on October 7, 2016. There was an important issue, however: how were professionals (think Kevin Durant, for example) to be taxed? These athletes were already making eye-watering sums of money, and to exclude their winnings seemed … an overreach … if one was truly trying to reward the amateur athlete.

Here is the Code section:

           Code § 74 - Prizes and awards

              (d) Exception for Olympic and Paralympic medals and prizes

(1) In general

Gross income shall not include the value of any medal awarded in, or any prize money received from the United States Olympic Committee on account of, competition in the Olympic Games or Paralympic Games.

(2) Limitation based on adjusted gross income

(A) In general

Paragraph (1) shall not apply to any taxpayer for any taxable year if the adjusted gross income (determined without regard to this subsection) of such taxpayer for such taxable year exceeds $1,000,000 (half of such amount in the case of a married individual filing a separate return).

How therefore is an Olympic winner taxed?

·      There is no tax on the medal itself.

·      Prize money is not taxed unless the athlete has substantial other income, with substantial meaning over $1 million (half that if married filing separately).

·      Endorsement income is taxable as normal.

Penalties, Boyle and “Reductio Ad Absurdum.”

 

In logic there is an argument referred to as “reductio ad absurdum.” Its classic presentation is to pursue an assertion or position until it – despite one progressing logically – results in an absurd conclusion. An example would be the argument that the more sleep one gets, the healthier one is. It does not take long to get to the conclusion that someone who sleeps 24 hours a day – in a coma, perhaps – is in peak physical condition.

I am looking at a tax case that fits this description.

What sets it up is our old nemesis – the Boyle decision. Boyle hired an attorney to take care of an estate tax return. The attorney unfortunately filed the return a few months late, and the IRS came with penalties a-flying. Boyle requested penalty abatement for reasonable cause. The Court asked for the grounds constituting reasonable cause. Boyle responded:

                  I hired an ATTORNEY.”

Personally, I agree with Boyle.

The Court however did not. The Court subdivided tax practice in a Camusian manner by holding that:

·      Tax advice can constitute reasonable cause, as the advice can be wrong;

·      Relying on someone to file an extension or return for you cannot constitute reasonable cause, as even a monkey or U.S. Representative could google and find out when the filing is due.

 Here is an exercise for the tax nerd.

(1)  Go to the internet.

(2)  Tell me when a regular vanilla C corporation tax return is due.

(3)  Change the corporate year-end to June 30.

a.    When is that return due?

Yes, the due dates are different. I know because of what I do. Would you have gone to step (3) if I had not pushed you?

Jeffery Lindsay was in prison from 2013 to 2015. He gave his attorney a power of attorney over everything – bank accounts, filing taxes and so on. Lindsay requested the attorney to file and pay his taxes. The attorney assured him he was taking care of it.

He was taking care of Lindsay, all right. He was busy embezzling hundreds of thousands of dollars is what he was doing. Lindsay got wind, sued and won over $700 grand in actual damages and $1 million in punitive damages.

The IRS came in. Why? Because the last thing that the attorney cared about was filing Lindsay’s taxes, paying estimates, any of that. It turns out that Lindsay had filed nothing for years. Lindsay of course owed back taxes. He owed interest on the tax, as he did not pay on time. What stung is that the IRS wanted over $425 grand in penalties.

He did what you or I would do: request that the penalties be abated.

The Court wanted to know the grounds constituting reasonable cause.

Are you kidding me?

Lindsay pointed out the obvious:

         I was in PRISON.”

Here is the Court:

One does not have to be a tax expert to know that tax returns have fixed filing dates and that taxes must be paid when they are due.”

The Court agreed with the IRS and denied reasonable cause.

Lindsay was out hundreds of thousand of dollars in penalties.

I consider the decision the logical conclusion of Boyle. I also think it is a bad decision, and it encapsulates, highlights and magnifies the absurdity of Boyle using the logic of “reductio ad absurdum.”

Our case this time was Lindsay v United States, USDC No 4:19-CV-65.

A Day Trader and Wash Losses

 

We have had a difficult time with the tax return of someone who dove into the deep end of the day-trading pool last year. The year-end Fidelity statement reported the trades, but the calculation of gain and losses was way off. The draft return landed on my desk showing a wash loss of about $2.5 million. Problem: the client was trading approximately $250 grand in capital. She would have known if she lost $2.5 million as either she (1) would have had a capital call, (2) used margin, or (3) done a bit of both.

Let’s talk about wash sales.

The rule was created in 1921 because of a too-favorable tax strategy.

Let’s say that you own a stock. You really believe in it and have no intention of parting with it. You get near the end of the year and you are reviewing your to-date capital gains and losses with your advisor. You have $5 thousand in capital gains so far. That stock you like, however, took a dip and would show a $4 thousand loss … if you sold it. The broker hatches a plan.

“This is what we will do” says the broker. We will sell the stock on December 30 and buy it back on January 2. You will be out of the stock for a few days, but it should not move too much. What it will do is allow us to use that $4 thousand loss to offset the $5 thousand gain.”

It is a great plan.

Too great, in fact. Congress caught wind and changed the rules. If you sell a stock at a loss AND buy the same or substantially identical stock either

·      30 days before or

·      30 days after …

… the sale creating the loss, you will have a wash sale. What the tax law does is grab the loss ($4 thousand in our example) and add it to the basis of the stock that you bought during the 30 day before-and-after period. The loss is not permanently lost, but it is delayed.

Mind you, it only kicks-in if you sell at a loss. Sell at a gain and the government will always take your money.

Let’s go through an example:

·      On June 8 you sell 100 shares at a loss of $600.

·      On July 3 you buy 100 shares of the same stock.

You sold at a loss. You replaced the stock within the 61-day period. You have a wash loss. The tax Code will disallow the $600 loss on the June 8 trade and increase your basis in the July 3 trade by $600. The $600 loss did not disappear, but it is waiting until you sell that July 3 position.

Problem: you day trade. You cannot go 48 hours without trading in-and-out of your preferred group of stocks.

You will probably have a lot of wash sales. If you didn’t, you might want to consider quitting your day job and launching a hedge fund.

Problem: do this and you can blow-up the year-end tax statement Fidelity sends you. That is how I have a return on my desk showing $2.5 million of losses when the client had “only” $250 grand in the game.

I want to point something out.

Let’s return to our example and change the dates.

·      You already own 100 shares of a stock

·      On June 8 you buy another 100 shares

·      On July 3 you sell 100 shares at a loss

This too is a wash. Remember: 30 days BEFORE and after. It is a common mistake.

The “substantially identical” stock requirement can be difficult to address in practice. Much of the available guidance comes from Revenue Rulings and case law, leaving room for interpretation. Let’s go through a few examples.

·      You sell and buy 100 shares of Apple. That is easy: wash sale.

·      You sell 100 shares of Apple and buy 100 shares of Microsoft. That is not a wash as the stocks are not the same.

·      You sell 30-year Apple bonds and buy 10-year Apple bonds. This is not a wash, as bonds of different maturities are not considered substantially identical, even if issued by the same company.

·      You sell Goldman Sachs common stock and buy Goldman Sachs preferred. This is not a wash, as a company’s common and preferred stock are not considered substantially identical.

·      You sell 100 shares of American Funds Growth Fund and buy 100 shares of Fidelity Growth Company. The tax law gets murky here. There are all kinds of articles about portfolio overlap and whatnot trying to interpret the “substantially identical” language in the area of mutual funds.  Fortunately, the IRS has not beat the drums over the years when dealing with funds. I, for example, would consider the management team to be a significant factor when buying an actively-managed mutual fund. I would hesitate to consider two actively-managed funds as substantially identical when they are run by different teams. I would consider two passively-managed index funds, by contrast, as substantially identical if they tracked the same index.  

·      You sell 100 shares of iShares S&P 500 ETF and buy the Vanguard S&P 500 ETF.  I view this the same as two index mutual funds tracking the same index: the ETFs are substantially identical.

·      Let’s talk options. Say that you sell 100 shares of a stock and buy a call on the same stock (a call is the option to buy a stock at a set price within a set period of time). The tax Code considers a stock sale followed by the purchase of a call to be substantially identical.

·      Let’s continue with the stock/call combo. What if you reverse the order: sell the call for a loss and then buy the stock? You have a different answer: the IRS does not consider this a wash.

·      Staying with options, let’s say that you sell 100 shares of stock and sell a put on the same stock (a put is the option to sell a stock at a set price within a set period of time). The tax consequence of a put option is not as bright-line as a call option. The IRS looks at whether the put is “likely to be exercised,” generally interpreted as being “in the money.”

Puts can be confusing, so let’s walk through an example. Selling means that somebody pays me money. Somebody does that for the option of requiring me to buy their stock at a set price for a set period. Say they pay me $4 a share for the option of selling to me at $55 a share. Say the stock goes to $49 a share. Their breakeven is $51 a share ($55 minus $4). They can sell to me at net $51 or sell at the market for $49.  Folks, they are selling the stock to me. That put is “in-the-money.”  

Therefore, if I sell a put when it is in-the-money, I very likely have something substantially identical.

There are other rules out there concerning wash sales.

·      You sell the stock and your spouse buys the stock. That will be a wash.

·      You sell a stock in your Fidelity account and buy it in your Vanguard account. That will be a wash.

·      You sell a stock and your IRA buys the stock. All right, that one is not as obvious, but the IRS considers that a wash. I get it: one is taxable and the other is tax-deferred. But the IRS says it is a wash. I am not the one making the rules here.

·      There is a proportional rule. If you sell 100 shares at a loss and buy only 40 shares during the relevant 61-day period, then 40% (40/100) of the total loss will be disallowed as a wash.

Let’s circle back to our day trader. The term “trader” has a specific meaning in the tax Code. You might consider someone a trader because they buy and sell like a madman. Even so, the tax Code has a bias to NOT consider one a trader. There are numerous cases where someone trades on a regular, continuous and substantial basis – maybe keeping an office and perhaps even staff - but the IRS does not consider them a trader. Maybe there is a magic number that will persuade the IRS - 200 trading days a year, $10 million dollars in annual trades, a bazillion individual trades – but no one knows.

There is however one sure way to have the IRS recognize someone as a trader. It is the mark-to-market election. The wash loss rule will not apply, but one will pay tax on all open positions at year-end. Tax nerds refer to this as a “mark,” hence the name of the election.

The mark pretends that you sold everything at the end of the year, whether you actually did or did not. It plays pretend but with your wallet. This tax treatment is different from the general rule, the one where you actually have to sell (or constructively sell) something before the IRS can tax you.

Also, the election is permanent; one can only get out of it with IRS permission.

A word of caution: read up and possibly seek professional advice if you are considering a mark election. This is nonroutine stuff – even for a tax pro. I have been in practice for over 35 years, and I doubt I have seen a mark election a half-dozen times.

Exceptions to Early Distribution Penalties

 

What caught my eye about the case was the reference to an “oral opinion.”

Something new, methought.

Better known as a “bench opinion.’

Nothing new, methinks.

What happened is that the Tax Court judge rendered his/her opinion orally at the close of the trial.

Consider that a tax case will almost certainly include Code section and case citations, and I find the feat impressive.

Let’s talk about the case, though, as there is a tax gotcha worth discussing.

Molly Wold is a licensed attorney. She was laid-off in 2017. Upon separation, she pulled approximately $86 grand from her 401(k) for the following reasons:

(1)  Pay back a 401(k) loan

(2)  Medical expenses

(3)  Student loans

(4)  Mortgage and other household expenses

You probably know that pulling money from a 401(k) is a taxable event (set aside a Roth 401(k), or we are going to drive ourselves nuts with the “except-fors”).

Alright, she will have income tax.

Here is the question: will she have an early distribution penalty?

This is the 10% penalty for taking money out from a retirement account, whether a company plan (401(k), 403(b), etc) or IRA and IRA-based plans (SIMPLE, SEP, etc). Following are some exceptions to the penalty:

·      Total and permanent disability

·      Death of the account owner

·      Payments over life expectancy; these are sometimes referred to as “Section 72(t)” payments.

·      Unreimbursed medical expenses (up to a point)

·      IRS levy

·      Reservist on active duty

Then it gets messy, as some exceptions apply only to company-based plans:

·      Leaving your job on reaching age 55 (age 50 if a public safety employee)

Is there a similar rule for an IRA?

·      Withdrawals after attaining age 59 ½.

Why age 55 for a 401(k) but 59 ½ for an IRA?

Who knows.

Molly was, by the way, younger than age 55.

There are exceptions that apply only to a company-based plan:

·      A qualified domestic relations order (that is, a divorce)

·      Dividends from an ESOP

There are exceptions that apply only to an IRA and IRA-based plans:

·      Higher education expenses

·      First-time homebuyer (with a maximum of $10,000)

Yes, Congress should align the rules for both company, IRA and IRA-based plans, as this is a disaster waiting to happen.

However, there is one category that all of them exclude.

Ms Wold might have gotten some pop out of the exception for medical expenses, but that exclusion is lame. The excluded amount is one’s medical expenses exceeding 7.5% of adjusted gross income (AGI). I suppose it might amount to something if you are hit by the proverbial bus.

The rest of the $86 grand would have been for general hardship.

Someone falls on hard times. They turn to their retirement account to help them out. They take a distribution. The plan issues a 1099-R at year-end. Said someone says to himself/herself: “surely, there is an exception.”

Nope.

There is no exception for general hardship.

10% penalty.

Let’s go next to the bayonet-the-dead substantial underpayment penalty. This penalty kicks-in when the additional tax is the greater of $5,000 or 10% of the tax that should have been shown on the return.

Folks, considering the years that penalty has been around, you would think Congress could cut us some slack and at least increase the $5 grand to $10 grand, or whatever the inflation-adjusted equivalent would be.

Ms Wold requested abatement of the penalty for reasonable cause.

Reasonable cause would be that this area of the Code is a mess.

You know who doesn’t get reasonable cause?

An attorney.

Here is the Court:

So I will hold her as a lawyer and as a highly intelligent person with a good education to what IRS instructions that year showed.”

Our case this time was Woll v Commissioner, TC Oral Order.

IRS Rejects A Religious Organization’s Tax-Exempt Application

 

We have a nonprofit application for exempt status that has gone off the rails.  

The reviewing (IRS) officer wanted them, for example, to recharter under a different category of nonprofit status.

I considered it arbitrary, but if it made him happy….

He called this week threatening to terminate his review altogether. I called him back immediately.

What happened, I asked

You have not forwarded all the information I asked for, he explained.

I faxed you several documents in early June. I said. I am unaware of having omitted anything.

I need state certification of the amendment to the charter, he replied.

Which he had not requested previously.

Fine. I called the secretary of state’s office, explaining my situation. They were very helpful and by the end of the day I received a verification that I could forward to the IRS.

The nonprofit, by the way, is a high school booster club. The IRS is treating them like they were Amazon. Folks, these are parents selling pop and snacks at high school games. All they are trying to do is buy bleachers and build restrooms nearer the athletic fields. The IRS overkill here is ridiculous.

My previous exempt application, on the other hand, went smoothly. I had one conversation with the reviewing officer and that was it.

Yes, one’s experience with the IRS can vary greatly depending on whom one is working with.

I am looking at IRS response to an application by an organization called Christians Engaged. It caught my attention for two reasons: first, the response came out of Cincinnati; second, the organization got turned down. I get curious when an application is rejected. I remember, for example, an application rejected for being little more than a masquerade for sending family members to college on a tax-deductible basis.

Let’s set this up:

(1)  The organization was organized in Texas in 2019.

(2)  The founder and president is a former Republican Congressional candidate and a preacher.

(3)  The vice president is a former Promise Keepers prayer coordinator and a homeschool mom.

(4)  The secretary is a millennial managing Republican field teams in Collins county, Texas.

Sounds 2021-ish.

The organization’s mission statement includes the following:

a.    Regular prayer for the nation

b.    Impact culture by voting every election

c.    Encourage political education and activism

d.    Educate Christians on the importance of prayer, voting and nonpartisan political engagement

Got it. There is noticeable call-to-action here.

So what are the activities of Christians Engaged?

(1)  Hold weekly prayer meetings for state and federal leaders, including distribution of program outlines to participating churches.

(2)  Maintain a website and social media providing educational materials and connections for Christians to become politically active.

(3)  Educate believers on issues central to biblical faith, such as the sanctity of life, the meaning of marriage, private versus governmental ethics, religious liberty, and so on.

(4)  Conduct educational activities, including a course in political activism, with a basis in Biblical and Christian value systems.

(5)  Educate on how to select between imperfect candidates as well as political party impact on elected officials.

Tax-exempts have to be careful when they approach political activities.  The type of exempt we are discussing here is the (c)(3) - the most favorable tax status, as contributions to a (c)(3) are tax-deductible.

As a generalization, a tax-exempt is permitted to advocate on issues affecting them, the community, society and the nation. Think environmental protection or domestic abuse, for example, and you will get a feel for it.

What it cannot do is lobby (at least, not to any significant extent).

What is lobbying?

An obvious example is direct lobbying: contacting an elected or government official with the intent of influencing new or existing legislation.

Less obvious is indirect lobbying, sometimes referred to as grassroots lobbying. Rather than contacting an elected or government official directly, the goal is to influence and motivate the public to do so.

To me this definition is soapy water. A tax exempt is allowed to advocate, and obviously it will advocate on behalf of its mission statement. An early education (c)(3) will, for example, advocate with the goal of getting someone to leave the couch and take action on early education matters.  

We have to tighten-up the definition of grassroots lobbying to make it workable.

How about this:

Attempt to influence the general public through communications that:

·      Refer to specific legislation

·      Reflect a point of view on said legislation, and

·      Include a call to action

Better. It seems that a general education or exhortation mission – and leaving specific legislation or candidates alone - will fit into this definition.

What did the IRS reviewing officer see in the Christians Engaged application?

(1)  The activities approach that of an action organization, involving itself with political campaigns and candidates.

How, me asks?

The organization involves itself on issues prominent in political campaigns, instructing what the Bible says about the issue and how the public should vote.

(2)  The issues discussed are more commonly affiliated with certain candidates of one political party rather than candidates of another party, meaning the organization’s activities are not neutral.

(3)  The organization itself is not neutral, as it instructs people on using and voting the Bible. 

(4)  The organization serves the interest of the Republican party more than incidentally, meaning it serves a substantial nonexempt purpose.

 Huh?

Let’s just quote the IRS: 

Specifically, you educate Christians on what the Bible says in areas where they can be instrumental including the areas of sanctity of life, the definition of marriage, biblical justice, freedom of speech, defense, and borders and immigration, U.S. and Israel relations. The bible teachings are typically affiliated with the [Republican] party and candidates.”

That took a turn I did not expect.

I expected an analysis of applying soapy-water standards of grassroots lobbying to societal reality in the 21^st century.  

We got something … else.

The matter is being appealed, of course.