Roth IRA Recharacterizations Are Going Away

You may have heard that there has been a tax change in the land of Roth IRAs. It is true, and the change concerns recharacterizations.

And what does that seven-syllable word mean?

Let’s say that you have $50,000 in a traditional (or “Trad”) IRA. “Traditional” means that you got to deduct the money when you put it in. You did so over several years, and you now have – after compounding - $50 grand. Congrats.

You read that this thing is a tax bomb waiting to go off.

How?

Simple. It will be taxable income when you take it out. That is the bargain with the government: they give you the deduction now and you give them the tax later.

You decide to convert your “Trad” into a Roth. That way, you do not pay tax later when you take the money out.

You find out that it is pretty easy to convert, irrespective of what you hear on radio commercials. Let’s say your money is with Vanguard or T Rowe Price. Well, you call Vanguard or T Rowe and explain what you are up to. They will explain that you need a Roth IRA account. You will then have two IRA accounts:

          CTG Reader Traditional IRA, and

          CTG Reader Roth IRA

There is $50 grand in the Traditional IRA account.

You convert.

There is now $50 grand in the Roth IRA and $-0- in the Traditional IRA accounts.

You did it. Good job.

BTW you just created $50 grand of taxable income for yourself.

How? Well, you converted money from an IRA that would be taxable someday to an IRA that will not be taxable someday. The government wants its money someday, and that someday is today.

You didn’t think the government would go away, did you?

Let’s walk this thing forward. Say that we go into next year and your Roth IRA starts tanking. It goes to $47 grand, then $44 grand. The thing is taking on water.

It is time to do your taxes. You and I are talking. We talk about that $50 grand conversion. You tell me about your fund or ETF slipping. I tell you that we are extending your return.

Why?

That is what changed with the new law.

For years you have had until the date you (properly) file your return to “undo” that $50 grand conversion. That is why I want to extend your return: instead of having to decide on April 15, extending lets you wait until October 15 to decide. You have another six months to see what that mutual fund or ETF does. 

Let's say that we wait until October 8^th and the thing has stabilized at $43 grand.

You feel like a chump paying tax on $50 grand when it is only worth $43 grand.

I have you call Vanguard or T Rowe and have them move that money back into CTG Reader Traditional IRA. Mind you, this has to be done by October 15 as the tax extension will run out. We file your return by October 15, and it does NOT show the $50 grand as income.

Why? You unwound the transaction by moving the money back to the Traditional account. Think of it as a mulligan. The nerd term for what we did is “recharacterization.”

It is a nice safety valve to have.

But we will soon have recharacterizations no more. To be accurate, we still have it for 2017 returns but it goes away for later tax years. Your 2017 return can be extended until October 15, 2018, so October 15, 2018 will be extinction day for recharacterizations. It will just be a memory, like income averaging.

BTW there is a variation on the above that will continue to exist, but it is only a distant cousin of what we discussed. Let’s go to your 2018 tax return. In March, 2019 you put $5,500 in a Roth IRA. You will still be able to reverse that $5,500 back to a regular IRA by October 15, 2019 (remember to extend!).

But the difference is that the distant cousin is for one year’s contribution only. You will not be able to take a chunk of money that you have accumulated over years, roll it from a Trad to a Roth and have the option to recharacterize back to a Trad in case the stock market goes wobbly.

Sad in a way.

Patents, Capital Gains and Hogitude

I have an acquaintance who has developed several patents.  He works for a defense contractor, so I suspect he has more opportunity than a tax CPA.

COMMENT: Did you know that tax advisors have tried to “patent” their tax planning? I suppose I could develop a tax shelter that creates partnership basis out of thin air and then pop the shelter to release a gargantuan capital loss to offset a more humongous capital gain…. Wait, that one has already been done. Fortunately, Congress passed legislation in 2011 effectively prohibiting such nonsense.

Let’s say that you develop a patent someday. Let’s also say that you have not signed away your rights as part of your employment package. Someone is now interested in your patent and you have a chance to ride the Money Train. You call to ask how about taxes.

Fair enough. It is not everyday that one talks about patents, even in a CPA firm.

Think of a patent as a rental property. Say you have a duplex. Every month you receive two rental checks. What type of income do you have?

You have rental income, which is to say you have ordinary income. It will run the tax brackets if you have enough income to make the run.

Let’s say you sell the duplex. What type of income do you have?

Let’s set aside depreciation recapture and all that arcana. You will have capital gains.

People prefer capital gains to ordinary income. Capital gains have a lower tax rate.

Patents present the same tax issue as your duplex. Collect on the patent - call it royalties, licensing fees or a peanut butter sandwich – and you have ordinary income. You can collect once or over a period of time; you can collect a fixed amount, a set percentage or on a sliding rate scale. It is all ordinary income.

Or you can sell the patent and have capital gains.

But you have to part with it, same as you have to part with the duplex. 

Intellectual property however is squishier than real estate, which make sense when you consider that IP exists only by force of law. You cannot throw IP onto the bed of a pickup truck.

Congress even passed a Code section just for patents:

§ 1235 Sale or exchange of patents.

(a)  General.

A transfer (other than by gift, inheritance, or devise) of property consisting of all substantial rights to a patent, or an undivided interest therein which includes a part of all such rights, by any holder shall be considered the sale or exchange of a capital asset held for more than 1 year, regardless of whether or not payments in consideration of such transfer are-

(1)  payable periodically over a period generally coterminous with the transferee's use of the patent, or (2) contingent on the productivity, use, or disposition of the property transferred.

The tax Code wants to see you part with “substantial rights,” which basically means the right to use and sell the patent. Limit such use – say by geography, calendar or industry line – and you probably have not parted with all substantial rights.

Bummer.

What if you sell to yourself?

It’s been tried, but good thinking, tax Padawan.

What if you sell to yourself but make it look like you did not?

This has potential. Your training is starting to kick-in.

Time to repeat the standard tax mantra:

pigs get fat; hogs get slaughtered

Do not push the planning to absurd levels, unless you are Google or Apple and have teams of lawyers and accountants chomping on the bit to make the tax literature.

Let’s look at the Cooper case as an example of hogitude.

James Cooper was an engineer with more than 75 patents to his credit. He and his wife formed a company, which in turn entered into a patent commercialization deal with an independent third party.

So far, so good. The Coopers got capital gains.

But the deal went south.

The Coopers got their patents back.

Having been burned, Cooper was now leery of the next deal. Some sharp attorney advised him to set up a company, keep his ownership below 25% and bring in “independent” but trusted partners.

Makes sense.

Mrs. Cooper called her sister to if she wanted to help out. She did. In fact, she had a friend who could also help out.

Neither had any experience with patents, either creating or commercializing them.

Not fatal, methinks.

They both had full-time jobs.

So what, say I.

They signed checks and transferred funds as directed by the accountants and attorneys.

They did not pursue independent ways to monetize the patents, relying almost exclusively on Mr. Cooper.

This is slipping away a bit. There is a concept of “agency” in the tax Code. Do exactly what someone tells you and the Code may consider you to be a proxy for that someone.

Maybe the tax advisors should wrap this up and live to fight another day.

The sister and her friend transferred some of the patents back to Cooper.

Good.

For no money.

Bad.

The sister and her friend owned 76% of the company. They emptied the company of its income-producing assets, receiving nothing in return. Real business owners do not do that. They might have a career in the House of Representatives, though.

Meanwhile, Cooper quickly made a patent deal with someone and cleared six figures.

This mess wound up in Tax Court.

To his credit, Cooper argued that the Court should just look at the paperwork and not ask too many questions. Hopefully he did it with aplomb, and a tin man, scarecrow and cowardly lion by his side.

The Tax Court was having none of his nonsense about substantial rights and 25% and no-calorie donuts.

The Court decided he did not meet the requirements of Section 1235.

The Tax Court also sustained a “substantial understatement” penalty. They clearly were not amused. 

Cooper reached for hogitude. He got nothing.

Mental Illness And The Statute Of Limitations

Many people and most tax practitioners (hopefully) know the statute of limitations on refunds from the IRS:

§ 6511 Limitations on credit or refund.

(a)  Period of limitation on filing claim.

Claim for credit or refund of an overpayment of any tax imposed by this title in respect of which tax the taxpayer is required to file a return shall be filed by the taxpayer within 3 years from the time the return was filed or 2 years from the time the tax was paid, whichever of such periods expires the later, or if no return was filed by the taxpayer, within 2 years from the time the tax was paid. Claim for credit or refund of an overpayment of any tax imposed by this title which is required to be paid by means of a stamp shall be filed by the taxpayer within 3 years from the time the tax was paid.

We can shorthand this as the “3 and 2” rule.

Then there was the Brockamp case in 1997, which many felt was unfair and which led Congress to write this beauty:

§ 6511 Limitations on credit or refund.

(h)  Running of periods of limitation suspended while taxpayer is unable to manage financial affairs due to disability.

(1)  In general.

In the case of an individual, the running of the periods specified in subsections (a) , (b) , and (c) shall be suspended during any period of such individual's life that such individual is financially disabled.

(2)  Financially disabled.

(A)  In general. For purposes of paragraph (1) , an individual is financially disabled if such individual is unable to manage his financial affairs by reason of a medically determinable physical or mental impairment of the individual which can be expected to result in death or which has lasted or can be expected to last for a continuous period of not less than 12 months. An individual shall not be considered to have such an impairment unless proof of the existence thereof is furnished in such form and manner as the Secretary may require.

Like so much of the tax Code, the heavy lifting is in the details. Brockamp had been senile. Congress addressed the issue by introducing the phrase “medically determinable,” and then handed the baton to the IRS to define what that verbal salad meant.

COMMENT: And there you have a capsule summary of how the Code has gotten away from us over the years. Congress writes words and then leaves it to the IRS and courts to determine what they mean. Congress did the pooch again with the Tax Cuts and Jobs Act.  Google “qualified business income” and tell me that isn’t an elmore waiting to happen.

           

The IRS issued its interpretation of “medically determinable” in Rev Proc 99-21:

SECTION 4. PROCEDURE Unless otherwise provided in IRS forms and instructions, the following statements are to be submitted with a claim for credit or refund of tax to claim financial disability for purposes of § 6511(h).

(1)   a written statement by a physician (as defined in § 1861(r)(1) of the Social Security Act, 42 U.S.C. § 1395x(r)), qualified to make the determination, that …

The IRS is pointing to the Social Security rules to define what a physician is. Methinks this is poor work. Why not reference Beat Bobby Flay to define meal expenses or Car Talk to define transportation expenses?

Let’s look at the Green case.

Richard Green and his wife (Hae Han) went to Tax Court in 2009. There were taxes due and tax refunds and quite the debate about offsetting one against the other.  The case eventually got to Sec 6511(h), and here is what the Court had to say about it:

An individual will not, however, be considered financially disabled unless proof of a medically determinable physical or mental impairment is provided in such form and manner as the Commissioner may require. More specifically, the Commissioner requires a written statement from a physician. Ms. Han, however, did not establish that she was financially disabled. In addition, she was treated by a clinical psychologist, not a physician, and thus could not and did not provide the requisite documentation.

Ms. Han’s letter was written by a psychologist. 

COMMENT: I am thinking: why is a psychologist not considered a “physician?” An optometrist is considered one for this purpose, although an optometrist has an O.D. and not an M.D.

There was no relief for Green and Han.

A number of practitioners considered this decision to be nonsense. The IRS had grafted a Medicare definition concerning payment for services onto Sec 6511(h), which was supposed to be a relief provision in the tax Code.

Enter the Estate of Stauffer, which is presently in Court.

Carlton Stauffer died in 2012 at the age of 90. His son is administering the estate. He discovered that his dad had not filed tax returns for 2006 through 2012. He filed those returns on behalf of his dad. One year alone – 2006 – had a refund of approximately $137,000.

The IRS denied the refund as outside the 3-year window.

The son appealed and pointed at Sec 6511(h).

His father had been seeing a psychologist, who treated him from 2001 until his death in 2012. The psychologist wrote a persuasive letter explaining how Carlton had suffered from psychological problems in addition to ailments including congestive heart failure, chronic obstructive pulmonary disease, leukemia, and chronic pneumonia. He explained how all these factors negatively impacted Carlton’s mental capacity, cognitive functioning, decision making and prevented him from successfully managing his affairs.

The IRS said: show us the “M.D.”

Why wouldn’t they? They had won with that play before.

The estate sued in District Court.

The IRS motioned to dismiss, order boneless chicken wings and watch the NBA over a pitcher of beer.

The District Court denied the IRS motion.

The Court pointed out that – for all the IRS’ power – that it could still review Rev Proc 99-21 under the “arbitrary and capricious” standard that government agencies are held to. The IRS had to articulate a rational connection for its standard, as well as explain why it rejected any reasonably obvious alternatives to the challenged rule.

The Court pointed out that Social Security does not restrict the types of professionals who may opine on whether someone has a disability qualifying for disability benefits. In fact, the opinion of a psychologist is given great weight in such a determination.

The Court did not see how the IRS dismissal of a psychologist’s letter passed the “arbitrary and capricious” standard.

Mind you, the Estate of Stauffer won a motion only; this does not mean that it will win the overall case.  

I for one hope it does.

Remember The Port

One thing about this blog is that it likely reflects what’s happening here at Intergalactic Command.

Here goes: it is unlikely that you will need an extensive and expensive estate tax plan, unless you (a) have unique family issues, such as a special needs child, or (b) have a tractor-trailer load of money.

Pass away in 2018 and you will not have a federal estate tax until you get to $11.2 million.

OBSERVATION: This amount increased under the new tax bill.

Folks, that excludes almost everybody.

I suppose you could live in a state with a state estate tax, like Illinois. If you do, here is some tax advice: move.

So how do you get into the federal estate tax?

It is easy enough in concept.  

Here goes:

                          Net FMV of assets you die with

                                           Plus

                    Reportable gifts made over your lifetime

BTW, notice that assets you die with and assets you gifted away are added together. The IRS is going to tax you whether you kept stuff or gave it away. The nerd term for this is “unified” tax.

There are tricks and traps to “assets you die with,” but, for the most part, it means what it says. The “net” means you get to deduct your liabilities from your assets. The “FMV” means fair market value. Take a car for example. You might get its FMV from Kelly Blue Book.

What does “reportable gifts” mean?

Let walk around the block on this. Let’s say you made a gift to a family member in 2017. Do you have to report it?

Depends on the amount. For 2017 the annual gift tax exclusion was $14,000. This means that you could gift anyone on the planet $14,000 and the government did not need to know. If you were married, then your spouse and you could double-up, meaning that together you could gift $28,000 without the government needing to know.

Let’s say that you are single. You gifted someone $50,000 in 2017. What have you got?

Easy enough: $50,000 – 14,000 = $36,000 is reportable. Yep, you went over the limit. You have to file a gift tax return.

Mind you, it is very unlikely that you will have any gift tax due on that return.

Why not?

Let’s circle back to the formula:

                             

                          Net FMV of assets you die with

                                           Plus

                    Reportable gifts made over your lifetime

You haven’t died yet, so the first line is zero.

But you still have the second line.

Remember that you can die in 2018 with $11.2 million and not be taxed.

Folks, if someone has gifted over $11.2 million (mind you, this is over a lifetime), please call or e-mail me. I want to get into that person’s will – I mean, I want to develop a lifelong friendship with a kindred soul.  

What if you fudge the numbers? You know, play down the gifts a bit? Who will know once you are gone, right?

If you are married, there could be a hitch with this.

Let’s take a look at the Estate of Sower case.

Frank Sower passed away in 2012, leaving Minnie as his surviving spouse. He filed an estate tax return, and it showed an unused estate tax exclusion of $1,250,000.         

COMMENT: Beginning in 2010, any unused estate tax exclusion of the first-to-die spouse could carryover to the surviving spouse. For example, the exclusion for 2011 was $5 million. Let’s say that the first-to-die had a taxable estate of $3.6 million. The balance - $1.4 million – could transfer to the surviving spouse.

This was a big improvement in tax practice. Previously tax professionals used trusts – “family” trusts and “marital” trusts, for example - to make sure that estate tax exclusions did not go squandered. One can still use trusts if one wants, but it is not as mandatory as it used to be. The transfer of the unused exclusion to the surviving spouse is called “portability” (“port” to the nerds) and it required (and still requires) the first-to-die to file a federal estate tax return, whether otherwise required, if only to alert the IRS that some of the exclusion is being ported.

There was however a problem with Frank’s estate return: the preparer left out $940,000 of reportable gifts. That in turn meant that the unused exclusion was overstated, as those unreported gifts would have soaked up a chunk of it.

Minnie died in 2013. Her estate showed the unused exemption ported from Frank. It was wrong, but it was there. The same tax preparer must have done her estate return, as once again her reportable gifts were left off.

The IRS audited her estate return and caught the mistake. They wondered whether Frank’s return had the same issue. It did, of course, so the IRS adjusted Frank’s ported exemption.

When the dust settled, Minnie’s estate owed another $788,165.

Ouch. Folks, the estate tax has one of the highest rates in the Code. A lot of effort goes into minimizing this thing. At least Congress has gotten away from having  taxable estates begin at $600,000, as it did in the nineties. Average folk did not consider $600,000 to be “wealthy,” no matter what Congress and the grievance mongers said.

The estate litigated. They argued that the Frank’s estate had a closing letter (think magical letter, but the estate’s letter was non-magical); that the adjustment to the port was an impermissible second review of Frank’s return; that the IRS position improperly overrode the statute of limitations, and so on. The estate lost on all counts.

What do we learn from Sower?

         

(1) It is OK to port.

(2) But the IRS can adjust the port if you get it wrong.

What did we learn from this post?

Remember the port.

The Backdoor Roth

It has come up often enough that I decided to talk about it.

The backdoor Roth.

What sets up this tax tidbit?

Being able to contribute to a Roth in the first place. More accurately, NOT being able to contribute.

Let’s say that you are single and work somewhere without a retirement plan. No 401(k), SIMPLE, SEP, nothing. You make $135,000.

Can you fund an Roth IRA?

Yep.

Why?

Because you do not have a plan at work.

How much can you fund?

$5,500. That becomes $6,500 if you are age 50 or over.

Let’s say you have a plan at work.

How much can you fund?

Nada.

Why?

Because you have a plan at work and you make too much money.

What is too much?

For a single person, $133,000. I question what fantasyland these tax writers live in where $133 grand is too-much-money, but let’s move on.

A Roth is a flavor of IRA. It is like going to Baskin Robbins and deciding whether you want your chocolate ice cream in a sugar cone or waffle cone. Either way you are getting chocolate ice cream.

Let’s say that someone wants to fund a Roth. Say that someone is a well-maintained, moderately successful, middle-aged tax CPA with diminishing dreams of ever playing in the NFL. He is married. His wife works. His back hurts during busy season. His daughter never calls ….

Uhh, back to our discussion.

He has a no plan at work. His wife does.

So we know the income limits will apply, as (at least) one of them is covered by a plan.

For 2017 that limit is $196,000.

Let’s say our tax CPA makes $18,000. His wife makes $180,000.

I see $198,000 combined. He is over the income limit.

Our CPA cannot contribute into a Roth, because a Roth is a flavor of IRA and he has exceeded the income limits for an IRA.

I suppose our CPA can ask his wife to dial it back a notch. Or get divorced.

Or consider a back door.

There are two things to understanding the backdoor:

(1)         We have discussed two types of IRAs: the traditional (that is, deductible) and the Roth. There is a third, although he has moved out of the house and rarely attends family events (at least willingly) anymore.

The third is the nondeductible. He is the wafer cone.

You get no deduction for putting money in. You will pay something when you take money out.

When you pull money out, you calculate a ratio:

 * Nondeductible money you put in/total value of account *

That ratio is not taxable; the balance is.

There is even a tax form for this - Form 8606. You are supposed to use this form every year you make a nondeductible contribution. I understand that there is a penalty for not doing so, but I have never seen that penalty in practice.

And no one would do this if a Roth is available. When you pull money out of a Roth, all of the distribution is nontaxable (if you followed the rules). That result will always beat a nondeductible.

The Roth effectively killed the nondeductible, which perhaps explains why the nondeductible is the unfriendly and distant family member.

But the nondeductible has one trick to its game: there is no income test to a nondeductible. Our tax CPA cannot fund a Roth (went over the limit by a lousy $2 grand), but he can fund that nondeductible. There is no deduction, but there will be no penalty for overfunding an IRA, either.   

(2)         But how to get this nondeductible into a Roth?

Call the broker and have him/her move the money from an account titled “Nondeductible IRA FBO Cincinnati Tax Guy” to one titled “Roth IRA FBO Cincinnati Tax Guy.”

This event is called a “conversion.”

You have to pay tax on a conversion.

Why?

Because you are moving money that has never been taxed to an account that will never be taxed. The government wants its vig, and the conversion is as good a time to tax as any.

How much tax?

Here is the beauty: since our tax CPA did not deduct the thing, tax law considers him to have dollar-for-dollar “basis” in the thing. If he put in $5,500, then his basis is $5,500.

Say he converts it when it is worth $5,501.

Then his income is $5,501 – 5,500 = $1.

Yep, he has to pay tax on $1 to convert the nondeductible to a Roth.

But there is ONE MORE RULE. Too often, tax commentators fail to point this one out, and it is a biggie.

He is probably hosed if he has ANY traditional (that is, deductible) IRAs out there. This triggers the “aggregation” or “pro rata” rule, and the rule is not his friend.

Let’s calculate a ratio.

The numerator is the amount he is converting: $5,500 in our example.

The denominator is ALL the money in ALL his traditional/deductible IRA accounts.

Say our tax CPA had $994,500 in his regular/traditional/free-range IRA before the $5,500 backdoor.

He now has $1 million after the backdoor.

His ratio would be 5,500/1,000,000 = 0.0055.

What does this mean?

It means that the inverse: 100% – 0.55% = 99.445% of every dollar will be taxable.

Counting with fingers and toes, I say that $5,470 is taxable.

The nondeductible saved him tax on all of $30, which appears to meet the definition of “near useless.”

So much for that $1 of conversion income he was hoping for. He got hung on the aggregation rule.

This is an extreme example, but any significant ratio is going to trigger significant taxable income on the conversion.

Is this deliberate by the IRS?

Does Tiger chase little white balls?

Our heroic and stoic tax CPA has other IRAs. The backdoor Roth has become unreachable for him.

Or has it?

Here is a thought: what if our tax CPA rolls ALL of his IRAs into the company 401(k)?

COMMENT: I know I previously said he did not have a plan at work. Work with me here, folks.

He would have to call the 401(k) people and see if they permit that. Federal tax law says he can, but that does not mean that his particular plan has to allow it.

Let’s say he can.

He now has zero/zip/zilch in traditional/deductible/sustainable IRAs.

Seems to me that he is back to converting for $1 in income, per our first example.

And there is your backdoor.