Donald Rumsfeld's Letter to the IRS

Did you hear about or see Donald Rumsfeld’s letter accompanying his tax  return to the IRS? Mr. Rumsfeld was Chief of Staff under President Ford and then Secretary of Defense in the George W. Bush Administration. 

It turns out that he writes a letter to the IRS to accompany his tax return every year. This year he published the letter on Twitter. Here it is:

He brings up a point that is on my mind this close to April 15: why do so many people use professional tax preparers? Mind you, over the years I have prepared or reviewed tax returns for very wealthy people. It is understandable why such people have preparers. I will when I become ridiculously rich.

What we are talking about are your neighbors or mine. Perhaps they have a small business, perhaps they own a duplex or perhaps inherited a little bit of money. They are far from broke but nowhere near wealthy. Why are they using a preparer?

Because the average person can hardly do his/her own return anymore.

If one is poor, then one is looking at the earned income tax credit. That thing makes even professional preparers cringe. Did you know there is a tax credit for low-income taxpayers contributing to their 401(k)?

Let’s say you start making a little bit of money. When does your deduction for student loan interest phase-out? Do you know how to handle the child care tax credit if you have dependent care taken out through your cafeteria plan? Is there a tax credit for those new windows on your house?

You and a family member own an LLC. You draw a paycheck. Do you owe self-employment tax on the profit left over?

That duplex shows a tax loss, caused mostly by depreciation. Can you claim the loss on your tax return?

You start making money. What is the “net investment income” tax, and does it apply to a family business you have little to do with, other than maybe annual meetings? What about that bank account you keep in Canada, as you have a cabin there? Is there any kind of tax break for all that alternative minimum tax you have paid in recent years?

I am a professional tax advisor, and I agree that the system is broken. There is no equivalent to our income tax preparation industry in the U.K. for example, which is even more remarkable when one remembers that perilously close to one-half of Americans do not pay income taxes.Thanks to Donald Rumsfeld for speaking out on this matter.

IRA Rollover Decision Stuns Advisors

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

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

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

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

We are talking today about Type 2.

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

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

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

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

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

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

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

Now we look at Bobrow v Commissioner.

Here is the setup:

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

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

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

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

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

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

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

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

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

Now think about this for a second.

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

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

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

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

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