The Economy and Other Retirement Account Mysteries

The economy and the markets were major factors in retirement plans last year. Roth individual retirement account 2010 conversions were recharacterized in the wake of declining account values. And during desperate times, some IRA owners were victimized. On the bright side, the income tax cost of converting to a Roth IRA, including reconverting a recharacterized Roth IRA, will remain constant through

The economy and the markets were major factors in retirement plans last year. Roth individual retirement account 2010 conversions were recharacterized in the wake of declining account values. And during desperate times, some IRA owners were victimized. On the bright side, the income tax cost of converting to a Roth IRA, including reconverting a recharacterized Roth IRA, will remain constant through the end of 2012, with the top tax rates set at 35 percent. After that, the Bush tax cuts are slated to expire, sending the top rates back up to 39.6 percent, unless Congress intervenes. Whether they will intervene remains a mystery.

Alternate Valuation

The Internal Revenue Service has proposed regulations on alternate valuation elections for retirement accounts. Market declines invariably cause some estates to make this election by choosing to value the assets on the alternate valuation date (AVD), instead of on the decedent's date of death (DOD). The AVD is the date when an asset that was part of the decedent's estate is distributed, sold, exchanged or otherwise disposed of. Otherwise, the AVD is six months after the DOD.

Estates are permitted to make the election when doing so reduces both the value of a gross estate and the combined amount of estate and generation-skipping transfer taxes.

Until now, it's been a mystery how alternate valuation applies to retirement accounts, which often hold investment portfolios. Some practitioners report each portfolio asset held in an IRA on Schedule I of Form 706 (the unbundlers), while others treat the account in its entirety as one asset to report (the bundlers). These two approaches can lead to very different alternate valuation results. Also, it hasn't been clear when retirement accounts passing to beneficiaries are considered distributions under various circumstances. The IRS' proposed regulations will solve most, if not all, of these mysteries.1

Affected plans

The proposed regulations apply to IRAs or similar trusts, such as Roth IRAs, Internal Revenue Code Section 403(b) plans and 401(k) accounts. The regulations don't apply to some types of qualified plan benefits and 457 accounts of exempt organizations and government agencies. The IRS should, at the very least, include elective deferral accounts and Roth elective deferral accounts of 457 plans. I'll use the term “IRAs” to refer to all the covered retirement plans.

What counts as distribution?

The proposed regulations don't treat an IRA passing at death as a distribution on the DOD. Instead, after death, the determination of the AVD is made separately for each asset held inside the account.

Transferring a decedent's IRA to an inherited IRA held for the benefit of the IRA's beneficiary doesn't fix the AVD. Moving an IRA from one account to another in a trustee-to-trustee transfer also shouldn't fix the AVD of the account's assets.

But if, for example, the beneficiary sells a bond held in the IRA's portfolio within six months of the decedent's death, that sale will fix the AVD as to those shares. So will payment in retirement of the bond at maturity.

Many IRAs have more than one beneficiary. The proposed regulations say that dividing the decedent's IRA into several accounts (one account for each beneficiary) won't count as a distribution and won't accelerate the AVD. Thus, the alternate valuation election shouldn't affect the decision as to when to divide the decedent's IRA into several inherited IRAs.

Trust as beneficiary

What if a trust is the beneficiary of an IRA and the trustee transfers it to one or more trust beneficiaries within six months of the owner's death? Unlike an IRA that passes to one or more individuals under the beneficiary designation, an in-kind transfer of an IRA from an estate or trust to its beneficiaries will fix the AVD. Thus, the proposed regulations view a change of beneficial interest in an IRA that occurs some time after death as an event that fixes the AVD.

Cash and property distributions

Cash and property distributions from an IRA to its beneficiary will fix the AVD as to the cash or other property distributed. Those distributions won't fix the AVD as to what remains in the IRA, provided the fair market value (FMV) of the account before the distribution equals the sum of the property distributed and the FMV of the property in the account immediately after the distribution. Here, the IRS is saying that post-death distributions can't create (or deepen) a valuation discount for alternate valuation purposes.

Surviving spouses

When an account passes to a surviving spouse because of a beneficiary designation, the proposed regulations say that a transfer to an account held solely in the name of that surviving spouse won't accelerate the AVD. But when it comes to an IRA, the regulations don't clearly spell out whether an IRA held in the name of the surviving spouse, instead of the decedent, for the benefit of the surviving spouse (a so-called “beneficiary IRA”), will avoid AVD acceleration. This is a point the IRS should clarify.

The significance of a transfer by the surviving spouse of a decedent's IRA to an IRA held in the surviving spouse's name (but not a beneficiary IRA) is that such a transfer will constitute an election by the surviving spouse to treat the IRA as his own2. That election affects required minimum distributions (RMDs) from the IRA and also exposes the surviving spouse to the 10 percent tax on distributions made before reaching age 59½.

Another way of making the election to treat a decedent's IRA as an IRA of the surviving spouse is for the surviving spouse to distribute the IRA to himself and then make a rollover to an IRA in his name alone. That transaction will fix the AVD because there was an actual distribution.

For more information on this topic, see “Estate Tax Alternate Valuation Method,” by Natalie Choate on the Trusts & Estates website, www.trustsandestates.com [5].

Real Whodundits

The economic downturn that began in 2007 has a darker side that has appeared in many 2011 private letter rulings. In those PLRs, taxpayers sought relief from the 60-day IRA rollover requirement for situations in which a scam resulted in the theft of an IRA distribution, preventing a timely IRA rollover. In some of these cases, an IRA distribution was misappropriated en route to a rollover IRA to be established at a “new” IRA custodian. In others, the scam was made to look like an IRA rollover had occurred, but the “new” IRA wasn't actually an IRA. Still others involved Ponzi schemes.

Punishing the guilty wasn't the only reason it was important to detect these scams. Uncovering these crimes was also necessary for taxpayers to get a waiver of the 60-day IRA rollover requirement. These scams differ from situations in which funds were stolen out of an IRA and recovered by the IRA owner. The IRA owner may deposit those recoveries in an IRA as a “restorative payment” without encountering a 60-day time limit.3 But this year's crop of rulings dealt with situations in which an IRA distribution was made, but as a result of theft, a corresponding IRA rollover was thwarted. To roll over any funds recovered from the perpetrator, the taxpayer needed to get a waiver of the 60-day time limit. What was common to all of these rulings was criminal action resulting in criminal proceedings. Because these fraud situations prevented taxpayers from completing timely rollovers, the IRS uniformly granted relief, permitting late rollovers.4

Excess Contributions

Even as the economy is sputtering, some people thrive, including those in the international arena. That was the case in Oshman v. Commissioner.5 The Tax Court ruled that dividends paid to a Roth IRA by a foreign sales corporation (FSC) that had been organized by a Roth IRA couldn't be characterized as excess contributions to it.

The FSC's sole source of income was commissions from Oshman & Sons Co., Inc. (a C corporation). The IRS sought to recast the dividends as having first been paid to the taxpayer, Michael Oshman, who then improperly contributed those payments to the Roth IRA.

In ruling favorably for Michael, the court stated that the IRS couldn't recognize an FSC for income tax purposes and then use the substance-over-form doctrine to claim that excise tax was due for the excess contributions.

Michael's advisors must have been visionary. But, another seemingly creative idea turned into a nightmare for Robert and Joan Paschall. In Paschall, et ux, v. Comm'r,6 income tax returns that were beyond the IRS' reach under the statute of limitations on assessments and collections were nevertheless open to audit for assessing and collecting excise tax on excess IRA contributions, because the Paschalls never included a Form 53297 with any of their income tax returns.

This was the case even though the couple's income tax returns included disclosure of the transaction that gave rise to the tax in a “reportable transaction disclosure statement.” Whether the statute of limitations runs on Form 5329 excise taxes when that form is absent from an income tax return was an issue of first impression. This holding likely applies to any of the taxes reportable on that form.

Robert Paschall, on the advice of a reputable certified public accounting firm's partner, engaged in a transaction involving a Roth IRA conversion. The transaction was called a “Roth restructure.” It involved a traditional IRA and a Roth IRA, each of which established, capitalized and owned one of two corporations. The traditional IRA owned a very rich corporation, and the Roth IRA owned a rather thinly capitalized one. The corporations then engaged in transactions with each other, ending with a merger designed to be a tax-free reorganization. The result was a significant shift in value from the traditional IRA to the Roth IRA.

Around 2003 or 2004, the CPA firm turned over to the IRS a list of clients who had engaged in the Roth restructure transaction. The IRS examined the Paschalls' returns for tax years 2002 through 2006. It found an excess contribution had occurred as a result of the Roth restructure and levied an excise tax, issuing notices of deficiency on Feb. 1 and July 23, 2008.

The excise tax applies every year, from the year an excess contribution occurs until the offending contribution is removed from the IRA or Roth IRA. Because the IRS issued its notices of deficiency after the income tax statute of limitations had run on the Paschalls' income tax returns for tax years 2002, 2003 and 2004, Robert argued those years were closed as to the excise taxes as well. Solving a mystery practitioners have pondered for years, the court disagreed with Robert and held for the IRS. The court said the statute of limitations was open because no Form 5329 had been filed.

As a result of the court's holding, taxpayers should consider filing Form 5329, even if no tax is due, when there's some chance (real or perceived) that the IRS will impose an excise tax on excess contributions or any other tax determined on Form 5329. Filing it at least gives the taxpayer the argument that Paschall doesn't apply, and the statute of limitations begins to run at the same time as for income tax.

IRA Investment Costs

One way to reduce tax risks is to seek a PLR before acting on a novel idea. In PLR 201104061 (Nov. 4, 2010), the taxpayer asked the IRS if investment wrap fees charged on a Roth IRA investment portfolio could be paid from funds outside the Roth IRA.

Here's how resolution of this issue can make a difference. Say that Barbara has an IRA investment portfolio of $1 million and that annual wrap fees amount to 1.5 percent of the portfolio's value, or $15,000, for 2012. If the IRS says that paying the fees outside the IRA constitutes an excess contribution, there's a 6 percent excess contribution tax to pay every year until the contribution is removed from the IRA — $900 per year in Barbara's case. But, if paying the wrap fees isn't an excess contribution, that would increase the IRA's after-tax returns by 1.5 percent per year for Barbara. The difference between compounding annual returns of say 7 percent and 8.5 percent can really make a difference over a span of just a few years, especially for larger accounts.

The wrap fees described in the PLR were equal to a percentage of assets under management (AUM). The fees included investment advice, as well as the cost of making trades. The IRS first noted that Revenue Ruling 86-1428 holds that broker's commissions charged in connection with the purchase and sale of securities for a qualified employee's trust or an IRA can't be deducted as IRA contributions. In other words, excess contributions can occur when those fees are paid from non-IRA funds.

But in this PLR, payment to an IRA custodian of a percentage of AUM with no further charges for trades or wrap fees, paid from non-IRA funds, was held not to constitute deemed contributions to IRAs.

It must have taken an enormous Roth IRA to justify paying for this ruling request! It would be nice if the IRS would issue guidance the rest of us can rely on, since only the taxpayer who requests a PLR may rely on it.

Surviving Spouses

PLRs were also favorable last year for some surviving spouses, with one notable exception. There's a very long line of PLRs saying that a surviving spouse may roll over the IRA of a deceased spouse when the IRA beneficiary is a trust or an estate, provided that the surviving spouse, acting alone, can take any and all actions needed to become the beneficial owner of that IRA.

PLR 201125047 (June 24, 2011) adds a new twist. The IRA was the community property of the decedent and the surviving spouse. A trust was the beneficiary of the IRA. The trust held their community property. The trust provided that, upon the death of the first spouse, the property of the surviving spouse, including that spouse's share of community property, would pass to a subtrust over which the surviving spouse had an unlimited power to withdraw trust corpus.

But unlike the surviving spouses in nearly all previous PLRs permitting spousal rollovers, the spouse in this case couldn't act alone to take all actions necessary to funnel the decedent's community property share in the IRA into the subtrust holding only property of the surviving spouse. That's because there was a co-trustee who had to agree to the division of community property.

And that brings us to a new twist in the long plot of spousal IRA rollovers. This very clever surviving spouse and the trustees entered into an agreement whereby the surviving spouse swapped the trust's interest in the deceased spouse's community property share of the IRA with non-IRA community property of the surviving spouse. Apparently, this is an acceptable way of divvying up community property after the death of a spouse under applicable state law, so the IRS allowed the spousal rollover. It was similar to other rulings in that a non-pro rata distribution occurred, but here, the division involved a swap.

In addition to granting the ruling request, the IRS stated, as it has in some other recent PLRs, that the determination of property interests in an IRA under a state's community property laws lies outside the scope of the IRS' rules.

Surviving spouses frequently are faced with a new and unfamiliar role: that of executor of the deceased spouse's estate. In that role, they may discover that the decedent wasn't able to complete an intended IRA rollover. The IRS has the authority to waive the 60-day rollover requirement in such cases, and it did so in PLR 201121035 (May 27, 2011).

Once relief is granted, the executor must complete the rollover in the same manner as the decedent would have, had the decedent survived. That means the rollover must be made to an IRA set up in the decedent's name. If there is none, the executor can establish such an IRA and apparently needed to do so in this case.

But, the IRS also said that any beneficiary the executor nominates in the beneficiary form of the newly established rollover IRA can't be recognized as a designated beneficiary for purposes of RMDs. Here, the decedent died after reaching his required beginning date, so distributions must be based on the single life table and the age the decedent attained (or would have attained) in his year of death. Treasury Regulations Section 1.401(a)(9)-4, Q&A 4, provides that a designated beneficiary must be a beneficiary as of the DOD.

In PLR 201123048 (March 17, 2011), the IRS was ready and willing to do likewise, but couldn't. The surviving spouse sought to complete the rollover by making the rollover contribution to an IRA held in her own name rather than in the decedent's. The IRS declined to grant the requested waiver of the 60-day rollover requirement.

Grantor IRA Trusts

Decedents' IRAs are sometimes left to children who might benefit from a special needs trust. Such trusts are commonly set up to protect assets and provide discretionary benefits, while still qualifying the beneficiary for government assistance. For example, in PLRs 200620025 (Feb. 21, 2006) and 200826008 (Feb. 7, 2008), the IRS approved this arrangement. In both PLRs, the trusts were grantor trusts treated as wholly owned by the decedent's child. The IRS relied on Rev. Rul. 85-13,9 holding that property held in a grantor trust is treated as owned by the taxpayer for all income tax purposes.

But, in PLR 201117042 (Jan. 31, 2011), the IRS said that an IRA creator wasn't allowed to do the same thing as the IRA beneficiaries did in those earlier PLRs. The IRS repeated this position in PLR 201129045 (April 26, 2011), which also involved a grantor trust, but that trust wasn't a special needs trust.

In each of the rulings, an employee of an IRA custodian concluded that an IRA can't be owned by a trust and then the employee placed intended lifetime IRA rollovers into non-IRA accounts. In the end, taxpayers only got half a loaf. The IRS granted waivers of the 60-day rollover period so that rollovers could be completed to IRAs held in the name of the original owners, not to IRAs owned by their grantor trusts.

The IRS offered no rationale for distinguishing decedents' IRAs held in grantor trusts from beneficiaries' IRAs held in grantor trusts. The IRS said only that the IRA custodians had correctly determined that an IRA may not be held in the name of a grantor trust.

The most likely reason (and possibly the only reason) for saying an IRA can't be held by a grantor trust is the exclusive benefit rule found in the statutory definition of an IRA. Specifically, IRC Section 408(a) says an IRA must be held “for the exclusive benefit of an individual or his beneficiaries,” and this applies by extension to Roth IRAs.

The exclusive benefit rule, as it applies to an IRA creator versus an IRA beneficiary, is hardly distinguishable, as “individual” and “beneficiaries” are separated only by a mere conjunctive article: “or.” The separation has no linguistic value as a qualifier.

The grantor trust rule treating an individual as the owner of trust corpus applies for all income tax purposes. IRAs, being creatures of the income tax code, are no exception. The IRS has some “I Love Lucy” style “'splaining” to do.

NUA Puzzler

Employees who receive distributions from qualified retirement plans also face rollover decisions. And when employer securities are part of that distribution, the head scratching that follows can draw blood.

In PLR 201144040 (Aug. 12, 2011), a former employee received a distribution of employer stock from a qualified plan. The stock's appreciation in the hands of the plan's trustee qualified, in the hands of the employee, for treatment as net unrealized appreciation (NUA). As such, only the plan's cost basis in the stock is treated as ordinary income to the former employee, while the unrealized appreciation generally isn't taxed until the stock is disposed of in a taxable sale or exchange. When that happens, the unrealized appreciation will be subject to tax at favorable capital gains tax rates.

Let's say, for example, that stock acquired by a retirement plan trustee for $10,000 grows to a value of $15,000 upon distribution. The distribution consists of currently taxable ordinary income of $10,000 and NUA of $5,000, taxed later.

Here, the former employee sought to shelter the $10,000 of ordinary income by making an IRA rollover of stock worth $10,000. The other $5,000 was kept out of the IRA.

But, when the retirement plan sent the year-end tax information, the amount of ordinary income was wrong: they understated it.

After learning of the employer's understatement, the former employee sought a ruling from the IRS, granting a waiver of the 60-day rollover requirement, to allow a rollover of stock equal in value to the amount of the understatement. The IRS granted that relief.

However, the IRS didn't say whether current taxation of all of the ordinary income associated with all of the shares could be avoided by rolling over appreciated stock of equal value. It could be that only the ordinary income portion of the stock can be used to shelter the ordinary income. In the above example, only $6,667 of the $10,000 of ordinary income would be treated as rolled over free of current income taxes.

IRS assent to the proposition that NUA inherent in the stock rollover will shelter the ordinary income from the plan's lump sum distribution can't be inferred from this PLR. It states (as all rulings do): “No opinion is expressed as to the tax treatment of the transaction described herein under the provisions of any other section of either the Code or regulations that may be applicable thereto.”

The IRS has ruled on this point twice in earlier PLRs, reaching opposite conclusions. In PLR 200202078 (Oct. 19, 2001), the IRS said that the taxpayer making a rollover of only some NUA shares “will not … recognize ordinary income on the portion of the ‘non-rollover shares’ representing the net unrealized appreciation,” which seems to imply that the taxpayer will recognize ordinary income on the portion of the “non-rollover shares” representing the plan's cost basis in those same shares.

In PLR 8538062 (June 25, 1985), the IRS approved a full ordinary income offset based on the value of the stock rolled over, but in PLR 8426132, the IRS disapproved, saying, “you must include in gross income the cost basis of the shares of Company M stock which are distributed from Plan X and aren't rolled over to an IRA. You may exclude from gross income the amount of net unrealized appreciation with respect to such shares.”

An unanswerable question for the NUA sleuth arises if a rollover of shares allows NUA resident in those shares to shelter the ordinary income portion of shares not rolled over: What's the cost basis of the shares not rolled over?

Merciful Ending?

For all the 2011 mysteries that confounded retirement account holders and their advisors, one mystery remains as we go to press: Will Congress extend qualified charitable distributions (QCDs) beyond 2011? QCDs are distributions from an IRA directly to a qualifying charity that aren't taxable distributions. Those over age 70½ may make such distributions, provided they amount to no more than $100,000 during the tax year.

Let's hope this mystery doesn't end in the death of QCDs.

The author would like to acknowledge Natalie B. Choate for her valuable contributions to this article.


  1. REG-112196-07 (Nov. 17, 2011), amending Treasury Regulations Section 20.2032-1. The proposed regulation would also make other important changes not related to retirement benefits.
  2. Treas. Regs. Section 1.408-8, Q&A-5(b).
  3. See Bruce D. Steiner, “Restorative Payments,” Trusts & Estates (June 2011) at p. 33.
  4. See, e.g., Private Letter Rulings 201116040 (Jan. 24, 2011), 201116041 (Jan. 24, 2011), 201116042 (Jan. 24, 2011), 201116043 (Jan. 24, 2011), 201116044 (Jan. 24, 2011), 201117038 (April 29, 2011), 201117039 (Feb. 24, 2011), 201119040 (Feb. 14, 2011), 201134025 (June 1, 2011) and 201143029 (Aug. 1, 2011).
  5. Oshman v. Commissioner, T.C. Memo. 2011-98 (May 3, 2011).
  6. Paschall, et ux, v. Comm'r, 137 T.C. No. 2 (July 5, 2011).
  7. “Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.” The form includes the 10 percent tax on distributions before reaching age 59 ½, additional tax on certain distributions from education accounts, additional tax on excess contributions to traditional individual retirement accounts, additional tax on excess contributions to Roth IRAs, additional tax on excess contributions to Coverdell education savings accounts, additional tax on excess contributions to Archer medical savings accounts, additional tax on excess contributions to health savings accounts and additional tax on excess accumulation in qualified retirement plans (including IRAs).
  8. Revenue Ruling. 86-142, 1986-2 C.B. 60.
  9. Rev. Rul. 85-13,1985-1 C.B. 184.

Michael J. Jones is a partner in Monterey, Calif.'s Thompson Jones LLP and chairs the Trusts & Estates Retirement Benefits Committee