• U.S. Supreme Court holds that inherited IRAs aren’t excluded from the bankruptcy estate—In a unanimous decision, Clark v. Rameker, 573 U.S. ______ (2014), the Supreme Court resolved the question of whether inherited individual retirement accounts are included in the bankruptcy estate and, ultimately, subject to the claims of creditors. There was a conflict between the U.S. Courts of Appeals for the Fifth Circuit and the Seventh Circuit; the issue was whether an inherited IRA in the hands of a beneficiary should be given the same creditor protection as an IRA in the hands of the original owner.
In Clark, Heidi Heffron-Clark held funds in an inherited IRA. She inherited the IRA (valued at about $450,000 at the time) from her mother and elected to take the minimum distributions from the account. The Supreme Court interpreted 11 U.S.C. Section 522(b)(3)C), which exempts “retirement funds to the extent those funds are in a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457 or 501(a) of the Internal Revenue Code.”
Because the account was clearly one protected by the enumerated code sections, the court interpreted the meaning of “retirement funds.” It reasoned that “retirement funds” are funds set aside for when an individual stops working. It noted three characteristics of inherited IRAs that indicated that they weren’t retirement funds as to the beneficiary: (1) the beneficiary of the inherited IRA may never contribute funds to it; (2) the beneficiary is required to withdraw money from the accounts, no matter how many years he may be from retirement; and (3) the beneficiary could withdraw the full balance of the account at any time, without penalty. These characteristics are very different from an IRA in the original owner’s hands. The original owner’s fund may not be withdrawn without penalty before age 59½, and his minimum required distributions only begin after he reaches retirement age.
As a policy matter, the court also noted that protecting retirement funds for owners allows them to have a “fresh start” without depleting the reserves that weren’t easily accessible to them and which they established for themselves later in life. Since the beneficiary of an inherited IRA is able to access the account at any time without penalty, this objective isn’t met by exempting the funds from the bankruptcy estate. Instead, it simply gives the debtor a “free pass” to keep those assets and access them as he wishes.
• District court holds that IRS may credit estimated estate tax payment to future installment payments—In Estate of Donald McNeely v. U.S. (D. Minn. June 12, 2014), the estate filed a Form 4768 to extend the filing deadline and made an estimated estate tax payment of almost $2.5 million. With its payment, it included a cover letter noting that it expected to make an IRC Section 6166 election to defer payments of estate tax related to closely held business interests and indicated that the estimated payment was intended to satisfy the amount of tax only on the non-deferred portion of the federal estate tax.
When the estate later filed its return, the total estate tax due was $9,125,878. Only $512,223 of this amount wasn’t subject to deferral under the Section 6166 election; the balance of $8,613,655 was related to the decedent’s closely held business interests and would be deferred under Section 6166. The estate sought a refund of $1,979,865 (the difference between its estimated payment of $2,492,088 and the non-deferred estate tax of $512,233).
The IRS denied the request for a refund, stating that the almost $2 million “overpayment” would be applied to the installments due under Section 6166, the first of which wasn’t due until almost five years later.
The estate filed a refund suit, and both parties filed motions for summary judgment. The estate argued that its designation of the estimated payment as payment for the non-deferred portion of its estate tax liability, before it could even apply for or obtain the 6166 election, obligated the IRS to refund the overpayment.
IRC Section 6402 provides that in the case of any overpayment, the IRS may:
. . . credit the amount of such overpayment, including any interested allowed thereon, against any liability in respect of an internal revenue tax on the part of the person who made the overpayment and shall . . . refund any balance to such person.
Relevant to the election under Section 6166, IRC Section 6403 provides that if:
. . . the taxpayer has paid as an installment of the tax more than the amount determined to be the correct amount of such installment, the overpayment shall be credited against the unpaid installments, if any. If the amount already paid, whether or not on the basis of installments, exceeds the amount determined to be the correct amount of the tax, the overpayment shall be credited or refunded as provided in section 6402.
The court held for the IRS. It determined that the IRS had the discretion to credit the overpayment to the outstanding tax liability, regardless of the taxpayer’s instruction. When the estate tax return was filed, the total liability was over $9 million, and the IRS was permitted to apply the estimated payment against the tax liability, regardless of the Section 6166 election. As a result, there was no “overpayment” that entitled the estate to a refund.
It’s not clear what caused the estate’s overestimation of the non-deferrable portion of the estate tax. However, this case serves as a warning to taxpayers: It’s not easy to obtain tax refunds, as the IRS can (and will) apply tax payments to outstanding liabilities, regardless of elections for deferral.
• Private letter ruling holds beneficiary’s appointment of trust property from grandfathered trust didn’t constitute a constructive addition for GST tax purposes—In PLR 201418005 (May 2, 2014), the IRS ruled on a trust beneficiary’s exercise of a limited power of appointment (POA) in favor of a new trust for the benefit of herself and her son. The existing trust was a pre-1985 trust grandfathered for generation-skipping transfer (GST) tax purposes. The grantors established the trust for their granddaughter, who was entitled to all the income during her life and eligible to receive additional distributions of principal for certain purposes. She had an inter vivos and testamentary power of attorney (to appoint the trust property to other trusts (or free of trust) to or for the grantors’ then-living descendants who, at the time the power is exercised, aren’t current beneficiaries of the trust. On her death, in default of the exercise of the POA, the trust property would be distributed to the granddaughter’s then-living descendants, or if none, to the grantors’ then-living grandchildren in equal shares.
The granddaughter proposed to appoint the trust property to a trust that had identical provisions for her during her life. On her death, instead of the trust property going outright to her then-living descendants, the new trust provided for a trust for her son. The trustees could accumulate income or pay out income and principal to her son in their discretion. Her son was also granted a limited POA to appoint trust property to his descendants, spouse, life partner, a charity or any descendant of the granddaughter. The rule against perpetuities (RAP) period for the new trust remained the same as the original trust.
It’s interesting to note that the granddaughter’s exercise of her limited POA appeared to be (at least in part) exercised in favor of herself, as she was the lifetime beneficiary of the new trust. However, the IRS didn’t discuss this point. The IRS appears to assume the exercise of the POA was valid and held that it didn’t constitute a constructive addition to either trust. Under Treasury Regulations Section 26.2601-1(b)(1)(v)(B), the exercise of a limited POA won’t be an addition to a trust if the POA was created in a trust that was irrevocable on Sept. 25, 1985, and the exercise of the power doesn’t postpone or suspend the vesting, absolute ownership or power of alienation of an interest in property for a period beyond a life in being at the time of the original trust plus 21 years. Here, because the POA was created in a trust that predated the GST tax, and the RAP period wasn’t extended, the exercise didn’t constitute a constructive addition. This ruling shows that appointing trust property from a grandfathered trust to a new trust with different terms (even when such appointment allows property to be retained in trust longer than it would have originally) may not be a constructive addition, as long as the perpetuities period with respect to the GST-exempt property remains the same.
Similarly, the IRS noted that the potential granddaughter’s son’s exercise of his POA in the second trust also wouldn’t result in a constructive addition because the RAP period wouldn’t be extended beyond that of the original trust. Therefore, it appears that the second trust must have been grandfathered as well (because under the regulations, the POA must have been created in a trust that predated the GST tax for its exercise not to be considered a constructive addition).