• U.S. Bankruptcy Court holds that inherited IRAs aren’t protected from creditors—In In Re Todd, (121 A.F.T.R.2d 2018-1474 (March 23, 2018)), the Bankruptcy Court, Northern District of New York, held that a debtor’s inherited individual retirement account wasn’t exempt under New York law. As a result, it was part of the bankruptcy estate and subject to the claims of her creditors.
Laurie Todd, the debtor, was the beneficiary of her mother’s IRA. After her mother died, Laurie kept it as an inherited IRA. She didn’t make any contributions to the inherited IRA from her own funds. When Laurie filed for bankruptcy, she claimed that her inherited IRA was exempt under New York law.
A New York statute provides several circumstances in which IRAs may be exempt from the judgment of a creditor. For example, certain trusts established with a third party’s funds for the benefit of the debtor might be exempt. However, if the debtor beneficiary can access the trust funds without restriction, the exemption doesn’t apply. Laurie argued that the IRA was a trust under the statute, but the court found that Laurie had full control over the inherited IRA, with the ability to withdraw the funds at any time, for any reason. This meant that the IRA wasn’t a protected trust under the New York statute.
The New York statute also exempted IRAs that are qualified under Internal Revenue Code Section 408. The court acknowledged that this portion of the statute was ambiguous because the statute didn’t define “qualified,” and the term isn’t used under IRC Section 408. While Section 408 governed the inherited IRA, the court interpreted the term “qualified” in the New York statute to be limited and encompass only IRAs funded by the debtor. Although exemptions are to be liberally construed in favor of the debtor, the court reasoned that the purpose of the exemption under the New York statute was only to protect funds set aside by a debtor for his own retirement. It also reasoned that inherited IRAs don’t receive all of the same benefits as other IRAs under the IRC, so that it wasn’t inconsistent to treat them differently for state law bankruptcy purposes.
• First Circuit upholds transaction involving IRAs and DISCs—In Benenson v. Commissioner (No. 16-2066 (April 6, 2018)), the taxpayers appealed to the U.S. Court of Appeals for the First Circuit after the Tax Court upheld the IRS’ treatment of payments to a Roth IRA as additional contributions, which exceeded the statutory contribution limits applicable to IRAs.
In Benenson, certain individuals and a trust were shareholders of a C corporation (C corp), Summa Holdings, which was the parent of a consolidated group of manufacturing companies with export sales. The taxpayers set up a structure in 2002 whereby their IRAs invested in a domestic international sales corporation (DISC). First, each of the taxpayers deposited $3,500 into an individual Roth IRA. The next day, the Roth IRAs paid for 1,500 shares in JC Export, a new DISC, and then sold those shares to a holding C corp, so that each Roth IRA ultimately owned 50 percent of the holding company. The DISC entered into agreements under which it would pay the commissions it received from Summa Holdings’ subsidiaries to the holding company, which then (after tax withholding) paid dividends to the Roth IRAs. By 2008, the Roth IRAs were each worth over $3 million.
In 2012, the Internal Revenue Service issued a notice of deficiency to the taxpayers, determining that the commissions paid by the subsidiaries to the DISC were actually dividends to Summa Holdings’ shareholders and that the payments from the DISC to the Roth IRAs weren’t dividends but IRA contributions. These contributions exceeded the limits applicable to Roth IRAs. The Tax Court agreed with the IRS. Summa Holdings appealed to the Sixth Circuit, which reversed the Tax Court on issues relating to its corporate tax liability. Two of the taxpayers in Benenson appealed to the First Circuit regarding the issue of contributions to their IRAs. Other family members have appealed to the Second Circuit, and that case is pending.
The First Circuit held that it was entitled to make an independent determination of the issues in the case and wasn’t bound by the Sixth Circuit holding. Regardless, it also overturned the Tax Court in the taxpayers’ favor. The First Circuit held that Congress created DISCs to stimulate economic activity and enable exporters to defer corporate income tax. It noted that the statutes governing DISCs anticipated that Roth IRAs could invest in DISCs and concluded that the Benensons’ transaction wasn’t outside the scope of the statute. The majority invited Congress to amend the law governing DISCs if it finds these transactions problematic.
The dissent, however, argued that while the elements of the transaction were permitted under the statute, the substance-over-form doctrine should apply. The dissent claimed that even though the transaction is compliant with the IRC, the Benensons’ use of the DISC wasn’t within Congress’ intended purposes.
This case concerns a similar transaction that was the subject of another Tax Court case reported last month, Mazzei v. Comm’r. That case, distinguished in the footnotes of Benenson, held against the taxpayers on similar transactions using a foreign sales corporation (FSC), with the result that the payments to the IRAs in Mazzei were deemed to be contributions to IRAs in excess of the applicable limits. The First Circuit distinguished the transaction using a DISC from the FSC, noting that Congress repealed the statute governing FSCs.
• Notice 2018-37 announces issuance of regulations relating to the repeal of IRC Section 682—Section 682 provides rules regarding tax treatment of income from trusts payable to former spouses who are divorced or legally separated. Section 682 provides that trust income payable to a spouse from certain trusts is taxable to the recipient spouse, regardless of other provisions of the IRC that might otherwise tax it to the other (donor) spouse. This rule wouldn’t apply to income payable for the support of minor children. Section 682 parallels the rules for the taxation of alimony and maintenance payments under IRC Section 71 and IRC Section 215 (taxable to recipient spouse, deductible by payer-spouse). However, Section 682 was repealed (along with Sections 71 and 215) for any divorce or separation instrument executed after Dec. 31, 2018 or modified after Dec. 31, 2018 if the modification so provides.
Notice 2018-37 provides that Section 682 will continue to govern the taxation of trust income payable to former spouses under a divorce or separation instrument executed on or before Dec. 31, 2018, unless the instrument is modified after that date to provide otherwise. The Notice requests comments regarding whether guidance is needed relating to the grantor trust provisions of Sections 672, 674 or 677, in light of the repeal of Section 682.
Taxpayers need to consider these issues when settling a divorce or separation. On the planning side, this is critical to consider when establishing an irrevocable trust that includes a spouse as a beneficiary. Such a trust is typically a grantor trust under IRC Section 677 because of the spouse’s interest. If the grantor and spouse subsequently divorce, it remains a grantor trust because Section 672(e)(1) says, “For purposes of this subpart, a grantor shall be treated as holding any power or interest held by any individual who was the spouse of the grantor at the time of the creation of such power or interest…” Thus, a divorce won’t negate Section 677. Section 682 previously would cause income paid to the former spouse to be taxable to the spouse notwithstanding grantor trust status, but with this repeal, the grantor will pay the income taxes on money his former spouse receives from the trust! Including a so-called “divorce clause” in irrevocable trusts is now even more important.