Proper Beneficiary Designations and Fixing Improper Ones Michael J. Jones

Transcription

1 Proper Beneficiary Designations and Fixing Improper Ones Michael J. Jones Michael J. Jones, CPA is a partner in Monterey, California s Thompson Jones LLP ( His tax consulting practice focuses on tax-efficient wealth transfer strategy, trust and probate tax matters (both administration and controversy resolution), and family business transitions. Mike is the author of four books, including Inheriting an IRA and Inheriting an IRA Professional Edition. He has written over 150 articles published in Trusts & Estates, Leimberg Information Services, Inc., Ed Slott s IRA Newsletter and elsewhere. He serves as chair of Trusts & Estates magazine s Retirement Benefits Committee and the CPE Forum of the Central Coast. He has lectured across the U.S. for Jerry A. Kasner Estate Planning Symposium; Southern California Tax & Estate Planning Forum, Hawaii Tax Institute, AICPA Advanced Estate Planning Conference, AICPA Conference on Tax Strategies for the High-Income Individual, UCLA-CEB Estate Planning Institute, New York University Institute on Federal Taxation, CEB Estate Planning and Administration Annual Updates panels, and others. He has been quoted in Natalie Choate s Life and Death Planning for Retirement Benefits, Keith Schiller s Estate Planning At The Movies Art of the Estate Tax Return, New York Times, Forbes Magazine, The Wall Street Journal, Bloomberg Financial Report and others. Mike is an avid prone paddleboarder and surfer. 1

2 Table of Contents Beneficiary Forms, Generally PLR : Bank, Surprisingly, Escheats IRA to State Annual check-up Spousal rollovers When Must The Spouse Be Beneficiary? Can It Be Otherwise? Who Is A Spouse? Cozen O'Connor PC v. Tobits et al., No. 2:11-cv-00045, Dist. Ct. E. PA (2013) Schuett v. FedEx Corporation, et al, ND CA (2016) Community Property and non-erisa Accounts Private Letter Ruling : IRS Says "No" To Surviving Spouse IRA Rollover Update Beneficiary Forms After Divorce Trusts Trust Income Taxes Income In Respect Of A Decedent; 691(c) Deduction Shifting Tax Burdens To Beneficiaries: Carrying Out DNI Charitable Income Tax Deduction Satisfaction Of Pecuniary Bequests To Charities Using IRA Assets Means Trust Must Pay Income Taxes: LTR (May 5, 2014) Direct Transfer To Charity - Trustee s Retitling of Decedent s IRA in Charity s Name Held Not To Be a Distribution: LTR (Mar. 24, 2014) PLR : Trust May Claim Charitable Deduction for IRA Proceeds Charitable Remainder Trusts Fixing Problems After Death Basics of Required Minimum Distributions Post-Mortem Deadlines Pay Off RMD-Busting Trust Beneficiaries Court Reformation Must IRS Recognize Trust Modification Under A Court Order? Option For Designated Beneficiary To Make A Direct Rollover To An Inherited Roth IRA Is Missing From Model Statutory Notice 2

3 Beneficiary Forms, Generally Beneficiary forms control disposition on death of certain assets, including Retirement benefits provided under employer-sponsored plans, Individual Retirement Accounts, and Individual Retirement Annuities. When beneficiaries can t be ascertained or located, the asset may escheat to a state. Estate planning for beneficiary forms must be coordinated with trusts. Too often, beneficiary designation forms get completed and submitted without such coordination. For example, Janet retires and decides to transfer her retirement account benefits to an Individual Retirement Account. Confronted with an application to open the IRA, Janet names her revocable living trust as death beneficiary. Was that choice the right one for Janet? While doing so may assure that her trust will dispose of her IRA according to its terms, trust drafting and administration becomes more complex and costly because of the presence of the IRA. In addition, when trust beneficiaries become entitled to take possession of trust property, IRA custodians may be reluctant to make transfers to Inherited IRAs of trust beneficiaries. Here s another example. Beth, a surviving spouse, successfully completed an IRA rollover from her late husband s IRA. Beth s attorney instructed her to name her four children as equal beneficiaries. But Beth named her trust instead. Beth s trust was distributable upon her death to her four children. The eldest child, as trustee, bore the burden of determining how to distribute the IRA in four shares while avoiding taxable IRA distributions. A friend, who was an attorney, advised the trustee to disclaim over to the estate, as well as the will s disposition in favor of the trust. That would have had the undesirable effect of forcing all four IRAs to make Required Minimum Distributions based on Beth s age, instead of distributing over the life expectancy of the oldest child. Fortunately, the trustee became convinced not to do so, but it was time-consuming to arrange the transfers to the Inherited IRAs of the trust s beneficiaries. PLR (March 11, 2016): Bank, Surprisingly, Escheats IRA to State An individual who held two IRAs withdrew the some of annual required minimum distributions of both IRAs from only one ( IRA 1 ). The other IRA ( IRA 2 ) went untouched. The bank stopped sending IRA 2 statements. Nevertheless, the taxpayer went to the bank each year to obtain the IRA 2 balance, so that he could determined each year s required minimum distribution. In 2013, the bank inexplicably assumed IRA 2 was unclaimed property and distributed its funds to the state as escheated property. The bank also issued Form 1099-R reporting the IRA distribution to IRS. The IRA owner first learned of the distribution and escheated property transfer when he went to the bank in 2014 to check his IRA balance. In response, the IRA owner immediately filed a claim with the state to recover the funds. 3

4 The IRS also issued a notice of deficiency to the IRA owner, based on Form 1099-R reporting for The IRS granted an extension of the 60-day rollover period so that the amount distributed to the state unbeknownst to the IRA owner could be rolled over. Annual check-up Annual beneficiary form checkups make it possible to assure that Beneficiaries address changes, births, deaths, marriages and marital dissolutions will be taken into account. Two court cases illustrate the importance of updating beneficiary forms. In Kennedy v. Plan Administrator for Dupont Savings and Investment Plan, Et al, U. S. No (2008) it was held that the ex-spouse of a deceased plan participant was entitled to ERISA-covered plan death benefits even though a marital settlement agreement the exspouse had entered into denied the ex-spouse any entitlement to those benefits. Although an ex-spouse is not entitled to ERISA-mandated spousal death benefits, the ex-spouse was still actually named as death beneficiary under the plan at the time of the decedent s death. As such, the ex-spouse must be recognized as the beneficiary of the decedent s plan benefits under ERISA. In Mays-Williams v. Williams, No , 9th Cir. (2015), Asa Williams, Sr., ( Asa, Senior ), while employed by Xerox Corporation, participated in various Xerox retirement plans Asa, Senior, while married, had formally designated his wife as death beneficiary under each such pan. After their divorce, new beneficiary forms were not filed. However, evidence admitted in this case showed he had numerous telephone conversations with plan representatives, during which he consistently stated his intention of naming his son, Asa, Junior, as beneficiary under each plan. Many of those conversations between Asa and employees of the plan administrator of those plans were recorded by those employees. On May 16, 2011, Asa, Senior, died. His ex-wife claimed the benefits, as did Asa Junior. The plan administrator filed an interpleader action to determine the identity of the beneficiary. The plan documents permitted participants to choose death beneficiaries, but the terms of the plan did not contain any requirement that a beneficiary form be submitted to do so. The court found, as a matter of first impression, that beneficiary forms were not plan documents. Because of this finding, the Court overturned the District Courts finding to the contrary. Examining the plan documents, the summary plan description, and communications with the plan administrator admitted into evidence, the Court concluded: In light of the evidence before us, including Xerox s call log from January 10, 2011, reflecting that Asa, Senior, called Xerox to change his beneficiary designation from Carmen to Asa, Junior, a reasonable trier of fact could determine that Asa, Senior, intended to change his beneficiary to Asa, Junior, and that his phone calls to Xerox 4

5 constituted substantial compliance with the governing plan documents requirements for changing his beneficiary designation. Accordingly, we cannot sustain the grant of summary judgment in favor of Carmen. The Court remanded the case to the lower court for further consideration. Spousal rollovers When a surviving spouse is named as beneficiary of an IRA or qualified plan account, the surviving spouse may generally roll over distributions from the inherited account. If a trust or an estate is beneficiary, it may nevertheless be possible. However, IRA custodians might not cooperate and may require a private letter ruling (or at least an opinion letter). If a trust is to be named as beneficiary, analyze whether a spousal rollover might be available. If so, name the spouse as beneficiary and, if desired, compensate by adjusting the trust terms. For example, trust that divides into a decedent s share and a surviving spouse s share could contain a funding provision to the effect that that the value of the IRA will be added to the value of property actually held in the trust. The value of the decedent s share would be half of the total so augmented. The remaining actual value of trust property (without regard to the IRA) will constitute the surviving spouse s share. When Must The Spouse Be Beneficiary? Can It Be Otherwise? Beneficiary forms must also be coordinated with rights of a spouse. A surviving spouse is entitled to certain benefits when the retirement plan is subject to ERISA and/or Internal Revenue Code provisions requiring either a joint survivor retirement annuity or a joint survivor preretirement annuity. Some plan documents of self-employed individuals contain these provisions even when not required by law. IRAs and Roth IRAs of individuals are not subject to statutory spousal benefits requirements. But, some types of IRAs could be subject to such requirements, when employers may offer them to employees. The plan participant s spouse may waive mandatory spousal death benefits, provided certain conditions are met. Beneficiary forms may therefore contain a waiver and consent for this purpose. Who Is A Spouse? In Obergefell v. Hodges, 135 S. Ct (2015)), the U.S. Supreme Court held that state bans on same-sex marriage violate the Due Process and Equal Protection Clauses of the Fourteenth Amendment to the United States Constitution. Cozen O'Connor PC v. Tobits et al., No. 2:11-cv-00045, Dist. Ct. E. PA (2013) The U.S. District for the Eastern District of Pennsylvania has held that retirement death benefits under a profit sharing plan must be paid to a surviving spouse and that Jean Tobits was a surviving spouse under U.S. v Windsor, 133 S. Ct (2013). 5

6 The decedent, Sarah Ellyn Farley and Ms. Tobits entered into a valid marriage in Canada. The couple lived in Illinois, which recognized same-sex marriages validly entered into in other jurisdictions. Sarah was an employee of Cozen O'Connor PC, a law firm that established and maintained a profit sharing plan. That plan was subject to the Employee Retirement and Income Security Act ( ERISA ) and therefore required to comply with its terms as a matter of federal law. ERISA requires, and so the plan s governing instrument required, that, upon the death of a married plan participant who dies before reaching retirement age, a death benefit must be paid to the surviving spouse in the form of a preretirement survivor annuity. The plan also contained a required provision that a participant s surviving spouse must sign a waiver of the survivor s annuity if the surviving spouse is not the sole beneficiary of the participant s account. The plan provided that lack of a valid waiver and consent nullifies the beneficiary designation. Sarah filed a beneficiary form with the administrator of her employer s profit sharing plan naming her parents as death beneficiaries of her account. However, Jean never signed a waiver and consent of her right to the death benefits owing to a surviving spouse of a plan participant. Absence of that consent caused failure of the beneficiary form under the terms of the plan. Following Sarah s death, Sarah s parents claimed all death benefits of Sarah s plan account. So did Jean. The plan administrator instituted an interpleader action, whereby the competing claimants are named as codefendants. ERISA and the Internal Revenue Code are federal laws regulating the profit sharing plan account of Sarah, including the payment of death benefits. There was no question how benefits must be paid if Jean was Sarah s surviving spouse. The sole question for the court to consider was whether Jean and Sarah were married for purposes of ERISA and the Internal Revenue Code. If Jean was not recognized as Sarah s surviving spouse, Jean had no rights to the plan s death benefits. The court deferred action until after the Supreme Court decided Windsor. Because the Supreme Court held that same-sex marriages valid under state law must be recognized for purposes of applying federal laws, Jean was entitled to receive the death benefits of Sarah s profit sharing account. COMMENT: Determining a plan s default beneficiary requires examining the plan and, if applicable, the plan s adoption agreement, where elections are made to adopt optional plan provisions contained in a master plan document. Schuett v. FedEx Corporation, et al, ND CA (2016) Lesly Taboada-Hall, an employee of FedEx Corporation and participant in the FedEx Pension Plan, died on June 20, She married her same-sex spouse, Stacey Schuett the day before, on June 19. By the time of Lesly s death, the committed relationship of Lesly and Stacey had spanned 27 years, within which they adopted and raised 2 children. 6

7 On June 26, 2013, the U.S. Supreme Court held unconstitutional section 3 of the Defense of Marriage Act ( DOMA, codified as 1 U.S.C.A. 7) in U.S v Windsor, 133 S. Ct (2013), Lesly, a 26-year employee of FedEx Corporation, was a participant in its Employees' Pension Plan, a defined benefit plan that it provided a joint and survivor annuity to a deceased plan participant s surviving spouse. But, Stacey was denied benefits because the plan incorporated DOMA 3 s definition of surviving spouse to mean only a person of the opposite sex who is a husband or wife. Stacey filed suit in the District Court of Northern California against FedEx Pension Plan Trustees, the FedEx Pension Plan, and others ( Defendants ). Stacey advanced three theories to establish her standing. The court explained: Plaintiff asserts three causes of action (1) a claim for benefits under ERISA 502(a)(1)(B), 29 U.S.C. 1132(a)(1)(B) (against all defendants); (2) a claim of breach of fiduciary duty under ERISA 502(a)(3), 29 U.S.C. 1132(a)(3) (against FedEx Corporation and FedEx RAC), for failure to administer the Plan in accordance with applicable law; and (3) a claim of breach of fiduciary duty under ERISA 502(a)(3), 29 U.S.C. 1132(a)(3) (against FedEx Corporation), for failure to inform and/or for providing misleading communications. The three causes of action are pled in the alternative. In the first two causes of action, plaintiff seeks payment of surviving spouse benefits under the Plan, or, in the alternative, equitable relief including payment of surviving spouse benefits for breach of fiduciary duty. In the third cause of action, plaintiff seeks an equitable remedy in the form of payment of non-spousal survivor benefits, based on a claim of breach of fiduciary duty for failure to disclose information. Defendants now seek judgment on the pleadings as to each of the three causes of action. The Defendants moved for judgment on the pleadings, and that motion was granted. However the burden to establish that Stacey had no standing to plead her case fell on Fed Ex. Stacey was found to have standing on her claim that she is entitled to equitable relief because Fed Ex breached its fiduciary duty by failing to follow federal law. Accordingly, the case will go forward. Community Property and non-erisa Accounts For IRAs not covered by ERISA and also for qualified plans not covered by ERISA, the community property rights of a surviving spouse can take precedence over the beneficiary form. However, the ability of a surviving to rollover the community property share of decedent s account when the surviving spouse wasn t a beneficiary under the governing instrument isn t settled. Private Letter Ruling : IRS Says "No" To Surviving Spouse IRA Rollover The following is reproduced from Steve Leimberg's Employee Benefits and Retirement Planning Newsletter - Archive Message #659 (Copyright 2016 Leimberg Information Services, Inc. and Michael J. Jones. Reproduced by permission.) EXECUTIVE SUMMARY 7

8 In Private Letter Ruling (6/3/2016), the IRS held that a surviving spouse could not complete a rollover based upon her community property claim to an IRA of her deceased spouse. The decedent s child was named as the IRA s beneficiary. The Decedent s child set up an Inherited IRA, then had his father s IRA transferred to it. While there s no authority for denying such a rollover, there is authority for allowing it. Treasury Regulations section , question and answer -5 addresses the ability of a surviving spouse to treat a decedent s IRA as an IRA of the surviving spouse. An IRA rollover is one method of doing so. In addition, The preamble to that regulation specifically states: If the spouse actually receives a distribution from the IRA, the spouse is permitted to roll that distribution over within 60 days into an IRA in the spouse's own name to the extent that the distribution is not a required distribution, regardless of whether or not the spouse is the sole beneficiary of the IRA owner. (Emphasis added.) Importantly, there s no precedent for denying recognition of community property rights in an IRA comparable to ERISA preemption applicable to employer-sponsored plan benefits. FACTS In Private Letter Ruling (6/3/2016), the IRS held that a surviving spouse could not complete a rollover based upon her community property claim to an IRA of her deceased spouse. The decedent s child was named as the IRA s beneficiary. The Decedent s child set up an Inherited IRA, then had his father s IRA transferred to it. The surviving spouse pursued her claim to the IRA based on community property rights. The matter was settled by agreement. A state court approved the agreement and ordered assignment of a specific amount of the inherited IRA to the surviving spouse as a spousal rollover IRA. The ruling requests sought approval of a rollover by the surviving spouse. The IRS denied the ruling requests, stating: [Internal Revenue Code] Section 408(g) provides that section 408 shall be applied without regard to any community property laws, and, therefore, section 408(d)'s distribution rules must be applied without regard to any community property laws. Accordingly, because Taxpayer A was not the named beneficiary of the IRA of Decedent and because we disregard Taxpayer A's community property interest, Taxpayer A may not be treated as a payee of the inherited IRA for Taxpayer B and Taxpayer A may not rollover any amounts from the inherited IRA for Taxpayer B (and therefore any contribution of such amounts by Taxpayer A to an IRA for Taxpayer A will be subject to the contribution limits governing IRAs). Additionally, because Taxpayer B is the named beneficiary of the IRA of Decedent and because we disregard Taxpayer A's community property interest, any assignment of an interest in the inherited IRA for Taxpayer B to Taxpayer A would be treated as a taxable distribution to Taxpayer B. Therefore, the order of the state court cannot be accomplished under federal tax law. COMMENT 8

9 PLR suggests that the terms of an IRA s governing instrument can t recognize community property rights. However, there s no authority that IRAs can preempt community property claims to death benefits. And there s no precedent for precluding a surviving spouse from making a rollover of a distribution from a deceased spouse s IRA, provided the spouse obtains the distribution pursuant to a valid claim. Regulations Allowing Spousal Rollovers While there s no authority for denying such a rollover, there is authority for allowing it. Treasury Regulations section , question and answer -5 addresses the ability of a surviving spouse to treat a decedent s IRA as an IRA of the surviving spouse. An IRA rollover is one method of doing so. The preamble to that regulation states, in part: If the spouse actually receives a distribution from the IRA, the spouse is permitted to roll that distribution over within 60 days into an IRA in the spouse's own name to the extent that the distribution is not a required distribution, regardless of whether or not the spouse is the sole beneficiary of the IRA owner. (Emphasis added.) Thus, being named as beneficiary isn t a required condition for the surviving spouse to make a rollover. A valid community property claim causes a surviving spouse to become entitled to a portion of an IRA, even though the surviving spouse is not the sole beneficiary of the IRA owner. Under the above-quoted regulation preamble, the surviving spouse should be able to roll over an IRA distribution of community property. Indeed, the IRS has a long history of citing the above-quoted regulation preamble language in private letter rulings as authority for permitting IRA rollovers of surviving spouses who weren t directly named as IRA beneficiary. Similar private letter rulings did the same thing for spousal benefits of qualified plans. For example, in PLR , the IRS said: Section of the Regulations, Q&A-5, provides that a surviving spouse of an IRA owner may elect to treat the spouse s entire interest as a beneficiary in an individual's IRA as the spouse's own IRA In order to make this election, the spouse must be the sole beneficiary of the IRA and have an unlimited right to withdraw amounts from the IRA. If a trust is named as beneficiary of the IRA, this requirement is not satisfied even if the spouse is the sole beneficiary of the trust. However, the Preamble to the Regulations under Code section 401(a)(9) and 408(a)(6) provides, in relevant part, that a surviving spouse who actually receives a distribution from an IRA is permitted to roll that distribution over into his/her own IRA even if the surviving spouse is not the sole beneficiary of the deceased's IRA, as long as the rollover is accomplished within the requisite 60-day period. A rollover may be accomplished even if IRA assets pass through either a trust and/or an estate. 9

10 Other recent examples are found in PLRs , , , , , and The earliest IRS grant of a spousal rollover based in part on the preamble language appears to be PLR (2002). Community Property Disregarded for Taxation of Lifetime IRA Distributions Community property laws have been disregarded by the Tax Court for purposes of imposing income taxes on distributions made while the person who accumulated the IRA was still living. In Bunney v. Commissioner, 114 T.C. No. 17 (April 10, 2000), Michael Bunney s IRA was divided along community property lines pursuant to a divorce decree. Michael withdrew $125,000 from the IRA, deposited the proceeds in a money market account, and used $111,600 to purchase his former wife s community property interest in the marital residence. The Tax Court held that 408(g) precluded taxation of half of Michael s IRA withdrawals to his spouse. All of the income tax fell on Michael. The Bunney opinion outlines four income tax reasons why community property in an IRA can t be recognized while the IRA owner is living: The requirement that an IRA be held for the exclusive benefit of an individual or his beneficiaries would be violated if, by application of community property, it were held for the benefit of two married individuals or their beneficiaries. The IRA participant wouldn t be able to make a rollover of his spouse s community property share. Application of Required Minimum Distributions rules would be affected. Treating a non-participant spouse as owning a portion of the IRA would create an asymmetry in that the tax deduction claimed by the contributing spouse wouldn t match the taxability of half of the distributions to each of the spouses. In Angela C. Morris, T.C. Memo (2002) the IRS asserted that community property laws applied. If sustained, Angela, as the spouse of Larry Morris, would have been required to report her one-half community property share of an IRA distribution Larry took from his IRA. But, the Tax Court disagreed. Angela filed separate income tax returns because she suspected Larry was less than honest in reporting his taxable income. She was right. Larry took IRA distributions that he did not report. The IRS examined both of their income tax returns and assessed deficiencies related to underreporting of IRA distributions against both spouses. The IRS argued that half of the IRA distributions were reportable by Angela because the IRA was community property (the exact opposite of what PLR says). The Tax court disagreed with the IRS and held for Angela, stating, in part: We held in Bunney that by operation of section 408(g), in a community property jurisdiction the spouse of a distributee, who did not receive the distribution from the IRA, is not treated as a distributee despite whatever his or her community property interest in the IRA may have 10

11 been. Accordingly, the Tax Court held that 408(g) precluded taxation of half Larry s IRA withdrawals to Angela. All of the income tax fell on Larry. It s clear from Bunney and Angela C. Morris that community property can t apply to tax the non-participant spouse on IRA distributions. Community Property Death Benefits: The Courts Courts have considered community property rights in retirement death benefits, including Individual Retirement Accounts. Where there s a conflict between state property laws and federal tax rules, the U.S. Supreme Court has held that state property laws should control, except when Congress has mandated federal preemption with force and clarity. Wissner v. Wissner, 388 U.S. 655 (1950). It took a divided Supreme Court to hold that the Employee Retirement Income Security Act of 1974 (ERISA) preempts community property claims. In Boggs v. Boggs, 117 S. Ct (1997), the Supreme Court resolved a conflict between the Fifth and Ninth Circuit Courts of Appeal. Boggs v. Boggs was appealed from the Fifth Circuit, which held community property rights took precedence over ERISA. The Ninth Circuit had held that an employee plan participant s deceased spouse could not bequeath community property rights in plan benefits because ERISA preempts community property rights. Ablamis v. Roper (9th Cir. 1991). The Supreme Court ruled that ERISA-covered death benefits were payable to a decedent s surviving spouse only. The decedent s children from a prior marriage were entitled to no part of those benefits. Their claim to benefits on the theory that those benefits were community property of the predeceased spouse was preempted by ERISA. ERISA was found to take precedence because a significant federal purpose could otherwise be violated. The federal purpose was found in ERISA s mandated spousal benefits. No Authority Supporting 408 Preemption of Community Property Rights in IRA Death Benefits Your author is not aware of any precedent extending the Supreme Court s preemption holding in Boggs v. Boggs to an Individual Retirement Account not covered by ERISA. Nor is your author aware of any other court precedent suggesting 408 preempts community property rights in an IRA s death benefits. In contrast to ERISA, 408 doesn t prescribe any form of spousal benefits and doesn t appear to contain any express federal purpose that would preclude recognition of a nonparticipant s community property rights in death benefits. Thus, it should be possible for a surviving spouse to confirm the right to receive the proceeds of a decedent s IRA as a result of litigation over community property rights. For example, that occurred in Estate of MacDonald, (1990) 51 Cal. 3d 262, 272 Cal. Rptr. 153; 794 P.2d 91. Robert and Margery MacDonald married in Each had children from a prior marriage. In 1983, Margery was diagnosed with cancer. Margery wished to leave all of her property to her four children. 11

12 Margery had her own assets, but no retirement benefits. Robert s property included three IRAs established to roll over pension benefits that had been held in a retirement account sponsored by his former employer. Margery held a community property interest in the pension benefits and the rollover IRAs. Wishing to set their affairs in order, Robert and Margery made plans and divided their property. Among other actions they took, Robert named a trust as beneficiary of each of his three IRAs, and Margery signed consents to those beneficiary designations. After Margery died, her executor petitioned in probate court for determination of title to property. That petition sought to establish Margery s community property interest in Robert s three IRAs. Her petition was denied on the basis that Margery had either waived her community property interest in the IRA funds or, alternatively, transmuted those funds to Robert's separate property. The executor appealed, and the Court of Appeal reversed, because the consent did not constitute a transmutation under California law. Examining California s requirements for transmutation of community property to separate property, the California Supreme Court sustained the Court of Appeal. Subsequent to MacDonald, California enacted probate code provisions clarifying that a consent to a beneficiary form does not constitute a transmutation of community property. Cal. Prob. Code Section 5000, et seq. The rule maintains the integrity of family law requirements for transmutation to occur. IRA Termination Events Are Statutory Events that terminate an IRA and cause a taxable distribution of the entire account are specified in 408(e): Engaging in a prohibited transaction, as defined in 4975; Borrowing on an Individual Retirement Annuity contract; Pledging an account as security; Purchasing an endowment contract with IRA funds (causes a partial distribution). Rollover of death benefits received by a surviving spouse by reason of community property rights is not included on 408(e) s list. Quasi-Community Property When a couple domiciled in a non-community property state moves to a community property state, quasi-community property ( QCP ) rights may also apply. QCP applies to property acquired during marriage, while domiciled in a non-community property state. QCP has no effect while both spouses are living. But, when one spouse dies, half of QCP belongs to the surviving spouse and half belongs to the decedent. The Lesson: Transmutation Family arguments and court fights can easily be avoided when it comes to IRA death benefits. If a surviving spouse isn t to be named as at least a 50 percent IRA beneficiary, transmute the IRA from community property to separate property first. Legal counsel is 12

13 recommended for considering and effecting a transmutation. Advice regarding what, if anything, might be exchanged in the transmutation should include valuation and tax advice. Reliance guidance needed Surviving spouse seeking spousal rollovers will be ongoing. In the interest of sound and consistent administration of tax laws, reliance guidance, such as a revenue ruling. The long history of private letter rulings should provide fertile ground for harvesting examples that can be incorporated into reliance guidance. CONCLUSION PLR might conflict with significant tax authorities. Taxpayers, Treasury, and IRA custodians would benefit greatly from reliance guidance regarding circumstances under which a spousal rollover may occur. Update Beneficiary Forms After Divorce In Kennedy v. Plan Administrator for Dupont Savings and Investment Plan, Et al, U. S. No (2008) it was held that the ex-spouse of a deceased plan participant was entitled to ERISA-covered plan death benefits even though a marital settlement agreement the exspouse had entered into denied the ex-spouse any entitlement to those benefits. At the time of the decedent s death, the ex-spouse was still named as death beneficiary under the plan and must be recognized as such under ERISA. In Mays-Williams v. Williams, No , 9th Cir. (Jan. 28, 2015), Asa Williams, Sr., ( Asa, Senior ) had had formally designated his wife as death beneficiary under each of several retirement plans sponsored by his employer, Xerox Corporation. But, after their divorce, new beneficiary forms were not filed. However, evidence admitted in this case showed he had numerous telephone conversations with plan representatives during which he consistently stated his intention of naming his son, Asa, Junior, as beneficiary under each plan. Many of those conversations were recorded by the recipients of those telephone calls who represented the plan administrator of those plans. On May 16, 2011, Asa, Senior, died. His ex-wife claimed the benefits, as did Asa Junior. The plan administrator filed an interpleader action to determine the identity of the beneficiary. The plan documents permitted participants to choose death beneficiaries, but the terms of the plan did not require that a beneficiary form be submitted to do so. The court found, as a matter of first impression, that beneficiary forms were not plan documents. Because of this finding, the Court overturned the District Court s finding to the contrary. Examining the plan documents, the summary plan description and communications with the plan administrator admitted into evidence, the Court concluded: In light of the evidence before us, including Xerox s call log from January 10, 2011, reflecting that Asa, Senior, called Xerox to change his beneficiary designation from Carmen to Asa, Junior, a reasonable trier of fact could determine that Asa, Senior, intended to change his beneficiary to Asa, Junior, and that his phone calls to Xerox 13

14 constituted substantial compliance with the governing plan documents requirements for changing his beneficiary designation. Accordingly, we cannot sustain the grant of summary judgment in favor of Carmen. The case was remanded to the lower court for further consideration. Trusts In some cases, naming a trust is appropriate. For example, there may be minor children; a need to regulate access to retirement benefits; a desire to assure that the value of stretching IRA distributions over the life expectancy of a trust beneficiary will be realized; professional investment management; or the presence of special needs. There may also be a need to provide for creditor protection. Unlike IRAs accumulated during lifetime, inherited IRAs may not be excluded from an individual s bankruptcy estate, where federal bankruptcy rules apply. Clark v. Ramaker, 573 U. S (Jun. 12, 2014). However, the presence of an inherited IRA will increase costs. Here are some examples of those costs: Risk of application of the 5-year rule (if no individual beneficiary is recognized as designated beneficiary for purposes of RMDs, and the decedent died before reaching the decedent s required beginning date). Determination of the designated beneficiary for purposes of RMDs. It may be deemed necessary by the trustee to obtain an opinion letter and/or a PLR. Exploration and determination regarding whether a spousal IRA rollover may be made by the decedent s surviving spouse. The trustee may deem it necessary to obtain an opinion letter and/or a PLR. The risk is that there are more transactions to navigate than when the spouse is named directly as the beneficiary. Some IRA custodians won t facilitate such a transfer without a PLR. Accomplishing eventual transfer of a trust s inherited IRA to a trust beneficiary s inherited IRA. The trustee may deem it necessary to obtain an opinion letter and/or a PLR. Some IRA custodians won t facilitate such a transfer without a PLR. Time communicating with a plan administrator or IRA custodian. Risk of triggering income taxation prematurely. Subtrust allocation decisions and execution. 14

15 Imposition of the highest tax rates on amounts accumulated in trust. Qualification for estate tax marital deduction. Qualification for estate tax charitable deduction. Avoiding income taxation on charitable bequests that will be (or could be) funded with retirement plan benefits. Accounting for income and principal under state law (see, for example, Uniform Principal and Income Act Section 409). Meeting requirements for qualified disclaimers under Internal Revenue Code Section If the trust doesn t qualify for the estate tax marital deduction, the deceased spousal unused exemption election with respect to retirement benefits may reduced or unavailable. Estate planning for assets subject to disposition upon death under beneficiary forms must be coordinated with trusts. Too often, beneficiary designation forms get completed and submitted without such coordination. For example, Janet retires and decides to transfer her retirement account benefits to an Individual Retirement Account. Confronted with an application to open the IRA, Janet names her revocable living trust as death beneficiary. Was that choice the right one for Janet? While doing so may assure that her trust will dispose of her IRA according to its terms, trust drafting and administration becomes more complex and costly because of the presence of the IRA. In addition, when trust beneficiaries become entitled to take possession of trust property, IRA custodians may be reluctant to make transfers to Inherited IRAs of trust beneficiaries. Here s another example. A surviving spouse successfully completed an IRA rollover from her late husband s IRA. She was instructed to name her four children as equal beneficiaries. She named her trust instead. Her trust was distributable upon her death to her four children. The eldest child, as trustee, bore the burden of determining how to distribute the IRA in four shares while avoiding taxable IRA distributions. A friend, who was an attorney, advised the trustee to disclaim over to the estate, as well as the will s disposition in favor of the trust. Fortunately, the trustee became convinced not to do so, but it was time-consuming to arrange the transfers to the Inherited IRAs of the trust s beneficiaries. Trust Income Taxes Naming a trust as beneficiary can mean subjecting distributions from the retirement account to the trust to trust income tax rates. The highest federal income tax rate of 39.6% applies when taxable income reaches $12,400 (under 2016 rates an brackets). Income In Respect Of A Decedent; 691(c) Deduction A decedent s death benefits that are taxable may not receive a basis increase upon death. 15

16 The term income in respect of a decedent (IRD) is used in 691(a). However, it is not defined in the statute. Reg (a)-1 provides the following definition: In general, the term "income in respect of a decedent" refers to those amounts to which a decedent was entitled as gross income but which were not properly includible in computing his taxable income for the taxable year ending with the date of his death or for a previous taxable year under the method of accounting employed by the decedent. See the regulations under section 451. Thus, the term includes: (1) All accrued income of a decedent who reported his income by use of the cash receipts and disbursements method; (2) Income accrued solely by reason of the decedent's death in case of a decedent who reports his income by use of an accrual method of accounting; and (3) Income to which the decedent had a contingent claim at the time of his death. The real meaning of IRD is that income tax potentially will apply to certain items transferred by a decedent, notwithstanding the basis step-up rule of Furthermore, 1014(c) denies basis step-up to any item of IRD. Deferred compensation constitutes IRD, whether qualified or nonqualified. Ballard v. Comr., T.C. Memo (1992); Hjess v. Comr., 271 F 2d 104, 3d Cir. (1959). Qualified plan death benefits are taxable to the recipient under the rules of Subchapter D of IRC Chapter 1. Individual Retirement Accounts also constitute IRD. Rev. Rul The status as potential IRD of Roth IRAs under 408A is not clear. Qualifying distributions within the meaning of 408A(d) are not taxable to the recipient. Distributions upon or after death to a beneficiary or the estate of the participant are qualifying distributions, unless the age of the initial contribution or Roth rollover is less than 5-years. None of the statutory language of 408A addresses the status of such an account as IRD or the income tax basis in the hands of the beneficiary. However, 408A(a) states that unless specifically provided otherwise, all rules applicable to traditional IRAs also apply to Roth IRAs. Thus, it appears that, to the extent a beneficiary of a Roth IRA would report taxable income from the account, that income would constitute IRD. Shifting Tax Burdens To Beneficiaries: Carrying Out DNI Trust distributions can shift the income tax burden on a trust s taxable income to its beneficiaries. Those rules are complex, and are not summarized here. Charitable Income Tax Deduction There s an income problem with running retirement benefits destined for charity through a trust: it s possible for the trust to be denied a charitable income tax deduction. 16

17 A trust that has charitable beneficiaries and that is named as beneficiary of retirement benefit may also be denied the ability to make Required Minimum Distributions based on the life expectancy of any non-charitable, individual beneficiary of the trust. Satisfaction Of Pecuniary Bequests To Charities Using IRA Assets Means Trust Must Pay Income Taxes: LTR (May 5, 2014) Using income in respect of a decedent ( IRD ) to satisfy a pecuniary gift generally means that the IRD will be recognized as taxable income. Taxable retirement benefits, such as an Individual Retirement Account, are IRD. Examples of a pecuniary bequest include a bequest of $50,000 to a friend, as well as a formula bequest such as the least amount of a marital deduction or charitable deduction gift necessary to reduce estate taxes to zero. In this ruling, a trust established by decedent was named as beneficiary of the decedent s IRA. The trust provided for two pecuniary bequests (specified dollar-amount gifts) to charities. Because non-ira assets weren t sufficient to satisfy those charitable pecuniary bequests, it was necessary to use some IRA assets to complete the funding of those bequests. The trustee sought and obtained a court order reforming the trust in an effort to establish a right in the charities to receive part of the IRA proceeds. The IRS refused to recognize the order, as it had no effect other than for tax purposes. The ruling held that use of IRA assets to satisfy the charitable pecuniary bequests must be treated as a sale or exchange of income in respect of a decedent. It was further held that the trust would not qualify for a charitable income tax deduction because the governing instrument (i.e., the trust) did not provide that income must be used to satisfy those charitable distributions from the trust. Direct Transfer To Charity - Trustee s Retitling of Decedent s IRA in Charity s Name Held Not To Be a Distribution: LTR (Mar. 24, 2014) Decedent s Trust provided that after two pecuniary bequests, the remainder would be immediately distributed to Charity. Decedent also owned an IRA with Trust as the primary beneficiary. The Estate and Trust intend to assign and transfer the IRA to Charity in accordance with the terms of the Trust. A ruling was requested that the proposed transfer would not be a transfer within the meaning of 691(a)(2). Section 691(a) provides that all items of income in respect of a decedent which are not properly includable in the taxable period in which falls the date of the decedent s death shall be included in the gross income, for the taxable year when received, of (A) the estate of the decedent, (B) the person who by reason of the decedent s death acquires the right to receive the amount or (C) the person who has received from the decedent s estate the right to receive the amount. Section 691(a)(2) that if a right described in 691(a)(1) is transferred by the estate of the decedent, the estate must include in its gross income the fair market value of such right. For 17

18 purposes of this paragraph, the term transfer includes sale, exchange or other disposition but does not include the transmission at death to the estate of the decedent or to a person entitled to receive such amount by reason of the death of the decedent or by bequest, devise or inheritance from the decedent. Section 1.691(a)-4(b)(2) provides that if a right to IRD is transferred by an estate to a specific or residuary legatee, only the specific or residuary legatee must include such income in gross income when received. Rev. Rul , C.B. 198, holds that a distribution to the beneficiary of a decedent's IRA that equals the amount of the balance in the IRA at the decedent's death, less any nondeductible contributions, is IRD under 691(a)(1) that is includable in the gross income of the beneficiary for the tax year the distribution is received. Rev. Rul , C.B. 157, provides, in general, that the direct transfer of funds from one IRA trustee to another IRA trustee does not result in such funds being treated as paid or distributed to the participant and such transfer is not a rollover contribution. Rev. Rul is applicable to a trustee-to-trustee transfer directed by the beneficiary of an IRA after the death of the IRA owner as long as the transferee IRA is set up and maintained in the name of the deceased IRA owner for the benefit of the beneficiary. In that situation, the transfer does not constitute a payment or distribution as those terms are used in 408(d). The IRS ruled that retitling the IRA in the name of the Charity will not constitute a payment or distribution out of the IRA to the Estate, Trust or Charity within the meaning of 408(d) and further ruled that the transfer will not be a transfer within the meaning of 691(a)(2). Charity will include the amount of IRD from the IRA in its gross income when distributions from the IRA are actually received by Charity. PLR : Trust May Claim Charitable Deduction for IRA Proceeds Each of a decedent s several IRAs named a trust as death beneficiary. The trust provided that all of the decedent s IRAs payable to the trust must be distributed to a foundation. The trustee seeking the ruling represented that the foundation is an organization described in Internal Revenue Code 170(c). The trustee proposes to cause all IRAs to be distributed to the trust, after which the proceeds of the IRA distributions would be distributed by the trust to the foundation. The IRS noted that income from IRA distributions constitute income in respect of a decedent under 691 and that, under Rev. Rul , IRA income is income in respect of a decedent. Citing 642(c)(1), the IRS noted that an estate or trust is entitled to a deduction from gross income for amounts paid or credited to a qualifying charity any amount of the gross income, without limitation, which pursuant to the terms of the governing instrument is, during the taxable year, paid for a purpose specified in 170(c) (determined without regard 170(c)(2)(A)). 18

19 The ruling concludes: provided that Trust pays the entire lump sum distribution to Foundation in the year received, Trust is entitled to a deduction under 642(c)(1) equal to the amount of IRD included in Trust's gross income as a result of the distribution of the IRAs. COMMENT: it would have been better for the trust to have made a direct transfer from its Inherited IRA to an Inherited IRA established by the Foundation for the benefit of the Foundation. Recognition of gross income and allowance of an income tax would then not be an issue. In addition, any trust deductions that might be reduced by two percent of the trust s adjusted gross income (such as investment expenses) would not be reduced at all. However, not all IRA trustees are comfortable with making a direct transfer to an Inherited IRA of a trust beneficiary, as illustrated by a significant number of private letter rulings approving such transfers. Reliance guidance from IRS would be helpful in that regard. Charitable Remainder Trusts Charitable remainder trusts ( CRT ) make payments to one or more non-charitable beneficiaries, for example, the trustor s spouse or children. When all of those payments have been completed, what remains in the CRT is distributed to one or more qualifying charities. A CRT can provide after-tax value similar to stretch distributions and, in addition, can ultimately deliver substantial value to one or more qualifying charities. A CRT is likely to provide greater after-tax value to the beneficiary than the after-tax value of complying with the 5-year rule. An estate tax deduction is available for the actuarial value of the charitable remainder interest. A marital deduction is available for lifetime payments to a surviving spouse, provided the surviving spouse of the decedent is the only non-charitable beneficiary. IRC 2056(b)(8) Payments to one or more non-charitable beneficiaries may be made over a stated number of years up to 20 years. Alternatively, payments may be for the lifetime of one or more individuals. The amount of the payments may be structured either as an annuity (Charitable Remainder Annuity Trust, or CRAT ) or as a Unitrust amount (Charitable Remainder Unitrust, or CRUT ). The Unitrust amount is equal to a percentage of the trust s value, determined annually. The Unitrust percentage must equal at least five percent. The actuarial value of the charitable remainder interest must equal or exceed ten percent of the value of all property contributed to the trust. Generally, there is no income tax imposed on a CRT. However, a 100 percent tax is imposed unrelated business taxable income (as defined in IRC 512, determined as if part III of subchapter F of the IRC applied to such trust). 19