Recent letter ruling must be considered before bequeathing retirement account to private foundation.

With the Federal and state estate and income taxes imposed on the benefits of funds received from retirement plan (corporate, Sec. 401(k), Keogh, individual retirement account (IRA), etc.) accounts, philanthropic individuals are being advised to consider naming their private foundations as the recipients of these proceeds.

When a charity (whether publicly supported or a private foundation) receives the proceeds of a qualified retirement plan account,it receives 100% of the account's gross value (unless Sec. 4980A, which imposes a 15% excise tax on an excess retirement plan accumulation, applies). That is, the retirement plan proceeds are not subject to income taxes (which the decedent or the decedent's beneficiaries would have paid), nor are they subject to estate taxes (as the estate will be entitled to a charitable deduction equal to the value of the retirement plan account). Disregarding the estate tax marital deduction, which only postpones the payment of estate taxes until the second spouse dies, the result of such a bequest is that the cost to the decedent's beneficiaries is only 25% (approximately) of the qualified retirement plan account's gross value. Since the normally charitable decedent would have, no doubt, left a substantial amount to charity in any event, the bequest of a retirement plan account should not unduly upset the beneficiaries and, in fact, should please them.

However, the IRS has now released Letter Ruling 9633006, which stands for the proposition that the 2% excise tax, imposed under Sec. 4940 on the net investment income of private foundations, applies to a portion of the retirement plan proceeds received by a private foundation. How the Service arrived at its conclusion is an exercise in obfuscation. Note that, since publicly supported charitable organizations are not subject to the 2% excise tax on net investment income, the letter ruling does not apply to those organizations.

The IRS's error, the authors believe, was in failing to recognize the firewall established under Sec. 691 (income in respect of a decedent or IRD). Simply put, pension income bequeathed to a decedent's beneficiary (whether it is an individual or a private foundation) is IRD under the principles of Sec. 691. Since the decedent would have recognized the pension account proceeds as taxable income, so must the beneficiary; however, in the case of a private foundation, no regular income tax is payable. In fact, if the retirement plan proceeds were classified entirely as pension income (as the authors believe it should have been), the Service agrees that the 2% tax on net investment income under Sec. 4940 would not apply (since pension income is not net investment income). However, the recently issued ruling pierces the firewall, i.e., it looks behind the pension income in order to break the pension income into its components (e.g., employer/employee contributions to the retirement plan, interest income, dividend income, capital gains, etc.). By taking this approach, the IRS maintains that the private foundation must calculate and pay the 2% excise tax on the proceeds attributable to the interest income, dividend income and capital gains. The Service and the authors agree that the contributions by the employer and/or the employee are not subject to the 2% excise tax. This is a very fine distinction that the Service has drawn and not one that, in the authors' opinion, is supported by the legislative history or the applicable Code sections.

The key language imposing the 2% excise tax stems from Sec. 4940(c)(1), which states that "[e]xcept to the extent inconsistent with the provisions of this section, net investment income shall be determined under the principles of Subtitle A." While Subtitle D contains the excise tax provisions, Subtitle A contains the income tax provisions. The key provisions of Subtitle A affecting the subject of this article are Secs. 163 and 691. Sec. 691 has been described previously Sec. 163 provides that investment income means income from property held for investment (e.g., interest on bonds and bank deposits, dividends on stocks, etc.)--hardly the equivalent of pension income. Sec. 691 looks to the character of the income in determining how it will be taxed to the recipient thereof. As noted before, the IRS has ignored pension income as a character of income and, instead, seeks to divide the pension income into multi-characters of other income. The basis for the Service's opinion is Rev. Rul. 80-118, which held that the excise tax applied when a private foundation received income on the redemption of Series E U.S. savings bonds received from an estate. The authors agree that the character of that income was interest income, and that the IRS has a stronger position that such interest income is subject to the 2% excise tax whether or not the savings bond interest was earned during the decedent's lifetime or while the private foundation held the bonds. However, there is a significant distinction between the public ruling and one in which the IRD is pension income. That is, the private foundation in the latter instance 1S receiving pension proceeds, not accrued interest.

The authors find nothing in the principles of Subtitle A that is inconsistent with the provisions of Sec. 4940 and, therefore, believe the Service's conclusion in Letter Ruling 9633006 is misguided.

For additional background on this area, the reader should review Letter Ruling 9341008, in which the IRS concluded that"the private foundation will not be subject to the Federal excise tax on investment income under Section 4940(a) when the taxpayer's IRA(s) pass to the private foundation." Unofficially, the Service has indicated that that phrase was meant only to apply to employer/employee contributions to a retirement account.

The IRS concludes, in Letter Ruling 9633006, that "[t]he proceeds in excess of the amounts contributed to the account are held to be investment income...because the assets in the account are of the type that produce investment income."What the Service ignores is that the decedent was not holding the pension account as an investment account (as would be the case with the decedent's brokerage account or Series E savings bonds). A pension account, whether controlled by the decedent or the decedent's employer, is a trust. The pension aspect serves as an umbrella over all of the components of the trust's assets; hence, the authors believe, it is the pension proceeds that the private foundation is receiving.

Finally, since a private foundation always has the respective state's Attorney General looking over its shoulder, the trustees or officers of the private foundation have an obligation to pay the lowest Federal excise tax possible. If the conclusions drawn in the ruling are followed, the recordkeeping ramifications boggle the mind. For example, how many taxpayers keep continuous annual records of the amounts contributed to their respective corporate or self-maintained (Keogh, 401(k), simplified employee pension, IRA, etc.) accounts? How many taxpayers keep a record of what their employers contribute annually on their behalf? What happens when companies or their plans merge? How do distributions during a decedent's lifetime affect the amounts to be treated as subject or not subject to the excise tax? What about a gain on an asset such as a stock warrant that is probably not subject to the tax on net investment income? How does the private foundation obtain this data? The permutations and combinations of these calculations are endless. While it is true that only a 2% excise tax is involved, the private foundation's responsible officers cannot merely dismiss the calculation as de minimis. Also, in some cases, the 2% excise tax can result in a substantial dollar amount.

From Alan E. Weiner, CPA, J.D., LL.M., and Timothy W. Mulcahy, CPA, MBA, Holtz Rubenstein & Co., LLP, Long Island, N.Y.