IRS ruling may open up a new estate-planning tool: using the qualified disclaimer provision of IRC section 2518.
Individual Retirement Accounts (IRA) are an incentive for taxpayers to save for retirement introduced by the Employee Retirement Income Security Act of 1974 (ERISA; P.L. 93-406). These savings grow tax-deferred and must be held until age 59'A before they can be withdrawn without penalty. These amounts must be distributed as taxable income by age 7014, based upon a minimum distribution schedule. The popularity of IRAs, along with other retirement programs available to U.S. taxpayers, is evidenced by the fact that such assets have steadily grown, from $3.9 trillion in 1990 to $17.9 trillion in 2011 (Investment Company Institute, 2012 Investment Company Fact Book, 52d Ed., Figure 7.2). IRAs are the largest component of this total at $4.9 billion in 2011 (ICI 2013, Figure 7.14).
Inherited IRA Assets
The greatest benefit of an IRA is its tax-deferred accumulation feature. To the extent that its assets are not needed to fund the account holder's expenses, it provides an efficient vehicle for estate planning by passing the assets to a beneficiary upon their death. The IRS classifies these in two main categories: spousal inheritance and non-spousal inheritance. This article deals with the taxability of the spousal inheritance feature.
In the case of a spousal inheritance, the surviving spouse usually has the option of treating the inherited account as her own, rolling it over into another IRA plan and taking distributions as a beneficiary as per the required minimum distribution rules based on the surviving spouse's life expectancy, or disclaiming up to 100% of the inherited IRA assets. This second option has received interest from estate planners, because it not only allows the surviving spouse to avoid recognizing any taxable income--it also enables any child to inherit the IRA assets, thereby implicitly adding a generation-skipping feature.
Disclaiming IRA Assets
Disclaiming an interest in an asset, according to IRS rules, results in such an interest never being transferred to the individual making the disclaimer--thus a disclaimer has essentially the same effect as the death of the beneficiary with regard to the interest in the disclaimed asset. But such a disclaimer has to be a "qualified disclaimer." The requirements for a qualified disclaimer are described in IRC Section 2518, originally enacted in 1976 and amended in 1981. According to IRC Section 2518(b), a "qualified disclaimer" is an "irrevocable and unqualified refusal to accept an interest in property" that satisfies the following four conditions:
* The refusal is in writing,
* The refusal is received by the person transferring the property, or his legal representative, within nine months of the creation of the interest or after the disclaimant turns 21,
* No interest or benefit in the transferred property have been accepted prior to the disclaimer, and
* As a result of the disclaimer, the interest passes either to the testator's surviving spouse or to a person other than the disclaimant without any disclaimant direction.
Although IRAs and inherited IRAs have been used by discerning taxpayers as a viable estate planning tool, the use of disclaiming an inherited IRA for such purposes has been rare.
In three cases taking place in 2005, covered by Internal Revenue Bulletin 2005-26 and Revenue Ruling 2005-36, 2005-1 C.B. 1368, the IRS upheld the "qualified disclaimer" claims of three different taxpayers. In each of these similar situations, the decedent died prior to receiving the year-of-death required minimum distribution (RMD), which was paid to the disclaimant; the balance of the IRA was then disclaimed in whole or in part and paid to the beneficiary designated if the disclaimant died before the decedent owner. The IRS quoted Treasury Regulations section 25.25183(c) to argue that, because the disclaimant received the RMD before the disclaimer, the distribution should be treated as coming from the principal of the IRA. According to the IRS, the receipt of the RMD by the disclaimant does not prevent a disclaimer of the remaining balance of the IRA if no benefit from the disclaimed amount is accepted by the disclaimant before or after the disclaimer. The income attributable to the RMD cannot be disclaimed, thus, the IRS argued, despite receiving the RMD for the year of the decedent's death, disclaiming the remaining IRA balance, in whole or in part, is appropriately treated as a "qualified disclaimer," excluding any income attributable to the RMD. The important point to note that the disclaimant received only the RMD from the corpus of the IRA assets, and the IRS's ruling affected the disclaimer for the balance of the IRA.
In a 2012 case, a surviving spouse disclaimed her interest in an inherited IRA although she continued to receive IRA distributions that exceeded the RMD for the year the deceased IRA owner died. Citing Revenue Ruling 2005-36, the taxpayer was also given a similar "qualified disclaimer" in Private Letter Ruling 201245004 (November 9,2012)--overlooking the fact that in the 2012 case, the spousal beneficiary collected more than the RMD. The facts of Revenue Ruling 2005-36 and Private Letter Ruling 201245004 are summarized in the Exhibit.
Comparing the 2005 Revenue Ruling with the 2012 Private Letter Ruling
Per Private Letter Ruling 201245004, a surviving spouse who, prior to making a disclaimer, received distributions in excess of the deceased's spouse RMD was ruled as having made a qualified disclaimer by the IRS. In addition to IRC section 2518 and Treasury Regulations section 25.2518, the IRS referred to Revenue Ruling 200536, 2005-1 C.B. 1368 as the basis for its conclusion. In the authors' view, Private Letter Ruling 201245004 is important because its facts, while similar, are not quite as on point as those of Revenue Ruling 2005-36. The result is that the scope of what qualifies as a disclaimer appears to have been broadened by the IRS.
While there are similarities between the cases, there are some remarkable differences. The facts are similar because both cases involve partial disclaimers of an interest for which an amount was determinable; in addition, both specifically mentioned the disclaimer of the income generated from the disclaimed interest. However, in the case of Private Letter Ruling 201245004, the distributions to the IRA's primary beneficiary, the spouse, were in excess of the decedent's RMD. In addition, prior to the disclaimer, some withdrawals were made from the bank account where these distributions were deposited, suggesting that the funds were being utilized. In Revenue Ruling 2005-36, the spouse had only received the RMD and there was no indication the funds were being utilized prior to the disclaimer. Furthermore, the spouse under Private Letter Ruling 201245004 would benefit from the IRA even after the disclaimer, because she was the sole beneficiary of the family trust that would be the destination of the disclaimed IRA assets. This was not the case for the spouse in Revenue Ruling 2005-36.
A major difference between the two rulings is that in Private Letter Ruling 201245004 the spouse would still receive beneficial enjoyment from the IRA after the disclaimer. IRC section 2518(b)(3) states such person has not accepted the interest or any of its benefits, and section 2518(b)(4) states that as a result of such refusal, the interest passes without any direction on the part of the person making the disclaimer and passes either to the spouse of the decedent or a person other than the person making the disclaimer. Under Treasury Regulations section 25.2518-2(e)( 1 )(ii), the requirements of a qualified disclaimer are not satisfied if the disclaimed property or interest in property passes to or for the benefit of the disclaimant as a result. There is an exception, however, in Treasury Regulations section 25.25182(e)(2), in the case of a disclaimer made by a decedent's surviving spouse with respect to property transferred by the decedent that can be satisfied if the interest passes as a result of the disclaimer without direction on the part of the surviving spouse. If the surviving spouse retains the right to direct the beneficial enjoyment of the disclaimed property in a transfer that is not subject to federal estate and gift tax (whether as trustee or otherwise), such spouse will be treated as directing the beneficial enjoyment of the disclaimed property--unless such power is limited by an ascertainable standard. In the case of Private Letter Ruling 201245004, the disclaimed interest passed to the family trust. The spouse was the sole beneficiary of the family trust. The trust's corporate trustee's decision as to the beneficial enjoyment of the IRA by the spouse is based upon the ascertainable standards of health, education, maintenance, and support. The facts in this case appear to indicate that the spouse was not the one directing the transfer upon disclaimer and her beneficial enjoyment was the result of an ascertainable standard made by someone else.
In the case of Private Letter Ruling 201245004, prior to the disclaimer some withdrawals were made from the bank account where the IRA distributions were deposited. IRC Section 2518(b) lists four requirements that must be met for a valid disclaimer. Treasury Regulations section 25.2518-2(dX 1) provides that a qualified disclaimer cannot be made if the disclaimant has previously made an express or implied acceptance of the interest or any of the benefits. The regulations define acceptance as an affirmative act consistent with ownership of the interest in property, which includes using the property and directing others to act with respect to the property. The regulations further provide that merely taking delivery of an interest or title does not constitute acceptance. One would think that the spouse's withdrawal of the funds deposited into her bank account would constitute use of the interest; yet, there were no specific comments regarding the withdrawals made in the IRS's analysis of Private Letter Ruling 201245004.
According to Private Letter Ruling 201245004, the distributions to the IRA's primary beneficiary were in excess of the RMD for the year of the decedent's death. (This was stated as the reason for the request of a private letter ruling.) Under Treasury Regulations section 25.2518-3(a), each interest in property that is separately created by the transferor is treated as a separate interest; under section 25.25183(a)(ii), a disclaimant is treated as making a qualified disclaimer of a separate interest in property if the disclaimer relates to severable property and the disclaimant makes a disclaimer that would be a qualified disclaimer if such property were the only property in which the disclaimant had an interest. Severable property is defined as property that can be divided into separate parts, each of which maintains a complete and independent existence (assuming local law has recognized the disclaimer of the severable property). In Revenue Ruling 2005-36, the IRS ruled that, all other requirements of IRC section 2518 being met, the spouse's acceptance of the RMD did not prevent the disclaimer of the remaining balance from being a qualified disclaimer. It would appear that the IRS is focused on the remaining IRA interest, not the distributions made; the remaining balance in the IRA is considered a severable property. This is what both rulings have in common: Under each ruling, immediately upon the disclaimer, the IRA with its related income was transferred under its instrument provisions as if the spouse had predeceased the decedent.
Private Letter Ruling 201245004 considers the remaining balance of an IRA interest with its related income to be a qualified disclaimer regardless of the distributions that have been made between the date of death and the date of the disclaimer, assuming all of the other requirements of IRC section 2518 have been met. The key is that, immediately upon the disclaimer, the IRA interest with its related income must be separated from the income that is related to the distributions that occurred prior to the disclaimer. Such a treatment of the qualified disclaimer rule significantly broadens its scope.
Use with Caution
Since their inception, IRAs have been a vital component of retirement savings of taxpayers in general. IRAs have also been used as an estate planning tool to pass on accumulated wealth from one generation to another. The qualified disclaimer provisions to such IRA assets added significantly to the use of such estate planning through Revenue Ruling 2005-36.
By definition, private letter rulings may not be relied upon as a precedent by other taxpayers. Thus, although the IRS has maintained that Private Letter Ruling 201245004 is similar to Revenue Ruling 2005-36, it is not as sound of a defense for a position. Historically, when private letter rulings have been issued on a common concern of taxpayers, they have been later incorporated in a Revenue Ruling.
With appropriate caution, Private Letter Ruling 201245004 may serve to provide some hope for taxpayers in similar situations. The creation of a trust as the beneficiary of IRA assets and the use of the trust assets to benefit the intended beneficiary appears to be an ingenious form of estate planning by avoiding the generation of taxable income.
Deborah Gonzalez, MPA, CPA, is on the faculty of the accounting and business law department at the University of Texas Pan American, Edinburg, Texas. Gouranga Ganguli, PhD, CPA (inactive), is a professor of accounting, also at the University of Texas-Pan American.
EXHIBIT Comparison of Revenue Ruling 2005-36 and Private Letter Ruling 201245004 Revenue Ruling 2005-36, 2005- Private Letter Ruling 1 C.B. 1368 201245004 While living, the decedent was While living, the decedent was receiving annual distributions receiving the RMDs via from the IRA. At time of automatic deposits into a bank death, decedent had not account held by a retirement received the RMD for that plan trust (trust). year. After the decedent's death, After the decedent's death, the designated primary the surviving spouse received beneficiary, the spouse automatic deposits into bank (situations 1 and 2) and account distributions in non-spousal beneficiary excess of the decedent's RMD. (situation 3), received the This occurred during the two RMD. This one-time payment months after decedent's death, occurred 3 months after the at which point distributions decedent's death. No other were cancelled. During those payments were received. two months, the spouse benefited from account withdrawals. The surviving spouse made no investment decisions for the IRA. Situation 1: The spouse Serving as attorney-in-fact, disclaims a specified amount the spouse's son exercised his of the IRA account balance power to disclaim on behalf of along with its associated the spouse. He irrevocably income earned after the date disclaimed the spouse's of death. interest in the balance of the IRA and a proportionate amount Situation 2: The spouse of income attributable to such disclaims 30% of interest in balance. the remaining balance of the IRA, excluding any income attributable to the RMD received. Situation 3: The primary non- spousal beneficiary disclaims the entire remaining IRA balance, along with associated income earned after the date of death. Per applicable state law, a The termination provisions of disclaimer will treat a the trust stated that at disclaimant as having decedent's death, a marital predeceased the decedent with trust and family trust were to respect to the disclaimed be created. In addition, the property. trust provisions stated that in the event surviving spouse Situation 1: The secondary disclaimed the IRA interest, beneficiary named in the IRA the disclaimed property would is paid a specified amount, pass to the marital trust. It along with related income further stated that if the earned after decedent's date decedent did not elect to of death. treat the marital trust as qualified terminable interest Situation 2: The secondary property (QTIP), then the beneficiary receives a disclaimed property would pass distribution representing 30% to the family trust. The of the IRA's remaining decedent did not make a QTIP principal balance and its election for the marital related income. Situation 3: trust. Therefore, the The secondary beneficiary is disclaimed property passed the decedent's spouse, who into the family trust. receives the remaining principal balance and its related income. Not applicable. Under the provisions of the family trust, a corporate trustee is required to withdraw each year from the IRA (now an asset of the family trust), the greater of the RMD and that portion of the IRA that constitutes the accounting income of the IRA benefits. In addition, the trustee can at its discretion withdraw from the family trust what is deemed necessary for the health, education, maintenance, and support of the family trust's sole beneficiary, the spouse. Upon the spouse's death, the assets will be paid out in accordance with the family trust's termination provisions. Note: RMD=required minimum distribution
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|Title Annotation:||Finance: estates & trusts|
|Author:||Gonzalez, Deborah; Ganguli, Gouranga|
|Publication:||The CPA Journal|
|Date:||Dec 1, 2014|
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