Announced in 2005: One court ruling on higher ed, one revenue ruling on disclaimers, and a series of PLRs on trustee-to-trustee transfers.

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1 By Marcia Chadwick Holt, Partner, Davis Graham & Stubbs LLP, Denver Helpful Rulings Announced in 2005: One court ruling on higher ed, one revenue ruling on disclaimers, and a series of PLRs on trustee-to-trustee transfers. Some helpful rulings for retirement benefits planning were announced in One court ruling defines higher education expenses, a revenue ruling clarifies disclaimers and a series of private letter rulings authorizes numerous trustee-to-trustee transfers by individual beneficiaries when a trust was the named beneficiary. HIGHER ED What constitutes a higher education expense that qualifies for an exception to the individual retirement account (IRA) early withdrawal penalty that imposes a 10 percent additional tax? Surprise! In Gorski v. Comm r 1, the U.S. Tax Court held Aug. 4, that books, a computer, housewares, furniture, appliances and bedding were not qualified higher education expenses. Because the case was heard pursuant to the Internal Revenue Code (IRC) Section 7463, the decision is not reviewable nor can the opinion be cited as authority. But it is useful to know. In Gorski, the Internal Revenue Service determined that a student s parents owed additional federal income tax because they failed to pay a 10 percent additional tax on an IRA withdrawal that they made to pay the student s higher education expenses. IRC Section 408(d)(i) requires that amounts distributed from an IRA be included in gross income pursuant to IRC Section 72, and imposes a 10 percent additional tax unless the distribution satisfies an exception under IRC Section 72(t)(2). One exception to the 10 percent additional tax is a distribution from an IRA used to pay qualified higher education expenses. Qualified higher education expenses include expenses for tuition, fees, books, supplies and equipment required for enrollment or attendance at an eligible educational institution as well as room and board for students who are at least half-time students. 2 This language also to IRC Section 529 plans. 3 The Tax Court denied the expenses for a computer, housewares, appliances, furniture and bedding, as they did not appear from the record to be required by the college for the student s enrollment or attendance in classes. It denied the expenses for books because they were not substantiated. Consequently, the court ruled that the parents were liable for the 10 Percent additional tax. Note that while the 10 percent additional tax does not apply to a withdrawal that is made to pay qualified higher education expenses from an IRA, there is no equivalent for withdrawals from any other retirement plan. In Henry Uscinski v. U S. Comm r, 4 the taxpayer discovered the hard way that a withdrawal from an IRC Section 40l(k) account to pay higher education expenses was subject to the 10 percent additional tax. #

2 The moral? If a taxpayer wants to qualify for an exception from the 10 percent additional tax on an IRA withdrawal that is made to pay qualified higher education expenses, appropriate records must be kept, and evidence must be produced to prove that expenses are required for the student s enrollment or attendance in classes. This applies for IRC Section 529 plans as well! RMDS AND DISCLAIMERS Revenue Ruling , IRB (dated June 27), helps clarify disclaimers. The taxpayer died in 2004, after his required beginning date (RBD) but before taking his required minimum distribution (RMD) from his IRA for the year of his death. Three situations involving RMDs and disclaimers were posited. In the first situation, the surviving spouse received the RMD after the decedent s death and made a qualified disclaimer of a pecuniary amount in the IRA balance and the income attributable to that disclaimed amount. In the second situation, the surviving spouse received the RMD after the decedent s death and made a qualified disclaimer of a percent of the IRA balance after reduction for the income the spouse was deemed to have accepted. In the third situation, the taxpayer s child received the RMD after the decedent s death and made a qualified disclaimer of the principal and income of the IRA remaining after the payment of the RMD, except for the income attributable to the RMD. The IRS ruled that in all three situations, the beneficiary may disclaim all or a part of an IRA balance remaining after his receipt of the RMD. However, the IRS indicated that there can be no qualified disclaimer of the RMD amount itself and the income allocable to it, as the beneficiary had already accepted those amounts. This revenue ruling is helpful in three ways: 1) Postmortem Planning: It provides an important tool for postmortem planning. RMDs are usually automatically distributed by a qualified plan and sometimes by an IRA to the named beneficiary after the participant s or owner s death if the RMD is required in the year of death and the decedent requested the RMD but failed to take it prior to death. The RMD must be paid by Dec. 31 of the year of death or a 50 percent excise tax could apply. Such an RMD is attributable to the decedent, even though it is payable to the beneficiary. This revenue ruling makes clear that despite the RMD being paid to the beneficiary in the year of decedent s death, the beneficiary can still disclaim the amount remaining in the plan or IRA after receipt of the RMD. Acceptance of the RMD and income attributable to it does not preclude a disclaimer of the remaining amount. 2) Separate Accounts: The ruling also confirms the availability of separate accounts after a disclaimer. The IRS indicated that the disclaimed amount need not be distributed outright but instead may be segregated and maintained in a separate IRA account for the benefit of the beneficiary as described in Treasury Regulations Section 1.401(a)(9)-8, A-3. This allows for a stretch-out of payments. 3) Timing of Disclaimers: The ruling confirms that a beneficiary who disclaims an entire remaining interest in the IRA will not be a designated beneficiary if: a qualified disclaimer is 2

3 made on or before Sept. 30 of the year following the year of the participant s or the owner s death; and the disclaimant is not entitled to any further benefits in the IRA. This is another important tool for postmortem planning. Remember, however, that the disclaimer must also qualify under IRC Section That section imposes a nine month deadline from date of death in which to disclaim. Consequently, the time for making a qualified disclaimer could expire long before the Sept. 30 deadline for determining the designated beneficiary. For example, the Sept. 30 deadline occurs within the nine months for making a qualified disclaimer if the decedent dies on Dec. 31, but it occurs 21 months after the decedent s death if the decedent dies on Jan. 1. In the first case, a disclaimer by Sept. 30 of the following year would be qualified, in the second case it would not. The qualified disclaimer and designated beneficiary deadlines are not the same. Plan carefully The qualified disclaimer and the designated beneficiary deadlines are not the same. Plan carefully. TRANSFERS In five private letter rulings, (dated April 18), each of the almost-identical letter rulings is addressed to a different one of the decedent s five nieces and nephews. The IRS approved 12 trustee-to-trustee transfers in connection with the decedent s IRA (IRA X) and the decedent s interest in a qualified plan (Plan W). (See Successful Trustee-to-Trustee Transfers, p. 67.) Each ruling requested that the IRS approve the trustee-to-trustee transfers made by the trust and by the nieces and nephews as beneficiaries of certain trusts, and approve the use of the life expectancy of the oldest beneficiary of Subtrust V for purposes of RMDs from IRA X and the life expectancy of the oldest beneficiary of Trust T for purposes of Plan W. The IRS ruled that a trustee-to-trustee transfer from one IRA to another, or from one IRC Section 403(b) account to another, may be accomplished after the death of an IRA owner or Section 403(b) annuitant by a beneficiary of such account or annuity as long as the new account remained in the name of the decedent. Furthermore, a trustee-to-trustee transfer did not constitute a distribution and accordingly was not subject to income tax. As to IRA X, the IRS also ruled that for purposes of IRC Section 401(a)(9), the life expectancy of the surviving spouse who was a beneficiary of Subtrust U but not of Subtrust V, must be considered with respect to the portion of IRA Y, because the allocation to Subtrust V was made in accordance with state law and not in accordance with the beneficiary designation. Consequently, separate accounts for RMD purposes were not created pursuant to Treas. Reg. Section 1.401(a)(9)-4, A-1. The surviving spouse was the eldest of such beneficiaries. Unfortunately, the nieces and nephews had to use the surviving spouse s life expectancy (and not their own) in determining their RMDs from IRA Y. Note that if the decedent in her beneficiary designation had specifically named Subtrust V as beneficiary, she would have created a separate 3

4 account for Subtrust V and the designated beneficiary for RMD purposes would have been the oldest of the nieces and nephews. This would have resulted in a stretch-out of payments. As to Plan W, the IRS ruled that the surviving spouse was the eldest beneficiary of Trust T and that the nieces and nephews must use the surviving spouse s life expectancy in determining their RMDs from Account U. Again, separate accounts for RMD purposes had not been created since Trust T and not Subtrust V was the named the beneficiary. SUCCESSFUL TRUSTEE-TO-TRUSTEE TRANSFERS The IRS recently released five PLRs showing what works The Internal Revenue Service issued PLRs on April 18, approving 12 trustee-to-trustee transfers. One of the best ways to understand the flow approved is to see it illustrated. IRA X PLAN W 50% to Subtrust U created under Trust T f/b/o Sp (by beneficiary designation) Subject of Favorable Ruling Requests 50% to Trust T (by beneficiary designation) Allocated by state law and trust provisions (not by beneficiary designation) to Subtrust V by Sept. 30, 2002 to new IRA Y (in A s name f/b/o Subtrust V) to 5 new separate IRAs in A s name with one niece or nephew as beneficiary of each such account Trust T (by beneficiary designation) % to Subtrust U f/b/o Sp Subject of Favorable Ruling Requests % to Subtrust V (f/b/o B,C,D,E,F and outright at age 21) to new Account U (in A s name f/b/o Subtrust V as beneficiary) to 5 new separate Section 403(b) accounts in A s name with one niece or nephew as beneficiary of each such account Successful Result B C D E F Successful Result B C D E F * f/b/o = for the benefit of * Sp = Decedent s surviving spouse * A = Decedent, who died in 2001 at age 64, owned IRA X and an account in Plan W * B-F = Nieces and nephews all over age 21 Source: Marcia Chadwick Holt 4

5 Note that in both cases, if the decedent in her beneficiary designation had specifically named each niece s and nephew s trust as a beneficiary, five separate accounts for RMD purposes would have been created and each nephew and niece could have used his or her own life expectancy for RMD purposes. This would have resulted in an even longer period of payments. In another PLR, (dated March 29), the IRS allowed the decedent s IRA to be divided into nine separate IRAs in the decedent s name by a series of trustee-to-trustee transfers. The ruling also allowed the age of each of nine different beneficiaries to be used for RMD purposes since the IRA s beneficiary designation specified each of nine different subtrusts as a beneficiary of a specified percentage of the IRA. In four more recent PLRs, , , and (dated June 28), the IRS allowed the trustee to distribute an IRA to three separate subtrusts by means of a series of trustee-to-trustee transfers which effectively bypassed the trust which had originally been named the beneficiary. Check out these rulings for more guidance on the availability and advantages of trustee-to-trustee transfers. A caveat: don t confuse the trustee-to-trustee transfer available to beneficiaries and discussed here with the direct rollovers available to spousal beneficiaries under IRC Section 402(c)(9). A direct rollover is a trustee-to-trustee transfer to a retirement account titled in the beneficiary s name but it is not available to a beneficiary who is not a surviving spouse. A trustee-to-trustee transfer as discussed here is a transfer to a retirement account titled in the decedent s name and it is available to all beneficiaries. What is the significance of these rulings? They provide proof to recalcitrant and uninformed IRA providers that trustee-to-trustee transfers can be an acceptable and appropriate alternative to outright distributions of the IRA to a trust that is named beneficiary. Endnotes 1. TC Summary Opinion (Aug. 4). 2. Internal Revenue Code Sections 72(t)(2)E and 529(e)(3)(B). 3. IRC Section 529(e)(3)(A). 4. TC Memo