Estate Planning for Retirement Benefits: Recent Developments

Transcription

1 ALIABANewDev wpd 7/8/05 Estate Planning for Retirement Benefits: Recent Developments Natalie B. Choate, Esq. Bingham McCutchen LLP Boston, MA Internal table of contents: Page numbers in this table refer to numbers at bottom of page 07/05: Self-Directed IRAs /05: Rev. Rul : IRS issues roadmap for partial disclaimers of retirement benefits /05: PLRs allow post-death rollovers of pre-death distributions, and other novelties /05: IRS Circular 230 creates extensive new requirements for any written tax advice /05: Creditors and Retirement Benefits: new Bankruptcy Act; Rousey v. Jacoway /05: Rev. Proc : IRS issues new rules for valuation of plan-owned life insurance /05: Mistakes you can t fix: PLR ; Owens v. Commissioner /05: Mistakes you CAN fix: PLR , PLR /05: Effective for 2005:MRDs and Roth IRA eligibility /04 to 01/05: New SOSEPP developments /04: PLRs regarding trusts as beneficiaries of retirement benefits /04: See-through trusts: PLR blesses snapshot theory

2 This paper discusses various new developments in the subject of estate and distribution planning for retirement benefits. New means occurring in approximately the last 14 months prior to the date on the first page. Background necessary to understand each development is briefly summarized. Full detail regarding the underlying subject matter can be found in the authorities cited, or in the referenced section of the author s book Life and Death Planning for Retirement Benefits, which can be purchased through the author s website by calling /05: Self-Directed IRAs enable IRA owners to lose money in real estate instead of stocks, while risking IRA disqualification through prohibited transactions and assignment of income; Rollins case shows PT rules are not a numbers game. EXECUTIVE SUMMARY Investing your IRA in real estate and other unconventional investments through a selfdirected IRA is the latest media darling and hot topic pathway to IRA hell. 1 IRA owners, bored with and mistrustful of the stock market, want to invest in real estate (and race horses and Alaskan sablefish, according to Fortune) instead. Real estate is the most popular unconventional investment, for the simple reason that real estate always goes up in value. (Although several former-millionaire clients of mine were wiped out investing in real estate in the last boom cycle in the late 1980 s, I understand that this time it s different!) This article explains four tax drawbacks and risks of self-directed real estate investing through an IRA as it is currently being promoted, listed in increasing order of seriousness: 1. Loss of the tax advantages usually associated with real estate investing; 2. Risk of IRA disqualification through failure to respect the IRA as a separate entity (especially if the IRA-owned LLC structure is used); 3. Risk of IRA disqualification through a prohibited transaction (PT) due to a common misinterpretation of the PT rules; and 4. Risk of IRA disqualification, penalties, and/or tax evasion charges, including listed transaction concerns, through performance of personal services to improve the value of the IRA-owned real estate. Note: Unconventional IRA investing is perfectly legal. The only things IRAs are actually forbidden to invest in are insurance, collectibles, and loans to the owner. Hopefully, most people who hold real estate in their IRAs are doing so in a perfectly legal manner that does not involve any of the pitfalls 1 See Franklin, Mary Beth, An IRA can invest in Real Estate, Kiplinger s Retirement Planning: Your Guide to Securing Your Dreams (Fall 2005), p. 72; Marino, Vivian, Wary of Stocks? Property Is an I.R.A. Option, New York Times 6/29/05 (p. C-10); Ryan, Oliver, Customize Your IRA, Fortune 2005 Retirement Guide (7/11/05), p

3 discussed here. They never commingle IRA and personal funds, never allow the IRA to transact with any relative or related entity, and perform no services for the IRA beyond investment management. This article is not aimed at them. I. REAL ESTATE LOSES ITS TAX ADVANTAGES INSIDE AN IRA The income tax drawbacks of investing in real estate inside an IRA rather than outside are covered in the Kiplinger s article (see footnote 1): loss of the deductions usually associated with real estate investments such as depreciation, turning potential capital gain into ordinary income, difficulty of obtaining financing (because the IRA owner cannot guarantee a loan to the IRA). Another drawback is that, if the IRA finances the real estate with a mortgage, as is typically done with real estate investments outside an IRA, some of the IRA s income will be considered income from debt-financed property, which is a form of unrelated business taxable income (UBTI), taxable to the IRA under 512. A qualified retirement plan gets the benefit of an exception for certain mortgages on investment real estate, but this exception does not apply to IRAs. 514(c)(9). The self-directed IRA fan is willing to accept these drawbacks in exchange for being able to invest the IRA funds in his favorite investment. He is using the IRA because that s where the money is. The tax advantage he seeks is, instead, to have the profits he expects to receive from the real estate investment be tax-deferred (traditional IRA) or tax-free (Roth IRA). II. MANY IRA OWNERS WILL COMMINGLE FUNDS, THEREBY CAUSING IRA DISQUALIFICATION OR OTHER TAX PROBLEMS The first obstacle to IRA real estate investing is that only a bank (or similar institution) can be the custodian or trustee of an IRA. 408(a)(2). Unlike with, say, a Keogh plan (where the owneremployee can also serve as plan trustee), you cannot personally hold title to your IRA assets. Most banks are unwilling to hold title to anything other than listed securities and cash in an IRA account. A. Leading self-directed IRA custodians Enter a new breed of IRA custodians, led by Pensco ( and Entrust ( who will hold real estate and almost anything else you want to invest in. So now you hold that apartment building in your IRA. The next question is, who collects the rent and pays the bills? Pensco s booklet on self-directed IRA investing, Take Control with a Self- Directed IRA, advises (correctly) that bills are to be paid directly to the applicable vendor by Pensco, at the IRA owner s direction. Paying the bills yourself and requesting reimbursement from the IRA is NOT possible because you are not allowed to take receipt of funds related to your IRA without them being treated as taxable distributions. The booklet is available at Entrust has a slide show on self-directed IRA real estate investing at its web site, where it advises that the IRA owner can either hire a professional management company (which cannot be you or a family member ) to collect rents and pay expenses, and have the manager send a net rent 3

4 check directly to the IRA monthly; or dispense with the professional manager and have the rent checks sent directly to the IRA custodian, which pays all applicable expenses directly from your IRA. See So the major self-directed IRA providers are correctly steering the IRA owner onto the straight and narrow path of keeping IRA funds separate from personal funds, and never using personal funds to pay IRA expenses. The question is, how well will the average IRA owner comply with this advice? The risk is that some day the real estate will need more money than the IRA has in its checking account. The property tax bill is due, but the rent check hasn t cleared yet. The IRA owner will pay the property tax bill himself, thereby making an illegal excess contribution to his IRA (unless the contribution happens to be within his annual IRA contribution limit). B. Farther afield: IRA-owned LLC manages property The risk of commingling personal and IRA funds is greatly exacerbated by interposing an owner-managed LLC between the property and the bank-custodian. Some IRA custodians willing to hold an unconventional IRA investment may not be willing to hold a parcel of real estate directly, because of the associated risks such as tort liability, tax liability, etc. Or, the IRA owner may not want to pay the IRA custodian or a professional management company to carry out such routine real estate-management duties as cashing rent checks and paying insurance bills. Enter the IRA-owned LLC, a structure promoted through various seminars and other sources. The IRA contributes all its assets to an LLC, of which the IRA itself is the sole member. The bank then holds title only to the LLC shares, while the IRA owner serves as director of the LLC and in that capacity performs the necessary management functions for the real estate investment. When the IRA owner, in his capacity as LLC manager, controls the checkbook, the chances for error are hugely increased. One day, the IRA owner will need money and he ll just take it out of the LLC s checking account (thereby making a taxable distribution to himself). Or the LLC will accidentally pay one of his personal bills (taxable distribution), or he will accidentally pay one of the LLC s bills (excess IRA contribution). Is this management structure consistent with Congressional purpose? Why did Congress dictate that only a bank (or equivalent) can hold title to IRA assets? Could it be because Congress wanted to be sure the IRA funds are kept separate from the owner s checkbook? The LLC structure does an end run around 408(a)(2), depending on the degree of the bank-custodian s involvement or noninvolvement. If the LLC s operations are totally run by the IRA owner, and the bank has no oversight, 408(a)(2) is bypassed. If IRA-owned LLCs lead to widespread commingling of IRA and personal funds, the IRS or Congress is likely to attack the LLC-managed-by-the-IRA owner as being a violation of 408(a)(2), or simply ban it. That will have a bad effect even on those who have been doing everything right. Summary: Properly managing an IRA-owned LLC may be no problem for a sophisticated, knowledgeable, careful person. My experience is that the average owner does not meet this description. Many IRA owners just don t get the picture that an IRA is a separate entity, whose funds must not be commingled with personal funds. The IRA custodians make their share of 4

5 mistakes too, but at least if the bank makes the mistake it can compensate the IRA owner. Also, the IRS is more likely to grant relief to the IRA owner for something that is the bank s fault rather than his own. The management of IRA-owned real estate should be performed by an (unrelated) professional real estate management company, or else through the IRA custodian-bank, with all outgoing checks signed by the bank. III. DESPITE CLEAR WARNINGS LIKE THE ROLLINS CASE, MANY BELIEVE (INCORRECTLY) THAT YOU CAN T HAVE A PROHIBITED TRANSACTION WITHOUT A DISQUALIFIED PERSON! A. WHY AND HOW TO AVOID A PT Violation of the prohibited transaction (PT) rules (IRC 4975) causes disqualification of the IRA. 408(e)(2). It is actually quite easy to avoid having a prohibited transaction with your IRA-owned real estate by following this rule: Never allow your IRA, or any entity it invests in where you have any say in the matter, to rent or sell to, or rent or buy from, or hire, or allow to use the IRA property in any way with or without consideration, (1) yourself or any person who is related to you by blood or marriage, or with whom you have any personal or business relationship outside the IRA, or (2) any entity that is owned in whole or in part or that employs or engages anyone in category (1). I think that covers it. Unfortunately, there is a widespread misconception that the only thing that 4975 prohibits is transactions between the IRA and a disqualified person. B. TRANSACTIONS WITH DISQUALIFIED PERSONS PROHIBITED It s true that 4975 does prohibit such transactions. The definition of disqualified person is somewhat unclear, in that the IRA owner qua owner is not listed as a disqualified person; however, whoever manages the plan s investments is a fiduciary of the IRA and as such is a disqualified person. Therefore, the owner of the self-directed IRA (who is by definition managing the IRA assets) is a fiduciary and as such he is a disqualified person, regardless of whether he is a disqualified person merely by virtue of being the IRA owner (that latter point being a subject of some debate among practitioners). Certain related parties are also disqualified persons, such as certain enumerated family members (including parents, spouse, and children) of the fiduciary and any entity more than 50 percent owned by the fiduciary. Here s where we come to the PT trap: Many commentators stop here, wrongly concluding that the IRA can freely do business with any person or entity who is not a disqualified person. C. CONFLICT OF INTEREST TRANSACTIONS ALSO PROHIBITED 4975(c)(1)(E) prohibits any act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interests or for his own account. There is no requirement in 4975(c)(1)(E) that the person or entity on the other side of the transaction be a 5

6 disqualified person. All that is required is for the fiduciary to deal with income or assets of the plan in his own interests. The IRS and DOL (Department of Labor, which has overlapping jurisdiction with the IRS on prohibited transactions) have never (that s right, NEVER!) interpreted 4975 as being limited to transactions between the plan and a disqualified person. In contrast, they interpret 4975(c)(1)(E) as prohibiting any fiduciary actions involving a conflict of interest, regardless of whether the act constitutes a transfer of assets to or from a disqualified person. The fiduciary may not authorize any transaction between the plan and any person in which such fiduciary has an interest which may affect the exercise of such fiduciary s best judgment as a fiduciary. Treas. Reg (a)(5). The person in which such fiduciary has an interest need not be a disqualified person. D. ROLLINS: THE NUMBERS WERE RIGHT BUT THE TRANSACTION WAS PROHIBITED ANYWAY The recent case of Rollins v. Comm r, T.C. Memo , is a clear warning to the selfdirected IRA world that the common wisdom about PT s ( no disqualified person = no PT ) is mistaken. In Rollins, P was sole trustee of the profit sharing plan of his wholly-owned CPA firm. In that capacity, he caused the plan, between 1996 and 1999, to make 10 loans to three businesses in which he and his wife owned minority interests (ranging from 16% to 32%). Each business was majority owned by between 28 and 80 other persons, who were unrelated to P. Although they were minority shareholders, P and his wife held the largest percentage interest in the borrowers of any shareholders. P also apparently managed these companies, so he was on both sides of the loan transactions in that sense. All the loans were paid back on time, with interest. P contended that the loans were not prohibited transactions because the borrowers were not disqualified persons. In order to be a disqualified person, a corporation must be 50 percent or more owned by disqualified persons, and the disqualified persons ownership of these three borrowers was well under that level. The IRS disagreed, and the Tax Court supported the IRS. It was not necessary for the borrowers to be disqualified persons. All that was needed to create a prohibited transaction was a conflict of interest, and that was supplied by P s minority ownership in the borrowing corporations. For example, the loans could have enhanced the value of P s equity interests in the borrowing businesses. The borrowing businesses were spared the necessity of borrowing from a possibly-less-friendly lender. The borrowing businesses might expect to benefit from P s leniency in delaying foreclosing the loans (in case of any problem) since P partly owned the borrowers. Thus, P s ownership interest in these companies created a conflict of interest between the Plan and the companies, resulting in dividing his loyalties to these entities, and so violated 4975(c)(1)(E). The fact that the loans might have been a good deal for the plan was irrelevant. P knew about the prohibited transaction rules. He just didn t know enough about them. He relied on the fact that the borrowers were not disqualified persons, and so concluded the loans were legal. He was wrong. P argued that the IRS s position made a mockery of all the other parts of 4975: if a loan to any entity that is partly owned by a disqualified person is a prohibited transaction, what is the 6