More on IRA Beneficary Designation Planning Opportunities

It is probably safe to say that most IRA owners really don’t put much thought into who they designate as their IRA beneficiary, but even IRA owners who do may very well have not done their planning correctly. This is especially true in that the IRA beneficiary designation rules are so complex.

With traditional IRAs (not Roth IRAs) one must generally start taking minimum required distributions when the beneficiary reaches age 70.5. Because investments held in IRAs grow tax-free, many taxpayers try to structure their affairs so that the bulk of the funds can remain in the IRA for the longest period of time.

The number of clients who ask about these planning opportunities seems to be on the rise. The facts are typically something like this: The husband owns the majority of the couple’s assets, which includes a couple of million dollars held in the husband’s IRA. Both the husband and the wife own their house jointly and it is now valued between $1 or $2 million. The husband and wife are younger than 70, so they haven’t begun taking minimum distributions from the IRA.

The husband wants to prepare his estate plan. His primary concern is how to leave the IRA funds to a trust so that his wife can benefit from the funds and not have any obligation to manage the funds and upon the wife’s demise the funds will pass to the couple’s children.

After running through the options with the husband and encouraging the husband to merely name his spouse or his children or a charity as the IRA beneficiaries, the husband almost always wants to name a trust as the beneficiary (see Trust As IRA Beneficiary post for more info).

One of the ways to structure this, the one that is outlined in the IRS’ recent Revenue Ruling (Rev. Rul. 2006-26), is to designate a marital trust created under the husband’s will as the IRA beneficiary.

If structured properly, if the husband predeceases the wife the husband’s executor can elect to treat the IRA as qualified terminable interest (QTIP) property for estate tax purposes. This allows the IRA to qualify for the 100% estate tax marital deduction upon the husband’s demise, which allows the IRA assets to avoid estate taxes upon the husband’s demise (the rest of the husband’s estate passes to a spousal trust created under the husband’s will, to use up the husband’s estate tax unified credit or applicable exclusion amount - thereby making that portion free of estate tax).

As outlined in the Revenue Ruling, the surviving spouse will be considered the sole beneficiary of the IRA if he or she has the right to the trust income at least annually and/or an equivalent power to demand access to the income and there are no non-individuals who are beneficiaries of the trust. This is a pretty common arrangement.

The problem lies in situations where there are distributions from the IRA to the trust that are not currently distributed to the spouse. In that case, the spouse is not considered the sole beneficiary of the trust. Depending on the terms of the trust, this can cause the IRA payout to have to use the measuring life for purposes of IRA distributions of that of the oldest - i.e., the wife - beneficiary - even after the wife’s demise. This can significantly reduce the number of years that the IRA can have continued tax-free growth and reduce the amount that will pass to the couple’s children.

In addition, taxpayers would still have to examine each individual beneficiary, rather than just the spouse, to ensure that the IRA beneficiaries are all individuals and not trusts or other entities.

The interesting tax issues that the Revenue Ruling addresses is what happens if the trustee, under state law, has the power to adjust between principal and income and/or convert the trust to a unitrust (for the non-tax folks, this allows the trustee to decide how much income to distribute to the wife during her lifetime, essentially regardless of what the trust provides).

The Revenue Ruling concludes that the trustee can in fact make such allocations between principal and income or can convert the trust to a unitrust and these decisions will be respected for tax purposes.

While most estate and trust attorneys are very familiar with the trust principles, I don’t think many have planned for whether the trustee could or should convert the trust to a unitrust and/or make allocations between income and principal when the trusts primary or sole asset consists of an IRA.

This seemingly presents yet another planning opportunity where the attorney - working with the IRA investment advisor and trustee - should be able to structure the trust and IRA so that they achieve one or more of the IRA owner’s goals in a very tax efficient manner.

Of course, given the complexities of the IRA rules it is imperative that IRA owners speak to their trusted financial advisors. This is especially true for owners of larger IRAs.

July 2nd, 2006 | No Comments »

A Look At A Typical IRS Audit

One of the interesting aspects of practicing as a tax lawyer who handles IRS tax cases is that you can regularly read what your “opponent ” is up to. This post discusses the recently published case of Miller v. Commissioner. This case doesn’t discuss interesting tax laws or structures and it really doesn’t add anything new. I decided to write about this case because it reminds me so much of scores of other tax cases and taxpayers that I have represented (on first read, I wondered if this was one of my prior cases - which, of course, it wasn’t). This case lays out what taxpayers can expect if they are subject to an IRS audit. I get a lot of questions about this, so perhaps this post will help answer some of those questions.

The taxpayer, Miller, was a small business owner. The business, which was a Subchapter S Corporation, took out loans in the business’ name. Miller was a grantor on the loans. The business subsequently incurred losses for six straight years. The tax losses exceeded the Miller’s taxable basis in the business so Miller was not able to deduct the losses. At the Miller’s accountant’s suggestion, Miller took out a personal loan and contributed the loaned funds to his company and his company repaid the debts that were presently outstanding to the bank. This made Miller more than just a grantor on the loans, which entitled him to increase his tax basis in the business by the value of the loans. This increased basis in the business allowed Miller to deduct the losses to the extent of that tax basis.

The key to these transactions is that at the end of the day the taxpayer is indebted to an independent third party (i.e., the bank). At the end of these transactions Miller was indebted to an independent bank. This is a pretty common transaction that many small business owners engage in, yet the IRS took the position that Miller was not entitled to deduct the losses. The IRS based its denial on the argument that the transaction should be ignored for tax purposes. As the Tax Court opinion alludes to, even a cursory review of the applicable law reveals that the IRS’ position was without legal support or basis. The IRS also cited the fact that Miller was inconsistent in reporting the interest from the transactions, a fact that the Tax Court “attached little consequence to. ” Of course the Tax Court held for the taxpayer.

Based on the court opinion, it is apparent that the IRS agent undertook the tax audit with the sole aim of disallowing the losses. Ultimately the IRS logic is that Miller paid too little in tax in relation to other somewhat similar situated taxpayers - even though he was well within the law - therefore it is the IRS agent’s job to collect tax revenues from Miller. I have seen this numerous times (so much so that I can almost see the look on the agents face as he or she is interviewing the taxpayer).

I bet the agent ended up spending a couple of weeks looking through Miller’s records and probably taking up a lot of Miller or Miller’s attorney’s time. When the agent wasn’t able to find anything significant (such as underreported income or inappropriate tax deductions or credits), the IRS agent closed the audit by proposing to deny the losses.

The IRS agent no doubt reminded Miller that he failed to consistently account for the interest on these loans and therefore he somehow wasn’t entitled to claim the losses. I often hear this argument by IRS agents in a number of contexts. Instead of addressing the main issues, the agents seem to always fall back on “the taxpayer elected an accounting method and he failed to comply with that election, therefore, he is not entitled to _______________. ”

Each time I hear this argument I cannot help but think how absurd it is. It reminds me of when I was a child and I would win an argument with a friend, only to have the friend say something unrelated and nonsensical such as “I know you are, but what am I? ” It us just such a silly statement that it is hard to find the right words to respond with. Based on the frequency with which I hear this statement, I think that it must be helpful for the IRS agents in convincing un-represented taxpayers that they will loose their case if they opted to fight their case. Luckily it didn’t work on Miller (Miller had already retained legal counsel) and the court didn’t even consider the argument worthy of further inquiry.

The agent probably even encouraged Miller by telling him that he could appeal the denial and that the process would only take a few more months to reach a resolution. Miller no doubt took the IRS agent up on that and lodged a timely appeal with the IRS Appeals Office. The Appeals Office undoubtedly offered Miller a compromise, as did the IRS attorney who was assigned the case; offers that were slightly less favorable that a full denial. The whole process probably took more than a year, perhaps more than two years.

This case presents such a common scenario, that it is worth pointing out to taxpayers. The Miller case highlights the IRS audit process and it shows that the IRS can and do take unsupportable positions and file frivolous lawsuits. It also shows some of the tactics IRS agents employ to encourage taxpayers to accept IRS determinations. Not an exciting case, but it has some instructional value.

June 18th, 2006 | No Comments »

IRS Looks At Improving Informants Rewards Program

One would think that the IRS using paid informants to identify compliance-challenged taxpayers would generate some controversy. But it really hasn’t. As a new TIGTA audit report reveals, the IRS’ Informants Rewards Program hasn’t generated much controversy because the program has been so poorly administered.

The informant process begins when a person approaches the IRS or when someone submits a Form 211 to the IRS. The Form 211 goes through an initial screening process, which consists of a review of the alleged taxpayers tax compliance and to see if the IRS is already pursuing the matter. At this point the claim will either be rejected or accepted for further review.

If an award is to be allowed:

the reward percentage is determined by whether the information directly led to the recovery (15 percent); indirectly led to the recovery (10 percent); or caused the investigation but had no direct relationship to the determination of tax liability (1 percent). The dollar amount of the reward is computed by multiplying the reward percentage by the amount of taxes, fines, and penalties (but not interest) collected. Different reward percentages can be used if the case involves multiple taxpayers and/or tax years. The reward amount must total at least $100 to be paid and cannot exceed $2 million in total.

The audit states that $340,329,427 was recovered due to informant information for FYs 2001 through 2005. Given the size of this figure, you might be wondering if “The Dog” bounty hunter might be in the wrong business. Based on the TIGTA report, the answer is clearly “no.”

There can be little doubt that most informant claims are rejected. Even if a claim is paid by the IRS, it is likely that the information provided will be deemed to “have no direct relationship to the determination of the tax liability” - which results in a mere 1% payment. Even then, the audit report indicates that it may take up to seven and one half years to receive payment. Given these constraints, potential informants should engage a tax lawyer to help them present their claim in a way that increases the chances that they will be compensated and be compensated sooner rather than later.

If the IRS implements the TIGTA audit recommendations, it is very likely that program could become one of the most efficient means for collecting unreported and underreported tax and interest and penalties. I wonder if we will then see a cottage industry of “tax bounty hunters” spring up….

June 10th, 2006 | No Comments »

New Offer in Compromise Legislation

As discussed in a previous post, Congress has been toying with making changes to the IRS offer-in-compromise program. These changes were included in the “Tax Increase Prevention and Reconciliation Act”, which was signed by President Bush on May 17th.

As such, offers in compromise filed after the magic date, which is sixty days after May 17, 2006, will have to comply with the new rules set out in the Act. Specifically, lump sum offers (those that propose five or fewer installments) must include a non-refundable twenty percent down payment and periodic payment offers (those that propose six or more installments) must include installment payments as outlined in the agreement.

While this may sound like a significant change, the impact it will have on taxpayers will probably be negligible. Luckily (for taxpayers), the legislation fails to tie the “down payment” or “installments” to any requirement that the taxpayers offers be “reasonable.” As such, taxpayers can continue to simply submit absurdly low initial offers – with the expectation that the IRS will submit a counter proposal. Since any denial of an offer in compromise is appealable, taxpayers can simply wait to appeal their offers rejection and up their offers at that time. This legislation incentivizes taxpayers to submit absurdly low offers. Think about it, why would any taxpayer submit a reasonable offer if they are going to be penalized up front for doing so?

While this may only have a negligible impact on taxpayers, this legislation will go further in making the IRS even less effective in collecting tax revenues. Given the “down payment” or “installment” game that the new legislation incentivizes taxpayers to play, the number of reasonable offers will decline and the number of absurdly low offers will increase. Ultimately, this will result in more offers that require two or more reviews by IRS personnel — doubling or tripling the IRSs offer-in-compromise workload.

Another boon for taxpayers is that the new legislation includes a provision that says that offers are deemed accepted if not rejected by the IRS within 24 months after receipt. Personally I have witnessed offers that, had I not continued to follow up with the IRS, that would very clearly not been resolved within two years. I have also submitted offers that were simply lost by the IRS (the IRS records show that the offer was received, but it was never assigned to anyone or otherwise processed). Given this new provision, now taxpayers, who are incentivized to submit low lump sum offers, may well find that their offers are inadvertently accepted. Taxpayers may now attempt to forestall the already inefficient process. This is especially true now that the IRS offer-in-compromise workload is going to increase dramatically.

The bottom line is that this new legislation was poorly conceived and it adds to the already poor tax administration legislation that is on the books today.

May 21st, 2006 | No Comments »

IRS Tax Collection Efforts

Since the tax-filing deadline is approaching and most of us are writing checks to the government, perhaps it is a good time to think about how the government chooses to exercise its finite tax collections resources. Take the recent example of Butti v. Commissioner.

Butti is a former chiropractor that is serving a criminal sentence in a New York prison. While Butti was serving his sentence, the IRS issued notices of deficiency, assessed tax liabilities, and commenced collections activities. As required, the IRS notified Butti of these actions by sending written correspondence to Butti’s prison address. Butti timely filed a collection due process hearing request, alleging that he was never given the opportunity to contest the underlying tax liability. Collection due process hearings temporarily halt the IRS collection efforts and afford taxpayers a hearing prior to the government resuming collections activity. Our law affords taxpayers the right to this type of hearing.

Collection due process hearings are conducted by the IRS appeals office. The IRS appeals officer assigned to this case, knowing that Butti was incarcerated, scheduled the hearing to be held at the IRS appeals office and asked the taxpayer to let the officer know if the hearing was not “convenient.” Of course, Butti responded with a letter indicating that he could not attend the meeting due to his being incarcerated. The appeals officer subsequently issued a determination upholding the IRS’s collection activities, without affording Butti a hearing – even though the officer knew that the prior hearing was not “convenient” for Butti. Butti brought a pro se action in the tax court to secure his right to a collection due process hearing. As could be expected, the tax court held that Butti was entitled to a hearing and that the IRS had not afforded Butti a hearing. The tax court remanded the case to the IRS appeals office so that they could afford Butti a hearing.

This case leaves me wondering why Butti had to go though all of this and taxpayers had to pay for the exercise. Taxpayers paid for the appeals officer’s time, the IRS attorneys time, and even the tax court special magistrates time. Had Butti secured legal representation, Butti’s attorney would probably have asked the court to order the government to pay Butti’s attorney fees and possibly damages (due to the government taking an unsupportable position), and taxpayers would have had to pay that as well.

Another reason why I wonder if the investment of taxpayer funds was worth while in this case is that it appears the collections period for two of the three years may have already expired and the last year may expire soon. If this is the case, there is a strong chance that the government will not be able to collect the tax debt. Even if the collections periods have not already expired, I wonder if Butti has any real assets upon which the IRS can levy. The opinion does not indicate whether Butti has significant assets, but there is a very good chance that he does not.

So what is the point? Why could the appeals officer not simply afford Butti the hearing that he was entitled to, assess (or not assess) the tax, and collect the tax (or put the tax on uncollectible status)? Why does the IRS have to put Butti though the motions of going to court to get a hearing that Butti is so obviously entitled to and why do the taxpayers have to foot the bill? Most importantly, when I think about all of the tax debts that go uncollected each year, I wonder how the government decides to expend its limited tax collection resources trying to collect a tax in cases like this one?

April 16th, 2006 | No Comments »

The Taxation of Military Benefits Provides an Example of How the Law Can Sometimes Go Awry

Few would argue that soldiers and military personnel, especially veterans, should be afforded certain privileges. In American society as of late these benefits have included free or reduced cost education, health benefits, and in some cases, retirement benefits. Yet, the courts, and ultimately Congress, have been less giving with regard to the tax treatment of retirement benefits for disabled soldiers. This body of law was again put on display in Reimels vs. US.

Reimels is a soldier who was exposed to Agent Orange while serving in Vietnam. In the late 90’s Reimels was unable to work due to the lung cancer he developed as a result of being exposed to Agent Orange. Reimels was awarded compensation from the Veteran’s Affairs Office and Social Security benefits. Reimels did not report either payment on his 1999 tax return, arguing that the payments were to be excluded from his gross income as amounts paid on account of his physical injury or sickness resulting from active military duty (section 104(a) for the tax jocks).

At issue was whether the Social Security payments were excludable. The US Tax Court and the Federal District Court held that the benefits were to be included in Reimels income because Social Security “was not designed to compensate for military injuries.” The logic is that Social Security benefits could be paid for other injuries, not just military injuries. In this case (as in Haar), the benefits were actually paid on account of military injuries. Thus, the standard is not what actually happened, but what could have happened. Think about that. The law in this line of cases is to be applied not to the actual facts of the cases, but rather, the law is to be applied to what the facts might have been, but were not.

Here is a quote from the Haar opinion: “Because disability payments under the Civil Service Retirement Act are not paid for personal injuries or sickness incurred in military service, we conclude that section 104(a)(4) did not entitle petitioner to exclude the disability payments he received in the years in issue.” Yet the benefits in that case were paid for personal injuries incurred in military service! The same goes for the Reimels case.

It is interesting to note what has happened in this line of cases. When the Tax Court initially heard Haar, the court noted that it was only following Haar because Haar was on the books. The Tax Court implied that it would have ruled differently if the current tax court judges had initially ruled in the Haar case; however, the current tax court juddges did not hear Haar so they were bound by that prior decision. It should be noted that Haar is merely a US Tax Court case and is not binding on the Federal District Court. When I looked at the Tax Courts opinion in Reimels a couple of months ago, my guess was that the District Court would overturn Haar. However, the District Court did not and now we have a District Court opinion that adds to the Haar legacy.

It will be interesting to see if Reimels appeals this case to the US Supreme Court (assuming that he appeals and is not successful in the Fifth Circuit). If Reimels does not appeal this case, it will be very difficult for another court to overturn Haar in the future. In that case, as the Tax Court stated, it is likely that only Congress would be able to overturn Haar and this body of law may very well remain on the books for some time. My first guess about this case was incorrect; however, assuming that the Supreme Court does not overturn the Reimels case, for what it is worth, my second guess is that this line of cases will be overturned when more of the soldiers who are now serving in active duty begin to receive benefits for injuries related to their military service. Thus, we may be hearing about this issue again in about twenty years….

April 11th, 2006 | No Comments »

Abatement of Tax Penalties and Interest

Many unfortunate taxpayers find themselves in the position of owing a tax debt that consists of a small tax liability and a large assessment of tax penalties and interest. In many of these cases the penalties and interest can be substantially larger than the original tax debt. This situation often forces taxpayers to seek the protection of bankruptcy or forces taxpayers to live with the uncertainty of having a large and growing debt until the collections period expires. A common remedy that many taxpayers fail to take advantage of is to request that the IRS abate the penalties and interest. This post will provide a very basic overview of the penalty and interest abatement rules.

Congress has expressly provided the IRS with the authority to abate some tax penalties and interest. As a general rule, the IRS does not abate penalties where abutment would be unfair to other tax compliant taxpayers or provide a taxpayer with a competitive business advantage over other tax compliant taxpayers. Section 6404(a) provides that the IRS may abate tax and any related liability if a taxpayer can demonstrate that the liability is: excessive, assessed after the expiration of the applicable limitations period, or illegally assessed. There are numerous administrative and judicial opinions that flesh out these terms.

Section 6404(b) specifies that taxpayers do not have the right to request abatement of income, estate or gift taxes. Pursuant to Section 6601(e), interest is generally treated as a tax; therefore, interest is subject to the 6404(b) limitation. Section 6601 does not treat penalties as a tax; therefore, penalties are not subject to the 6404(b) limitation. Moreover, this limitation does not expressly limit taxpayers right to request abatement of employment or other taxes.

If taxpayers cannot qualify under these principles then they must pursue abatement under the other provisions of Section 6404. Most of these cases fall under Section 6404(e). This section addresses abatement of interest that is attributable in whole or in part to an unreasonable error or delay by an IRS officer of employee in performing a ministerial or managerial act. Each of these terms are defined in the Regulations and expanded upon in various administrative and judicial opinions. As a side note, some courts have unfortunately and mistakenly held that the IRS does not have the authority to abate employment taxes under this provision (such as the Tax Court and the Ninth Circuit in Miller v. Commissioner).

Even if taxpayers cannot request abatement or the IRS does not have the authority to abate, there are circumstances where the IRS must abate interest and time-sensitive penalties. Section 6404(g) and Revenue Procedure 2005-28 provide that interest and certain penalties must be suspended if the IRS fails to provide a taxpayer with timely notice of the amount and basis for a tax liability. Suspension of interest under this provision is mandatory. Timely notice is defined as within 18 months of the later of the due date of the return or the date the return was filed. The IRS does not permit taxpayers to request abatement for periods where this mandatory suspension provision applies; however, taxpayers can notify the IRS of improperly assessments under 6404(g).

A last consideration that taxpayers must address is how best to protect their right to appeal any adverse and arbitrary IRS decision not to abate penalties and interest. The law provides a number of rules to preserve the right to appeal. Failure to do so substantially increases the chances that abatement and/or suspension requests will fall on deaf ears. In the right circumstances requests to abate penalties and interest can be a viable alternative to bankruptcy or living with a large and growing tax debt.

February 19th, 2006 | No Comments »