Leimberg Information Services

Friday, May 11, 2012

Steve Oshins & the Hybrid Domestic Asset Protection Trust

Reproduced with Permission by and Courtesy of Leimberg Information Services, Inc. (LISI).  For information about how to subscribe to LISI, click here.

“After approximately 15 years since the first DAPT legislation passed, not a single DAPT has been tested all the way through the court system.  Most likely this is because such a large supermajority believes that if tested the DAPT will work to protect its assets from a creditor of the settlor.  However, despite the very high likelihood of protection, if there is a way to increase the odds of success even more, then such a strategy should be utilized whenever possible.

The Hybrid Domestic Asset Protection Trust (“Hybrid DAPT”) is such a strategy, and it is very simple.  The Hybrid DAPT is like a regular DAPT except that the settlor isn’t an initial discretionary beneficiary of the trust, but can be added later.”

We close this week Steve Oshins’ commentary on a strategy he refers to as the “Hybrid Domestic Asset Protection Trust.”  According to Steve, the Hybrid DAPT puts the client in a significantly stronger position than with a traditional Domestic Asset Protection Trust.  As he explains below, this strategy can be used with both an incomplete gift version and a completed gift version of the Domestic Asset Protection Trust. 

Steven J. Oshins, Esq., AEP (Distinguished) is a member of the Law Offices of Oshins & Associates, LLC in Las Vegas, Nevada.  Steve is a nationally known attorney who is listed in The Best Lawyers in America® and has been named one of the Top 100 Attorneys in Worth magazine.  He was inducted into the NAEPC Estate Planning Hall of Fame® in 2011.  He has written some of Nevada's most important estate planning and creditor protection laws, including the law making the charging order the exclusive remedy of a judgment creditor of a Nevada LLC and LP (in 2001, 2003 and 2011), the law changing the Nevada rule against perpetuities to 365 years (in 2005) and the law making Nevada the first and only state to allow a Restricted LLC and a Restricted LP creating larger valuation discounts than any other state allows (in 2009).  He is also the author of the Annual Domestic Asset Protection Rankings which you can download from our Free Resources page.  Steve can be reached at 702-341-6000, x2 or at soshins@oshins.com.  His law firm's web site is http://www.oshins.com. 

Before we get to Steve’s commentary, members should take note of the fact that a new 60 Second Planner by Bob Keebler was just posted to the LISI homepage. In his commentary, Bob reviews the May 4th opinion by the Ninth Circuit in Estate of Morgans, where the issue presented was whether Section 2035(b)’s gross-up rule applies in the case of a surviving spouse's deemed gift of a QTIP remainder. You don't need any special equipment to listen- just click on this link.

Now, here is Steve Oshins’ commentary:

EXECUTIVE SUMMARY:

Asset protection has become one of the hottest areas of law and has become the ideal complement to estate planning.  Consequently, the Domestic Asset Protection Trust (“DAPT”) has become one of the most popular asset protection tools in the planner’s toolbox.  As more states have enacted DAPT legislation, practitioners have started doing more DAPTs for their clients.

FACTS: After approximately 15 years since the first DAPT legislation passed, not a single DAPT has been tested all the way through the court system.  Most likely this is because such a large supermajority believes that if tested the DAPT will work to protect its assets from a creditor of the settlor.  However, despite the very high likelihood of protection, if there is a way to increase the odds of success even more, then such a strategy should be utilized whenever possible.

The Hybrid Domestic Asset Protection Trust

The Hybrid Domestic Asset Protection Trust (“Hybrid DAPT”) is a strategy that should increase the probability that the trust assets will be protected.  And it is very simple.  The Hybrid DAPT is just like a regular DAPT except that the settlor isn’t an initial discretionary beneficiary of the trust, but can be added later.  Thus, the trust is initially set up for the benefit of the settlor’s spouse and descendants, for example, but not for the settlor.  By not including the settlor as a beneficiary of the trust, the Hybrid DAPT is by definition a third-party trust and therefore almost certainly avoids the potential risk of uncertainty of a regular DAPT.

Especially where the settlor is married and has a strong, trusting relationship with his or her spouse, is there any good reason that the settler must have his or her name in the trust agreement as a beneficiary?  It is very simple to indirectly access the trust assets through the spouse.  And the trust agreement should define the “spouse” using a “floating spouse provision” that defines the spouse as the person the settlor is married to and living with from time to time.  This gives the settlor the ability to access the trust assets through a subsequent spouse in the event of a divorce or the death of the settlor’s spouse.

If the settlor has no spouse, then it becomes more difficult to access the assets.  However, since a good asset protection planner will be sure to leave sufficient wealth outside of the client’s asset protection trust, in most cases the settlor won’t have to work through this issue anytime soon.

If the Settlor Is Added as a Beneficiary

In case the settlor needs to be a discretionary beneficiary of the Hybrid DAPT sometime in the future (i.e., if the settlor has no spouse or child that will “share” a distribution with the settlor and the settlor now needs a distribution), the trust agreement provides that the trust protector or independent trustee can add additional beneficiaries, including the settlor.  However, if the settlor is added, then the Hybrid DAPT becomes a regular DAPT and thus risks that the law is still unsettled on DAPTs (even though most people believe that they work).

What happens if the settlor suspects that a creditor attack may be forthcoming?  Or what if the settlor is considering filing bankruptcy?  In either case, very far in advance of the problem occurring, the settlor would ask the trust protector or independent trustee to remove him or her as a discretionary beneficiary. 

§548(e) of the 2005 Bankruptcy Act

It is extremely unlikely that a DAPT settlor will file for bankruptcy, especially if the settlor has an “old and cold” DAPT that is past the applicable state’s statute of limitations period.  In fact, of the hundreds of DAPTs created by the author, not one of those clients has gone through bankruptcy. 

However, in maintaining the philosophy of this commentarythat it is important to build into the structure every safeguard available, it is interesting to note that the Hybrid DAPT most likely does not fit the definition required by §548(e) of the 2005 Bankruptcy Act that would otherwise potentially claw back the assets of a traditional DAPT.  The requirements of §548(e) are as follows:

(1) In addition to any transfer that the trustee may otherwise avoid, the trustee may avoid any transfer of an interest of the debtor in property that was made on or within 10 years before the date of the filing of the petition, if—

(A) such transfer was made to a self-settled trust or similar device;

(B) such transfer was by the debtor;

(C) the debtor is a beneficiary of such trust or similar device [emphasis added]; and

(D) the debtor made such transfer with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made, indebted.

Unless the settlor is added as a discretionary beneficiary of the Hybrid DAPT, Subsection (C) doesn’t apply.  Also, arguably Subsection (A) doesn’t apply either since the Hybrid DAPT isn’t a “self-settled trust or similar device” at the time the provisions are applied.

The Completed Gift Hybrid DAPT

Most DAPTs are designed as Incomplete Gift DAPTs where the sole objective is asset protection.  However, many DAPTs are designed as Completed Gift DAPTs where the settlor is a discretionary beneficiary of a trust designed with the following attributes: 

(i)                It’s a completed gift for gift tax purposes,

(ii)             The settlor is a discretionary beneficiary,

(iii)           The trust assets are protected from the settlor’s beneficiaries, and

(iv)           The trust assets are outside of the settlor’s estate for estate tax purposes at the settlor’s death.

The Completed Gift DAPT strategy was approved by the Service in PLR 200944002 where a resident of a DAPT jurisdiction established the DAPT using the laws of that DAPT jurisdiction. 

However, with respect to a resident of a non-DAPT jurisdiction, although most practitioners are comfortable that this strategy works, whether the trust assets are open to creditors of the settlor is still uncertain, since it is unclear which state law will apply for creditor purposes.  The DAPT will be includible in the settlor’s estate at death if the trust assets are open to the settlor’s creditors.  If this were the case, this would occur under IRC §2036(a)(1) since the settlor would be treated as retaining the ability to run up creditor debts which can be paid out of the trust at the settlor’s death. 

IRC § 2036(a)(1) provides that the value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in the case of a bona fide sale for an adequate and full consideration in money or money's worth), by trust or otherwise, under which the decedent has retained for life or for any period not ascertainable without reference to the decedent's death or for any period that does not in fact end before death the possession or enjoyment of, or the right to the income from, the property.

The Completed Gift DAPT reduces this risk significantly since the settlor isn’t a discretionary beneficiary of the trust and, thus, it isn’t a self-settled trust.  In an ideal scenario, the settlor will never need to be added as a discretionary beneficiary by the trust protector or independent trustee.  However, if the settlor does need to be added at a later date, since the Completed Gift Hybrid DAPT also gives the trust protector or independent trustee the power to remove beneficiaries, as long as the settlor is removed as a discretionary beneficiary more than three years prior to death, there is no estate tax inclusion since IRC §2035 (the three-year contemplation of death rule) won’t apply.

Down and Dirty

To this date, there is still no case law saying that a DAPT does or does not work to shield the assets from the creditors of a settlor who is a resident of a non-DAPT jurisdiction.  Although all the cases have settled, or the creditors have decided not to sue, the estate or asset protection planner must still consider how to plan if the law does go the wrong way.  Unfortunately, although there will ultimately be case law, whether good or bad, unless the case law goes through the appeal process and is ultimately decided by the highest court, we still won’t have any certainty.  So it is prudent to plan for this uncertainty.

If the settlor has set up a Hybrid DAPT, whether as an Incomplete Gift Hybrid DAPT or as a Completed Gift Hybrid DAPT, if the settlor wants to be sure to preserve a portion of the Hybrid DAPT’s assets if the settlor is being added in as a discretionary beneficiary, the trustee can split the Hybrid DAPT into two separate trusts and the trust protector or independent trustee can add the settlor as a discretionary beneficiary of only one of the two trusts so as not to taint the other trust.

For example, if there are $10 million of assets in the Hybrid DAPT, the trustee might divide the trust into two trusts – the “Clean Hybrid DAPT” which doesn’t include the settlor as a discretionary beneficiary and has $8 million of assets, and the “Dirty Hybrid DAPT” which includes the settlor as a discretionary beneficiary and has $2 million of assets.  Thus, the risk has been transferred away from the Clean Hybrid DAPT to the Dirty Hybrid DAPT (which, again, should be protected, but is potentially being sacrificed in the interests of not tainting the assets in the Clean Hybrid DAPT).  This is nothing more than a risk management decision.

COMMENT:

It is imperative that the asset protection planner create a plan with the highest probability of success.  In most cases, it is possible to significantly increase the protection by simply using a Hybrid DAPT rather than a traditional DAPT.  This commentary describes this structure, and also creates a further structure where the Hybrid DAPT can be divided into a Clean Hybrid DAPT and a Dirty Hybrid DAPT, so that even if the Dirty Hybrid DAPT is unsuccessful, it doesn’t taint the Clean Hybrid DAPT. 

HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!

Steve Oshins

TECHNICAL EDITOR: DUNCAN OSBORNE

CITE AS: LISI Asset Protection Planning Newsletter #200 (May 10, 2012) at http://www.leimbergservices.com  Copyright 2012 Leimberg Information Services, Inc. (LISI). Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Permission.

CITES: PLR 200944002; Oshins & Keebler on Mortensen:  “No, the Sky Isn’t Falling for DAPTs!”, Asset Protection Newsletter #186 (Oct. 31, 2011); Battley v. Mortensen, Adv. D.Alaska, No. A09-90036-DMD, May 26, 2011 (Original Memorandum) and July 18, 2011 (Memorandum Denying Motion For Reconsideration).

This post has been brought to you by The Ultimate Estate Planner, Inc., providing practical, tested and proven technical and marketing products to help estate planning professionals throughout the country build their practices.  Connect with us on Facebook, Twitter or LinkedIn.

Sources: Leimberg Information Services & Steven J. Oshins, Esq.

Monday, April 30, 2012

LISI.com - Practice Pointers on the Core Concern of Blended Family Estate Planning: Joint or Separate Representation

Reproduced with Permission by and Courtesy of Leimberg Information Services, Inc. (LISI).  For information about how to subscribe to LISI, click here.

“Statistics show that approximately 60% of second marriages end in divorce, and almost 75% of third marriages do as well.  These figures loom large in the minds of couples with the “yours, mine and/or ours” scenarios in their step and blended families.

There are pluses and minuses to couples sharing everything regarding their estate planning together, and when it comes to couples with blended families, the minuses can outweigh the pluses substantially. While there is great value in working together in approaching estate planning, it is important to be aware of the cautions against representing both partners in estate planning, especially when it is the second or third marriage or partnership for one of the members of the couple.

When couples who have children from prior relationships contact you about possibly representing them, the first question that should go through your mind is: “Should I represent this couple together or should I only represent one of the partners in the couple?”

The pros and cons of joint representation of blended family couples is the subject of L. Paul Hood, Jr. and Emily Bouchard’s commentary. Paul and Emily have written a book on the subject titled Estate Planning for the Blended Family, (Self-Counsel Press 2012) that will be released at the end of April. Their book will be available on all of the major online bookstore, and order information can be obtained through the following link: http://blended-families.com/estateplanning/

LISI members should also look for their three-part series on blended family estate planning that they are presenting on May 8, 15 and 22 for Phil Kavesh’s The Ultimate Estate Planner, Inc. The information on how to register for their upcoming teleconference series can be obtained either by clicking the following link: Estate Planning for the Blended Family 3-Part Teleconference Series.

L. Paul Hood, Jr. received his J.D. from Louisiana State University Law Center in 1986 and Master of Laws in Taxation from Georgetown University Law Center in 1988. Paul is a frequent speaker, is widely quoted and his articles have appeared in a number of publications, including BNA Tax Management Memorandum, CCH Journal of Practical Estate Planning, Estate Planning, Valuation Strategies, Digest of Federal Tax Articles, Loyola Law Review, Louisiana Bar Journal, Tax Ideas and Charitable Gift Planning News. Presently, He has spoken at programs sponsored by a number of law schools, including Duke, Georgetown, NYU, Tulane, Loyola (N.O.) and LSU, as well as many other professional organizations, including AICPA and NACVA. From 1996-2004, Paul served on the Louisiana Board of Tax Appeals, a three member board that has jurisdiction over all Louisiana state tax matters.  Paul Hood can be reached directly at paul@paulhoodservices.com

Emily Bouchard is a family, wealth, and money coach, and the managing partner of Wealth Legacy Group (WLG), specializing in the emotional impact of wealth in people’s lives.  She has been working with inheritors in high net worth families since 2004 with a specialty in step and blended family issues.  She is also the director of www.Blended-Families.com and has appeared on the Today Show and NPR, and has been featured in publications such as New York Times and Newsweek.  Along with coaching individuals, couples, and families, she consults with advisors in responding effectively to their client’s emotional needs related to estate planning.  Her book, co-authored with Paul Hood, from Self Counsel Press on Estate Planning for the Blended Family is due out later this month. Emily can be reached at 360.991.9558 or by e-mail to emily@wealthlegacygroup.net.

Here is their commentary:

EXECUTIVE SUMMARY:

Statistics show that approximately 60% of second marriages end in divorce, and almost 75% of third marriages do as well.  These figures loom large in the minds of couples with the “yours, mine and/or ours” scenarios in their step and blended families.

There are pluses and minuses to couples sharing everything regarding their estate planning together, and when it comes to couples with blended families, the minuses can outweigh the pluses substantially. While there is great value in working together in approaching estate planning, it is important to be aware of the cautions against representing both partners in estate planning, especially when it is the second or third marriage or partnership for one of the members of the couple.

When couples who have children from prior relationships contact you about possibly representing them, the first question that should go through your mind is: “Should I represent this couple together or should I only represent one of the partners in the couple?”

COMMENT:

Advantages of One Strategy versus the Other

Obviously, most professionals want what is in the client’s best interest.  And there are advantages to both separate and joint representation. 

Some advantages of joint representation for couples on blended families include:

• It is a way to build greater trust and more open communication between the two of them, and possibly with all of the children in their lives.
• It is more cost-effective, since they only have to pay one set of estate planners.
• It can be more efficient for them, as they can work together and divvy up tasks as they prepare to meet with you.

Some pro’s of having separate representation for clients with blended families include:

• Each may have more freedom to speak up about their specific concerns and desires without having to necessarily compromise with their partner.
• The best interests of the individual you represent are the only interests guiding you, and this is an important consideration since there can often be competing agendas, and potential conflicts of interest, often between a step parent and their step children.
• How suited the couple is for joint representation can be discovered in an introductory session with you, which we see also is advantageous for you, even if it is complimentary.  No one wants a problem client, as they are more likely to sue you and less likely to pay you.  Even in these uncertain economic times, sometimes the best decision that an estate planner can make is to not take on certain people as clients.  Taking the time to determine the best route to go up front makes a lot of sense, even if you give a bit of your time away for free.

Without healthy communication between the couple, joint representation could be disastrous. Paul witnessed this first hand with a couple, he in his early sixties, and she in her early fifties.  Outwardly, they looked like a routine couple coming in for estate planning, and Paul agreed to represent the couple together, despite lingering concerns about how much was left unsaid at their introductory session, particularly about the abilities of each of their children, who should serve as their successor trustees, and how much to leave to all the children in their lives.  However, shortly after the meeting, things quickly disintegrated between the partners, so much so that the couple ultimately divorced, in part over the significant differences in their estate planning goals and plans.

To make sure that he complied with the legal rules of ethics, Paul withdrew from representing both of them, and so they had to start over with two new attorneys. There were so many differences between the partners that they would have been better served by each having a separate set of estate planners from the start. The husband wanted their oldest son to serve as executor, while the wife was adamant that her younger daughter was the most capable.  He felt strongly that her “baby” wasn’t ready or capable enough to handle her step-brothers and she wouldn’t command the boys’ respect or cooperation; his wife was just as adamant that his “baby” was neither incompetent nor unable to handle the enormity of the responsibilities.  This couldn’t have been the reason for the divorce, but it was apparently just the straw that broke the camel’s back on a life-long tortured marriage, and it all came tumbling down.

Emily got to witness the other side of the equation, where joint representation created an opening for results beyond what anyone could have imagined.  The advisory team at a well-known bank referred a client couple to Emily after then went two years without signing their estate planning documents.  Their stand-off was a result of a blended family situation, where the husband had two children from a prior marriage and his second wife had two children with him.  He wanted the estate equalized at the time of his death and to be assured that all four of his children received the same amounts. 

She saw things very differently, since his children were not the same as theirs together, being able to benefit (or not as the case may be) from their bio-mother’s estate.  As a result, she wanted her two children to receive the bulk of her estate, including that which she would be the beneficiary of if she were to outlive her husband (which was very likely since she was significantly younger than him).  After four months of family dynamics coaching, they learned some communication strategies that allowed them to address over 30 years of long standing hurts and resentments.  As a result of some in-depth, facilitated conversations, they not only came up with an innovative approach to their estate planning that honored both of their concerns, they also expressed feeling closer as a couple. They then worked effectively with their team at the bank and found an estate planning attorney who specialized in blended family issues who was able to easily incorporate their wishes into their documents.

Signposts for Joint or Separate Representation
In order to make the decision of joint or separate representation a bit more straightforward, there are some signposts that strongly indicate the need for considering separate representation:

• If one partner is childless but the other has children. These people are not in similar circumstances if only one of them has descendants.  Most people want to leave their estates to their children; it’s only natural.  However, childless people don’t have such a tie.  The risk here is where the stated goal of the parent partner is to leave everything to his or her children may be changed if the parent partner is the first to die.
• There is a significant disparity in wealth or income in the couple.  While not always definitive, an income or wealth disparity between the partners can signal an economic imbalance in the couple that could adversely affect the estate planning of the partner who has less.
• One of them is economically dependent on the other. This signpost alone is usually not necessarily of the need to have separate representation.  However, it together with the presence of other signposts discussed in this recording can be a strong signal of the need for separate representation.
• One of them does all of the talking or appears to exert strong influence over the other.  As an estate planner, you should take note of this sort of situation and take steps to delve into what appears to be a problem in communication between the two of them.  The one who is being strongly influenced (or oppressed) will certainly know but may lack the self-will or the perceived freedom to point it out.
• Length of the relationship. Generally speaking, the shorter the relationship, the stronger the suggestion of separate representation. 
• The number of past relationships one, or both of them, have had. Generally speaking, the greater the number of past relationships, the stronger the suggestion of separate representation.
• The two of them were separately represented in a pre-nuptial agreement or property agreement.  If it was important enough to have been separately represented in an earlier agreement, it is probably still important enough to maintain separate representation with respect to estate planning.
• There is a significant age disparity between the couple.  Generally speaking, the greater the age disparity between the couple, the greater is the need to consider separate representation.
• If one of them has a significant secret from the other partner like another child, other assets or another lover.  Secrets can have an insidious impact on relationships and can really put your estate planners in a difficult spot when the secret comes to light. Obviously, clients who are inclined to hold on to secrets aren’t going to be forthcoming, so you’ll have to ascertain this indirectly by reading between the lines and finding points of aggravation where you have violated the boundaries that the secret holding client has set around that secret information. 

Ways to Address These Concerns with Potential Couple Clients
These are not easy points to consider and, the more uncomfortable they make the couple as you bring them forward, the stronger the indication that you all should slow things down.  Give them sound legal reasons for why you think they need to seriously consider separate representation, if that’s what their particular circumstances call for at the time of your initial meeting.  You can assure them that there are ways that they can stay in communication and connection around their planning even as they are represented separately.

Once they are clear about why you are recommending separate estate planners, you can then breakdown the different details to be determined together, such as medical/durable powers of attorney, and show them that they can still share with each other their thinking, and explore the pros and cons of their pending decisions.  You can also note that when conflicts of interest arise, couples who can find places to align with each other, instead of needing 100% agreement, are able to feel more connected as they make their individual decisions. 

With regards to alignment, in Emily’s earlier story about the couple with “yours and ours”, the husband was able to let go of needing 100% equality.  They were able to come up with a strategy that honored the wife’s contribution to their marriage in a monetary fashion. They both agreed that her earning potential was about one sixth of his, and they calculated a percentage that seemed to fairly represent both of their views.  This percentage was then taken into consideration in the difference that their two children together would receive over and above what his two would get.  They were in alignment around the new approach and were able to get there by both letting go of their attachment to having their original views seen as right. In his estate, should he outlive his wife, all four children received the same amounts. She was able to be in alignment with that decision, even though it wasn’t her first choice.

Conclusion
If you determine that separate representation is the best option for a couple, communicate how you see it professionally and with a sense of truly taking care of both of their needs and concerns.  Frame your assessment in ways that show them why this in their best interest and that it is not personal but is based on sound advice.

HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!

CONTRIBUTORS: L. Paul Hood, Jr., J.D., & Emily Bouchard

CITE AS: LISI Estate Planning Newsletter #1954, (April 26, 2012) at http://www.leimbergservices.com/

© Copyright 2012 Paul Hood. Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Permission.

This post has been brought to you by The Ultimate Estate Planner, Inc., providing practical, tested and proven technical and marketing products to help estate planning professionals throughout the country build their practices.  Connect with us on Facebook, Twitter or LinkedIn.

Sources: Leimberg Information Services, Inc. & Robert S. Keebler, CPA, MST, AEP

Wednesday, April 18, 2012

Keebler & Ward on Taproot v. Commissioner: Roth IRA Not Eligible Shareholder of S Corporation

Reproduced with Permission by and Courtesy of Leimberg Information Services, Inc. (LISI).  For information about how to subscribe to LISI, click here.

Traditional IRAs are not eligible S corporation shareholders under Rev. Rul 92-73 on the theory that the beneficiary of a traditional IRA is not taxed currently on the IRA's share of the S corporation's income. But what about Roth IRAs?

In Employee Benefits and Retirement Planning Newsletter #506 Bob Keebler provided LISI members with his analysis of the initial Tax Court decision in Taproot, that at the time supplied the answer to the fascinating question set out above.  Now, Bob returns with Michelle Ward, and together they comment on the 9th Circuit’s affirmation of the Tax Court’s decision.

EXECUTIVE SUMMARY
In Taproot, the Ninth Circuit Court of Appeals upheld the U.S. Tax Court’s finding that a Roth IRA is not an eligible S-corporation shareholder.

FACTS
Paul Di Mundo incorporated Taproot Administrative Services, Inc. in the state of Nevada in 2002. Taproot elected S corporation status effective as of the date of incorporation and filed its 2003 tax return on a U.S. Income Tax Return for an S Corporation.

In early 2003, Taproot issued all outstanding shares of its stock to a custodial Roth IRA account held at the First Trust Co. for the benefit of Di Mundo. The custodial Roth IRA account remained Taproot’s sole shareholder during the 2003 tax year.

In 2007, the Commissioner of the Internal Revenue Service issued a notice of deficiency to Taproot for the 2003 tax year. Among other findings, the Commissioner determined that a Roth IRA did not qualify as an eligible shareholder of an S corporation. Consequently, Taproot was deemed taxable as a C corporation for the 2003 tax year.

DISCUSSION
Taproot argued that the individual beneficiary of a custodial account also qualifying as a Roth IRA should be considered the shareholder for purposes of the S corporation statute.

Treas. Reg. Sec. 1.1361-1(e)(1) provides that “[t]he person for whom stock of a corporation is held by a nominee, guardian, custodian, or an agent is considered to be the shareholder of the corporation for purposes of [the S corporation statute].” Taproot contended that as the sole beneficiary of the DiMundo Roth IRA, DiMundo should be considered the shareholder and, thus a qualifying individual for the purposes of the statute.

IRC Sec. 1361(c)(2)(A)(i) also extends shareholder eligibility to any grantor trust “all of which is treated...as owned by an individual who is a citizen or resident of the United States.” Taproot therefore also argued that a Roth IRA should be classified as a grantor trust.

In Rev. Rul. 92-73, the IRS ruled that an IRA is not a permitted shareholder of an S corporation under section 1361. The IRS reached similar conclusions regarding an IRA’s eligibility as an S corporation shareholder in a least 42 PLRs (see, e.g., PLRs 200915020, 200931039 and 200940013). While the Court acknowledged that such rulings were not binding precedent, it also noted that they can be used as evidence of an administrative practice of the IRS.

The Tax Court, along with noting the functional differences between IRAs and grantor trusts, found Rev. Rul. 92-73 to “sensibly distinguish[ ] IRAs from grantor trusts.” In making that determination, the Tax Court relied in part on the rationale of Revenue Ruling 92-73, stating that:

[T]raditional IRAs are not eligible S corporation shareholders because the beneficiary of a traditional IRA is not taxed currently on the IRA’s share of the S corporation’s income whereas the beneficiaries of the permissible S corporation shareholder trusts listed in section 1361(c)(2)(A) are taxed currently on the trust’s share of such income.

On appeal, Taproot maintained that the Di Mundo Roth IRA functioned merely as the form of Di Mundo’s individual investment account and that the plain language of Treas. Reg. Sec. 1.1361-1(e)(1) explicitly authorizes those IRAs and Roth IRAs created as custodial accounts to be shareholders of S corporations.

Taproot first claimed that both forms of IRAs and Roth IRAs—trusts and custodial accounts—lack the essential characteristics of a separate taxpayer and should therefore be treated as indistinguishable from the individual owners. The Court, however, found that Taproot did not provide persuasive reasoning or convincing authority for this conclusion and found the reasoning in Rev. Rul. 92-73 to support the opposite result. The Court found that the distinguishing feature is the deferred income tax treatment, which differentiates IRAs from beneficiaries listed in IRC Sec. 1361(c)(2)(A) who are taxed currently on the trust’s share of income.

The Tax Court also discussed the legislative intent behind the S corporation statute, finding the only available evidence suggested that Congress did not intend to allow IRAs to own S corporation stock. Although at the time Congress initially drafted the S corporations statute, both traditional and Roth IRAs had yet to be created, the Tax Court reasoned that “had Congress intended to render IRAs eligible S corporation shareholders, it could have done so explicitly,” as it did with the 2004 amendment allowing banks with IRA shareholders to elect S status in specific circumstances.

This was especially true in light of Congress’s 1999 directive to “the Comptroller General of the United States to conduct a study of possible revisions to the rules governing S corporations including “permitting shares of such corporations to be held in individual retirement accounts.” For these reasons, the Tax Court concluded that traditional and Roth IRAs were not eligible shareholders. On appeal, the Court found the legislative history of the S corporation statute favored limited eligibility and that if at any point Congress had intended IRA eligibility, it could have amended the statute. The Court pointed out that if IRAs and Roth IRAs qualified as eligible shareholders in 2003, then the subsequent 2004 amendment would have been completely unnecessary.

CONCLUSION
It is interesting to note that the Tax Court was also mindful that under Taproot’s theory of statutory construction, DiMundo would avoid virtually all taxation on his S corporation profits. This would enable S corporations to achieve an overwhelming benefit over C corporation competitors which are subject to two levels of taxation —one at the corporate level and another at the shareholder level.

In a lengthy dissent, however, Judge Halpern notes that “this underestimates the strengths of the Code's other defenses against such shenanigans.” He noted that there are numerous limitations on what can go in and out of an IRA—income-contribution limits, deadlines for contributions, penalties on prohibited transactions, and penalties on excess contributions. Judge Halpern further noted that while custodial retirement accounts are generally exempt from tax on undistributed IRA income, they are still subject to the taxes imposed on Unrelated Business Income Tax. In general, the Unrelated Business Income Tax subjects the business earnings of tax-exempt organizations to taxation.

The majority of the Tax Court, however, expressed its skepticism that the Unrelated Business Income Tax could adequately mitigate this tax advantage. Although Taproot contended that the Unrelated Business Income Tax negates the Tax Court’s policy concerns, the Appeals Court agreed with the IRS that I.R.C. Sec. 512 generally excludes passive investment income, such as interest income, from application of the UBIT and thus, in this case, the interest income at issue would not be subject to the UBIT.

HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!

TECHNICAL EDITOR: Barry Picker

CITE AS: LISI Employee Benefits and Retirement Planning Newsletter #603 (April 17, 2012) at http://www.leimbergservices.com/ Leimberg Information Services, Inc. (LISI). Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Permission.

CITES: Taproot Administrative Services v. Commissioner, Case No. 10-70892; Revenue Ruling 66-266, 1966-2 C.B. 356; Revenue Ruling 92-73, 1992-2 C.B. 224

This post has been brought to you by The Ultimate Estate Planner, Inc., providing practical, tested and proven technical and marketing products to help estate planning professionals throughout the country build their practices.  Connect with us on Facebook, Twitter or LinkedIn.

Sources: Leimberg Information Services, Inc. & Robert S. Keebler, CPA, MST, AEP

Friday, March 23, 2012

Steve Oshins on Weddell v. H20, Inc: Nevada Supreme Court Affirms Creditor Protection Benefits of Nevada LLCs

Reproduced with Permission by and Courtesy of Leimberg Information Services, Inc. (LISI).  For information about how to subscribe to LISI, click here.

“Prohibiting the creditor from exercising the debtor’s management rights reflects the principle that LLC members should be able to choose those members with whom they associate.  Thus, the historical rationale for charging order protection was to protect the other members of an LLC where one member has a personal creditor problem. 

However, as asset protection planning has evolved and the competition among the states to have the most protective asset protection laws has intensified, the asset protection planners now have the ability to use charging order protected entities to protect their clients’ assets from potential creditors.  This tool is so easy, yet it is extremely underused by estate planners who at a minimum should be integrating this form of asset protection planning into their repertoire.” 

We close this week with Steve Oshins’ observations on the “hot off the press” case of Weddell vs. H2O, Inc., an opinion issued by the Supreme Court of Nevada on March 1, 2012.  As Steve points out in his commentary, this case illustrates the creditor protection benefits of using a Nevada LLC.

Steven J. Oshins, Esq., AEP (Distinguished) is a member of the Law Offices of Oshins & Associates, LLC in Las Vegas, Nevada.  Steve is a nationally known attorney who is listed in The Best Lawyers in America® and has been named one of the Top 100 Attorneys in Worth magazine.  He was inducted into the NAEPC Estate Planning Hall of Fame® in 2011.  He has written some of Nevada's most important estate planning and creditor protection laws, including the law making the charging order the exclusive remedy of a judgment creditor of a Nevada LLC and LP (in 2001, 2003 and 2011), the law changing the Nevada rule against perpetuities to 365 years (in 2005) and the law making Nevada the first and only state to allow a Restricted LLC and a Restricted LP creating larger valuation discounts than any other state allows (in 2009).  He is also the author of the Annual Domestic Asset Protection Rankings Chart, which can be downloaded on our website under our Free Resources.  Steve can be reached at 702-341-6000, x2 or at soshins@oshins.com.  His law firm's web site is http://www.oshins.com. 

Here is Steve’s commentary:

FACTS:

Between 2000 and 2007, Michael B. Stewart and Rolland P. Weddell entered into a business relationship concerning a number of different projects, ranging from garlic farming to geothermal energy. Several disputes arose between the two parties, ultimately leading to the collapse of their business relationship. Upon the relationship's demise, Weddell filed a complaint asserting numerous claims against Stewart. Stewart also filed a complaint and asserted numerous counterclaims. After a four-day bench trial, the district court found in Stewart's favor on all counts. Weddell appealed the decision.

Stewart and Weddell both owned percentages of Granite Investment Group, LLC (“Granite”) and High Rock Holding, LLC (“High Rock”).  In October 2008, in an unrelated matter, the district court granted an application by a creditor to charge Weddell's membership interest in Granite and High Rock, among other Weddell entities, for over $6 million. Pursuant to NRS 86.401.2, the charging order issued by the court entitled the creditor to any and all disbursements and distributions, including interest, and all other rights of an assignee of the membership interest.

Creditor’s Rights under Charging Order

The primary issue in the case was whether the judgment creditor receives any rights to participate in the management of a Nevada LLC upon receiving a charging order over the debtor’s membership interest.  The district court had ruled that the charging order against Weddell's membership interests in Granite not only gave the judgment creditor Weddell’s economic rights over the membership interest, but also his managerial rights.

The collection rights and remedies against a member's interest in a Nevada limited liability company are governed by NRS 86.401. This provision recognizes the charging order as a remedy by which a judgment creditor of a member can seek satisfaction by petitioning a court to charge the member's interest with the amount of the judgment.  A charging order directs the LLC to make distributions to the creditor that it would have made to the member.  As a result, a charging order affects only the debtor's membership interest and does not permit a creditor to reach the LLC assets.

Consequently, the judgment creditor does not step into the shoes of the member.  The judgment creditor only receives the rights of an assignee of the member's interest.  A judgment creditor, or assignee, is only entitled to the judgment debtor's share of the profit and distributions, takes no interest in the LLC's assets, and is not entitled to participate in the management or administration of the business. 

After the entry of a charging order, the debtor member no longer has the right to future LLC distributions to the extent of the charging order, but retains all other rights that the debtor had before the execution of the charging order, including managerial interests. The Supreme Court of Nevada reversed the district court's judgment relating to the scope of the charging order against Weddell's membership interests.  The Supreme Court ruled that the charging order only divested Weddell of his economic opportunity to obtain profits and distributions from Granite, not his managerial rights.

COMMENT:

It is no surprise that the Supreme Court of Nevada reversed the district court on the issue of the extent of the rights the holder of a charging order has with respect to the LLC.  This decision is in line with decisions in other charging order cases.

This case was decided under the Nevada charging order laws that were modified in the 2003 legislative session and did not include the substantial enhancements made in the 2011 legislative session.  See Steve Leimberg's Asset Protection Planning Email Newsletter - Archive Message #180.  The 2003 version of Nevada’s charging order laws specifically made the charging order the exclusive remedy of a judgment creditor.  However, there were no provisions disallowing the judge from issuing an equitable remedy to find a way around the exclusive remedy language.

For example, the judge could have used one of a number of potential equitable remedies, including the constructive trust theory, the resulting trust theory, the alter ego theory or the reverse veil-piercing theory as a way around the statutory provisions.  Maybe none of these potential theories were raised by the attorney for the holder of the charging order or maybe the judge determined that it wasn’t appropriate to go beyond the charging order remedy.

The 2011 legislative changes to Nevada’s charging order laws specifically disallow the issuance of any equitable remedies.  Therefore, in future litigation, members of Nevada LLCs will be even more protected than the degree of protection provided by pre-2011 laws. 

Planning Opportunities

Prohibiting the creditor from exercising the debtor’s management rights reflects the principle that LLC members should be able to choose those members with whom they associate.  Thus, the historical rationale for charging order protection was to protect the other members of an LLC where one member has a personal creditor problem.

As asset protection planning has evolved and the competition among the states to have the most protective asset protection laws has intensified, the asset protection planners now have the ability to use charging order protected entities to protect their clients’ assets from potential creditors.  This tool is so easy, yet it is extremely underused by estate planners who at a minimum should be integrating this form of asset protection planning into their repertoire. 

By itself, a charging order protected entity almost always causes a creditor to settle a dispute for less than the amount that the creditor would be able to reach if the charging order protected entity did not exist.  This is why there are relatively few published charging order cases in comparison to the endless number of litigation cases filed each year.  So, at a bare minimum, an LLC (or LP) should be used for almost every client who has sufficient at-risk assets to substantiate the cost of forming and maintaining an LLC (or LP).

Taking this a step further, when the charging order protected entity is combined with an asset protection trust, the odds are even more stacked against a potential creditor from the creditor’s perspective.  Thus, there are even fewer published cases involving asset protection trusts.  The more roadblocks the planner can include, the more frustrated a potential creditor will get and the better the negotiation will tilt in favour of our debtor clients.

HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!

TECHNICAL EDITOR: DUNCAN OSBORNE

CITE AS: LISI Asset Protection Planning Newsletter #196 (March 22, 2012) at http://www.leimbergservices.com  Copyright 2012 Leimberg Information Services, Inc. (LISI). Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Permission. 

CITES: Weddell v. H2O, Inc., 128 Nev.Adv.Op. #9 (Nev., Mar. 1, 2012); NRS 86.401

This post has been brought to you by The Ultimate Estate Planner, Inc., providing practical, tested and proven technical and marketing products to help estate planning professionals throughout the country build their practices.  Connect with us on Facebook, Twitter or LinkedIn.

Sources: Leimberg Information Services & Steven J. Oshins, Esq.

Friday, March 16, 2012

Leimberg Information Services: 60-Second Planner on Fifth Circuit Affirms Chilton on Inherited IRAs

Reproduced with Permission by and Courtesy of Leimberg Information Services, Inc. (LISI).  For information about how to subscribe to LISI, click here.

Nationally renowned CPA, Robert S. Keebler, recently produced an audio recording for Leimberg Information Services on the court ruling in the Chilton case pertaining to Inherited IRAs.  CLICK HERE TO LISTEN TO THE LEIMBERG 60-SECOND PLANNER RECORDING

Special thanks to Robert S. Keebler and Stephan Leimberg for sharing this valuable information!

Additionally, Robert Keebler is gearing up for his upcoming Learn it Live 2-day IRA seminar in Green Bay, Wisconsin on May 14-15, 2012 and just announced a June seminar to take place in Minneapolis. The Minneapolis seminar will be held June 20-21, 2012. This 2-day seminar for lawyers, CPAs and financial advisors is titled: "What the Lawyer, CPA and Financial Advisor Need to Know about Sophisticated Planning and Drafting for IRA & Qualified Plan Distributions Including How to Plan with a $5,120,000 Exemption." The seminar provides extensive coverage regarding planning with retirement accounts including: Estate planning for IRAs with a $5,120,000 exemption, the Pension Protection Act, the IRA Regulations, pre-retirement issues, required beginning date issues, the inherited IRA, the minimum distribution rules, spousal rollovers, QTIPing an IRA, charitable bequest planning, beneficiary designation planning, retirement plans payable to trusts, Roth IRA issues, distribution of employer securities, insurance strategies and new, innovative planning strategies.   For more information and to register...

This post has been brought to you by The Ultimate Estate Planner, Inc., providing practical, tested and proven technical and marketing products to help estate planning professionals throughout the country build their practices.  Connect with us on Facebook, Twitter or LinkedIn.

Sources: Leimberg Information Services, Inc. & Robert S. Keebler, CPA, MST, AEP

Friday, February 24, 2012

Leimberg Information Services: 60-Second Planner on President Obama's Estate & Income Tax Proposal

Reproduced with Permission by and Courtesy of Leimberg Information Services, Inc. (LISI).  For information about how to subscribe to LISI, click here.

As mentioned previously by Robert S. Keebler in a previous blog entry, President Obama's Fiscal Year 2013 budget was released on February 13th. Follow this link to get a full copy of the 2013 Budget. The Treasury's Green Book containing general explanations of the Administration's revenue proposals can be found here.

We now wanted to share with you two Leimberg Information Services, Inc. 60-Second Planner podcasts in response to this budget. One podcast deals with the estate and gift tax proposals of the budget and the other addresses the income tax proposals. These recordings are reproduced courtesy of LISI (Leimberg Information Services, Inc.) and can be found on their website, along with plenty of other resources for you and your practice.

Special thanks to Robert S. Keebler and Stephan Leimberg for this valuable information!

This post has been brought to you by The Ultimate Estate Planner, Inc., providing practical, tested and proven technical and marketing products to help estate planning professionals throughout the country build their practices.  Connect with us on Facebook, Twitter or LinkedIn.

Sources: Leimberg Information Services, Inc. & Robert S. Keebler, CPA, MST, AEP
Photo Source: politico.com

Monday, February 06, 2012

Michelle Ward & PLR 201203033: Trust Qualified as Designated Beneficiary After Beneficiary Released Certain Powers

Reproduced with Permission by and Courtesy of Leimberg Information Services, Inc. (LISI).  For information about how to subscribe to LISI, click here.

EXECUTIVE SUMMARY
In PLR 201203033, a trust qualified as a designated beneficiary after a trust beneficiary released certain portions of a power of appointment. The trustee of the trust was also allowed to transfer the inherited qualified plan to an inherited IRA for the benefit of the trust.

FACTS
“Alex” died at age 62 after establishing a trust that became irrevocable at his death. Alex was survived by his wife, “Lydia”, and his two children, “Nicholas” and “Melissa.”

The trust provided for the creation of a marital trust for the benefit of Lydia. The marital trust was named as primary beneficiary of Alex’s qualified defined contribution plan. The marital trust was to be funded by (in addition to other amounts) the value of any employee benefit plans made payable to the marital trust.

The trust also provided for the creation of "Primary Trusts" and "Exemption Trusts" for each of the two children. The Exemption Trusts receive equal shares of Alex's remaining GST exemption. The Primary Trusts receive the balance of the assets of the trust after all other distributions or allocations under the trust.

Lydia receives all income from the marital trust and discretionary distributions of principal. Upon Lydia’s death, any remaining property in the marital trust passes in this manner: (1) from the marital trust property includable in Lydia’s gross estate, a share equal to Lydia’s remaining GST exemption, to be divided equally between each Exemption Trust, and (2) the
remaining balance, divided equally between each Primary Trust.

During the term of each Exemption Trust, the trustee may distribute to each child the income and principal the trustee considers necessary for the child's health, education, maintenance and support. Upon the death of each child, the child may appoint the remaining principal and accumulated income among Alex’s lineal descendants. To the extent the child does not exercise this power, the remaining principal and income are to be distributed to the child's lineal descendants, per stirpes, and if there are none, to Alex’s lineal descendants, per stirpes.

During the term of each Primary Trust, all net income is paid to the child, plus discretionary distributions of principal. The child may withdraw up to one half of the principal upon reaching age 30, and the entire principal upon reaching age 35. Melissa had already reached age 35 at the time of Alex’s death.

A child who dies before receiving the entire principal of their Primary Trust may appoint any or all of the principal and income by will among one or more persons or organizations; however, the child may not exercise this power of appointment over any portion of the trust in favor of the child, the child's estate, or the creditors of either unless a federal GST tax would be payable.

To the extent that the child does not exercise this appointment power over their Primary Trust, the remaining principal and income are to be distributed to the child's lineal descendants, per stirpes, and if there are none, to Alex’s lineal descendants, per stirpes.
The trust provides that any property not effectively disposed of under the provisions of the trust is to be distributed to a charity.
After Alex’s death but before September 30 of the year following the year of Alex’s death, Nicholas executed a "Partial Release of Power of Appointment". The Release irrevocably released Nicholas’ right to appoint at his death any portion of the Primary Trust in his name to any beneficiary who is not a natural person or who was born before Lydia. Nicholas had no children as of September 30 of the year following Alex’s death.

COMMENT
An individual’s designated beneficiary is determined by September 30 of the year following the year of the plan participant’s or IRA owner’s death. In order for a trust to be considered a designated beneficiary under the IRC Sec. 401(a)(9) regulations governing RMDs from plans and IRAs, the following requirements must be met:

1. The trust is a valid trust under state law, or would be but for the fact that there is no corpus.
2. The trust is irrevocable or will, by its terms, become irrevocable upon the death of the employee.
3. The beneficiaries of the trust who are beneficiaries with respect to the trust’s interest in the employee’s benefit are identifiable within the meaning of Treas. Reg. Sec. 1.401(a)(9)-4, A-1 from the trust instrument.
4. The documentation described in Treas. Reg. Sec. 1.401(a) (9)-4, Q&A 6 has been provided to the plan administrator (this requirement can be satisfied by providing a copy of the trust to the plan administrator by Oct. 31 of the year following the year of the owner’s death).

If these requirements are satisfied, the beneficiaries of the trust (and not the trust itself) will be treated as having been designated as beneficiaries for purposes of determining the distribution period. Accordingly, the life expectancy of the oldest trust beneficiary can be used to determine RMDs. If the trust does not meet the above requirements, the owner is considered to have no designated beneficiary and the retirement plan must be distributed in five years if the plan owner died, as did Alex, before his required beginning date.

Requirements 1, 2 and 4 are easily met. Most trusts fail to qualify as designated beneficiaries because of the third requirement. While at first blush it may appear simple to identify the beneficiaries of a trust, the analysis is not that straightforward.

One must look at all potential beneficiaries of a trust to determine (1) if such beneficiaries can be identified by September 30 of the year following the year of the plan owner’s death and (2) if such beneficiaries are all individuals with an ascertainable life expectancy.

Accordingly, in PLR 201203033, the potential beneficiaries of the trust upon the death of Lydia needed to be considered in determining if the trust qualified as a designated beneficiary.

A person will not be considered a beneficiary for purposes of determining who the beneficiary with the shortest life expectancy is, or whether a person who is not an individual is a beneficiary, merely because the person could become the successor to the interest of one of the employee’s beneficiaries after that beneficiary’s death. Such beneficiary is referred to as a “mere potential successor.

The above rule does not apply to a person who has any right (including a contingent right) to an employee’s benefit beyond being a mere potential successor to the interest of one of the employee’s beneficiaries upon that beneficiary’s death. Therefore, if benefits will not accumulate in trust for a particular beneficiary under the facts existing at the plan owner’s death, any contingent beneficiary taking as a result of such beneficiary’s death is disregarded. In essence, one would keep going down the beneficiary line to determine the oldest potential beneficiary until there comes a point when the trust would be distributed outright given the facts that exist at the owner’s death.

Because of this “mere potential successor” rule, the potential remainder beneficiaries of Melissa’s Primary Trust did not need to be considered because Melissa was already age 35 at Alex’s death and therefore her Primary Trust would be distributed outright to her if she were living at Lydia’s death.

Nicholas, however, was not age 35 at his father’s death and therefore contingent beneficiaries of his Primary Trust had to be taken into account. If Nicholas were to die before the entire principal of his Primary Trust was distributed, he had the power to appoint the trust among one or more persons or organizations. In addition, to the extent the GST tax would otherwise apply, his power of appointment expanded to include himself, his estate, and the creditors of both. In other words, Nicholas had the power to appoint his Primary Trust to a non-individual or to an individual who is older than Lydia (whose identity could not have been known as of September 30 of the year following the year of Alex’s death).

Nicholas’ power of appointment would disqualify the trust as a designated beneficiary because, as of September 30 of the year following the year of Alex’s death, not all beneficiaries were identifiable and those that were included non-individuals. This situation
was rectified by Nicholas releasing, before September 30 of the year following the year of Alex’s death, his right to exercise his power of appointment in favor of any non-individual or anyone older than Lydia.

Under Treas. Reg. 1.401(a)(9)-4, Q&A 4 (except as provided in Treas. Reg. Sec. 1.401(a)(9)-6) any person who was a beneficiary as of the date of the employee's death but is not a beneficiary as of that September 30 of the year following the year of the employee’s death is not taken into account in determining the employee's designated beneficiary for RMD purposes. As a result of Nicholas’ release, the class of potential beneficiaries as of September 30 of the year following the year of Alex’s death contained only individuals and the beneficiary with the shortest life expectancy was identifiable (Lydia). Accordingly, the trust qualified as a designated beneficiary under the IRC Sec. 401(a)(9) regulations.

The potential charitable beneficiary that would take if there was a total failure of beneficiaries did not need to be considered because the trust would pay outright to a beneficiary at the death of Nicholas. The charity, therefore, was a “mere potential successor”.
Regarding the trustee’s desire to have the qualified plan transferred to an inherited IRA, IRC Sec. 402(c)(11) allows the post-mortem transfer of qualified retirement plans to inherited IRAs by non-spousal beneficiaries when such transfer is done via direct trustee to trustee transfer. As long as the trust qualified as a designated beneficiary, the trustee was entitled to have a direct trustee-to-trustee transfer made of the inherited qualified plan to an inherited IRA. Because the IRS ruled that the trust did qualify as a designated beneficiary, the IRS further ruled that such a transfer would be allowed.

CONCLUSION
Along with being a good example of how a trust is analyzed to determine if it qualifies as a designated beneficiary, this ruling also shows a post-mortem technique (i.e. a release or disclaimer) that can be utilized to save the designated beneficiary status of a trust. It highlights the fact that even if the plan owner has died and the trust does not qualify as a designated beneficiary as drafted, the advisor can explore options such as disclaimers or cashing out a beneficiary to allow the trustee to stretch out required minimum distributions for as long as possible.

CONTRIBUTOR: Michelle Ward, J.D.

TECHNICAL EDITOR: Barry Picker

CITE: PLR 201203033 (January 20, 2012).

CITE AS: LISI Employee Benefits and Retirement Planning Newsletter #594 (February 1, 2012) at http://www.leimbergservices.com Copyright 2012 Leimberg Information Services, Inc. (LISI). Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Permission is Prohibited.  The Ultimate Estate Planner, Inc. has received permission from Leimberg Information Services, Inc. to repost this newsletter.

Friday, January 20, 2012

Bob Keebler on Roth Conversions in 2012: Now's the Time to Convert

Reproduced with Permission by and Courtesy of Leimberg Information Services, Inc. (LISI).  For information about how to subscribe to LISI, click here.

“For more than 14 years, we have been advising clients about converting to a Roth IRA. For the first ten years, most of our collective efforts focused on the long-term strategic benefits of converting to a Roth IRA with us preparing complex spreadsheet analyses on the front-end to determine an ‘ideal amount’ to convert.

Like other tax professionals, with the extreme volatility of the stock market in recent years, our Roth IRA conversion paradigm has shifted.

Instead of spending hours on the front-end analyzing Roth IRA conversions to find a so-called ‘ideal amount’ to convert, we only spend an hour or so to determine if a Roth IRA conversion is feasible in the first place. After determining feasibility, we then advise our clients to convert to a Roth IRA as early in the year as possible and take a 'wait-and-see' approach over the next year.

Only after the client’s tax situation becomes clearer in the following tax year and we have the benefit of hindsight (to analyze post-conversion returns within the Roth IRA) will we take the next step and carefully analyze where a potential ‘sweet spot’ exists. Given the above considerations, with proper planning a client who converts to a Roth IRA in early 2012 can create a ‘heads I win, tails I tie’ scenario.”

Now, Robert S. Keebler, CPA, MST, AEP provides members with important commentary on Roth IRA conversions in 2012.

EXECUTIVE SUMMARY:

The 2012 tax year is the perfect time to take advantage of converting to a Roth IRA before income tax rates go up in 2013. In many cases, a “heads I win, tails I tie” situation can easily be achieved by taxpayers, especially for those who have sufficient wherewithal outside of their IRAs to pay the income tax liability on a Roth IRA conversion. In most cases, all post-conversion income and growth can be sheltered from future income tax while any post-conversion losses can be made less painful by recharacterizing the prior conversion. Moreover, with the proper timing, a taxpayer can hedge against the pending 2013 income tax rate increases and effectively use certain tax attributes (such as NOLs).

FACTS:

For more than 14 years, we have been advising clients about converting to a Roth IRA. For the first ten years, most of our collective efforts focused on the long-term strategic benefits of converting to a Roth IRA with us preparing complex spreadsheet analyses on the front-end to determine an “ideal amount” to convert. While these analyses were generally prudent, there were several times where our analyses were all for naught, especially when the value of the Roth IRA went down from the time of conversion.

Like other tax professionals, with the extreme volatility of the stock market in recent years, our Roth IRA conversion paradigm has shifted.

Instead of spending hours on the front-end analyzing Roth IRA conversions to find a so-called “ideal amount” to convert, we only spend an hour or so to determine if a Roth IRA conversion is feasible in the first place. After determining feasibility, we then advise our clients to convert to a Roth IRA as early in the year as possible and take a “wait-and-see” approach over the next year. Only after the client’s tax situation becomes clearer in the following tax year and we have the benefit of hindsight (to analyze post-conversion returns within the Roth IRA) will we take the next step and carefully analyze where a potential “sweet spot” exists.

Given the above considerations, with proper planning a client who converts to a Roth IRA in early 2012 can create a “heads I win, tails I tie”scenario. The six things to keep in mind when converting to a Roth IRA in 2012 are the following:

1. Recharacterizations
2. Roth IRA Segregation Conversion strategy
3. Reconversions
4. Impact of recharacterizations on RMDs
5. Annual Roth IRA conversion/distribution strategy
6. Special tax attributes (such as NOL carryovers, excess itemized deductions, AMT credits, etc.)

Recharacterizations

Under the tax law, a taxpayer is allowed to “recharacterize” (i.e. undo) a Roth IRA conversion anytime from the day after the conversion all the way up to the filing date of the taxpayer’s individual income tax return, including extensions (i.e. October 15th of the year following the year of the conversion). This allows the taxpayer the benefit of hindsight to determine if the Roth IRA conversion was prudent. Consequently, if designed and executed properly, the taxpayer can create a “heads I win, tails I tie” scenario.

As mentioned above, the primary benefit of recharacterizations is that the taxpayer has the benefit to assess the post-conversion returns and determine if the conversion was worthwhile in the first place. For example, let’s assume a taxpayer converts $100,000 to a Roth IRA in January 2012. Now let’s assume that the value of the Roth IRA is $80,000 on March 1, 2013. In this case, the taxpayer would simply “recharacterize” (i.e. undo) the conversion by moving the entire $80,000 Roth IRA back to a traditional IRA on or before the time he files his 2012 individual income tax return (i.e. April 15, 2013 or October 15, 2013 if an extension is filed). The effect of the recharacterization is that the taxpayer will not be taxed on any of the $100,000 original conversion because he recharacterized the entire amount back to a traditional IRA.

Roth IRA Segregation Conversion Strategy

While recharacterizations provide a significant benefit for taxpayers, the IRS realized that taxpayers could abuse this privilege, so the IRS enacted the “anti-cherry-picking rules” under Notice 2000-39 (which were later codified under Treas. Reg. §1.408A-5). Under the “anti-cherry-picking rules” one cannot recharacterize an asset which has gone down in value within the Roth IRA (i.e. “loser asset”) while keeping an asset which has gone up in value (i.e. “gainer asset”) within the same Roth IRA. The purpose of this rule is to pro-rate gains and losses across all assets within the same Roth IRA in determining the amount of gain (or loss) to apportion to the recharacterized conversion amount.

Example:

Connie converts $100 of Stock A and $100 of Stock B to a Roth IRA on January 3, 2012. On September 30, 2013, the value of Stock A is $120 and the value of Stock B is $90.

Because Stock B has gone down in value since the time of conversion, Connie would recharacterize Stock B back to a traditional IRA before she files her extended 2012 individual income tax return. Stock A, on the other hand, would be kept in the Roth IRA.

Absent of the “anti-cherry-picking rules”, if Connie were to recharacterize Stock A back to a traditional IRA, she would be allowed to reduce the taxable portion of her conversion (i.e. $200) by the value of Stock A at the time of conversion (i.e. $100). Thus, Connie would only have to pay income tax on a $100 conversion amount (i.e. $200 total conversion - $100 recharacterized amount).

However, because of the “anti-cherry-picking rules”, Connie cannot simply recharacterize Stock A back to a traditional IRA and get a $100 reduction (i.e. the original conversion value of Stock A) in her taxable income.

Instead, Connie can only reduce her taxable income by the recharacterized amount (i.e. $90). As a result, Connie will pay income tax on $10 of income (i.e. $100 original conversion value - $90 recharacterized amount) on something that no longer exists. Further, to add insult to injury, Connie must allocate a portion of the net income from the Roth IRA (i.e. $210 current value - $200 conversion value = $10 net income) to the recharacterized amount. In this case, Connie will have to add $4.50 ([$10 net income/$200 conversion amount] x $90 recharacterized amount) to the recharacterized amount going back to the traditional IRA.

As a solution to the “anti-cherry-picking rules”, instead of converting all assets to a single Roth IRA, the taxpayer would group like-assets together (e.g. small cap stock, large cap stock, international equities) and then convert those groups of like-assets to separate Roth IRAs. This is commonly known as the “Roth IRA Segregation Conversion” strategy.

The benefit of the “Roth IRA Segregation Conversion” strategy is that, unlike the example above, a taxpayer does not have to pro-rate gains and losses against each other (for purposes of recharacterization) because each asset (or grouping of like-assets) is in a separate Roth IRA. Therefore, when the taxpayer chooses to recharacterize a “loser asset”, he simply recharacterizes the entire Roth IRA with the “loser asset” back to a traditional IRA and receives a full reduction in his taxable income for the original conversion amount of that “loser asset”. (NOTE: Under Treas. Reg.

§1.408A-5, there is no aggregation rule for the separate Roth IRAs, so the gain in one Roth IRA does not have to be offset against the loss in another Roth IRA for purposes or recharacterization.)

Example:

Assume the same facts as the example above, except that Connie converts Stock A to Roth IRA #1 and Stock B to Roth IRA #2.

When Connie recharacterizes Stock B, she will be recharacterizing the entire amount in Roth IRA #2. As a result, Connie will be able to reduce her taxable income by $100 (i.e. the original conversion value of Stock B) and not have to pro-rate any of the gain from Stock A to the recharacterization because Stock A is held in a separate Roth IRA.

Reconversions

Even though a taxpayer may choose to recharacterize a prior year Roth IRA conversion (because the value of the Roth IRA has gone down since the time of the original conversion), he/she may want to take advantage of current market conditions to convert back to a Roth IRA. This is known as a “reconversion”.

In general, reconversions are permitted. However, a reconversion cannot take place until the later of: (1) the year following the year of the original conversion or (2) more than 30 days after the recharacterization. The purpose of this rule is to keep taxpayers from flipping in and out of Roth IRAs during the tax year.

Example

Gary converts $100,000 to a Roth IRA on January 3, 2012. On November 15, 2012, the Roth IRA declines to $75,000, so Gary recharacterizes the entire account back to a traditional IRA on November 16, 2012. In this case, Gary must wait until January 1, 2013 to reconvert back to a Roth IRA.

Example

Emma converts $200,000 to a Roth on July 3, 2012. On March 1, 2013, the Roth IRA declines to $180,000, so Emma recharacterizes the entire account back to a traditional IRA on March 4, 2013. Emma must wait until April 4, 2013 to reconvert.

Despite the disadvantage created by the reconversion rule, there is an exception. If a taxpayer has a separate traditional IRA, he is free to convert that separate traditional IRA to a Roth IRA without having to wait the statutory holding period.

Example

Randy converts $100,000 to a Roth IRA on January 3, 2012. On April 1, 2013, the value of the Roth IRA is $80,000, so Randy recharacterizes the entire amount back to a traditional IRA (i.e. Traditional IRA #1) on April 2, 2013.

While Randy must wait until May 3, 2013 to reconvert Traditional IRA #1, he is free to convert any other traditional IRAs he has to a Roth IRA at any time.

Impact of Recharacterizations on RMDs

There is an interesting anomaly in the Treasury Regulations regarding Roth IRAs which might be helpful for clients who need to take required minimum distributions (RMDs) from their traditional IRAs. Usually, under Treas. Reg. §1.401(a)(9)-5, RMDs are calculated under the following formula:

12/31 prior year account balance / RMD life expectancy factor

However, in cases where the entire traditional IRA is converted to a Roth IRA before December 31st and the Roth IRA is recharacterized in a subsequent tax year, the recharacterization date becomes the day from which to measure the subsequent year’s RMD.

Example

On January 3, 2012, Herman, age 74 in 2012, converts $600,000 to a Roth IRA.

On December 31, 2012, the value of the Roth IRA is worth $500,000. On March 1, 2013, when the Roth IRA is worth $400,000, Herman recharacterizes the entire Roth IRA back to a traditional IRA.

Given these facts, the account balance for purposes of calculating Herman’s RMD for the 2013 tax year would be $400,000, making his RMD for the 2013 tax year $17,467.25 ($400,000/22.9 RMD factor). Had Herman not converted to a Roth IRA at all in 2012, he would have used a $500,000 IRA balance (as of December 31, 2012), making his RMD for the 2013 tax year $21,834.06 ($500,000/22.9 RMD factor).

As illustrated in the example above, Herman was able reduce his RMD by $4,366.81 (a 20% difference) assuming he did not convert to a Roth IRA in 2012. On the other hand, it is important to point out that, from an RMD standpoint, while this strategy works for the taxpayer when the Roth IRA goes down in value (from the end of the year until the time of recharacterization), it also could work against the taxpayer if the Roth IRA were to go up in value (from the end of the year until the time of recharacterization).

Annual Roth IRA Conversion/Distribution Strategy

If a taxpayer knows that he/she is going to withdraw funds from his/her traditional IRA during the year, it may be prudent for him/her to convert (what would otherwise be distributed from the traditional IRA) to a Roth IRA early in the tax year and then take withdrawals from the Roth IRA during the course of the year.

Example

Mary, age 65, usually withdraws $10,000 per month ($120,000 annually) from her traditional IRA to cover her living expenses. Instead of taking monthly distributions from her traditional IRA in 2012, Mary converts $120,000 of her traditional IRA to a Roth IRA on January 3, 2012. During the course of the 2012 tax year, Mary withdraws $10,000 per month from her new Roth IRA.

Any residual balance left in the Roth IRA at the end of 2012 will be kept in the Roth IRA for future distributions.

Assuming that Mary did not have any other existing Roth IRAs in the example above, none of the Roth IRA distributions during the 2012 tax year would be “qualified distributions”, thus making the distributions subject to income tax. However, under the tax law, Roth IRA distributions are deemed to be on a “basis out first” basis. Therefore, none of the Roth IRA distributions would be taxable (assuming she does not withdraw more than $120,000) because Mary had already paid income tax on the $120,000 deemed distributed at the time of conversion. (NOTE: If Mary were under the age of 59½ at the time of distribution from the Roth IRA, some or all of the distribution would be subject to the 10% early withdrawal penalty under IRC §72(t).)

Although not readily apparent, the key to this strategy is to siphon off a portion of income and growth (which would otherwise be generated in the traditional IRA) and transfer it to a Roth IRA. While not a great advantage on an annual basis, over time the amount of income and growth transferred to a tax-free environment can be substantial. (NOTE: Because required distributions cannot be converted into a Roth IRA, this strategy cannot be used when the traditional IRA is in pay status, unless the entire RMD is withdrawn first.)

This is illustrated in the following charts:

Special Tax Attributes

Over the last few years taxpayers have suffered significant losses. Some of these losses, in particular trade/business losses, have created Net Operating Losses (NOLs) which have carried forward to the current tax year.

These NOLs, in turn, can be used to offset the taxable income generated by a Roth IRA conversion. If planned for carefully and analyzed correctly, a taxpayer can, in essence, do a Roth IRA conversion for free.

Example

In 2011, Jack suffered a $500,000 NOL. Of the $500,000 NOL generated in 2011, $100,000 was carried back and utilized in 2009 and $100,000 was carried back and utilized in 2010. As a result, Jack has a $300,000 NOL carryover to the 2012 tax year.

Assuming Jack had other income and deductions which offset each other in 2012, if Jack were to convert $300,000 to a Roth IRA in 2012, he could shelter the entire Roth IRA conversion with the $300,000 NOL carryover, thereby causing $0 of income tax on the conversion.

In addition to NOLs, there are situations where taxpayers may have negative taxable income (i.e. itemized deductions and personal/dependency exemptions greater than gross income). In most cases, if these “excess deductions” are not used in the current tax year, they are irrevocable lost. Thus, it is important for taxpayers in this situation to seriously consider a Roth IRA conversion in that, like a NOL carryover situation, a Roth IRA conversion can be done with little to no income tax being incurred.

Finally, there are situations where taxpayers may have tax credits which could absorb the income tax liability created by a Roth IRA conversion. One such example is the Alternative Minimum Tax (AMT) credit. In this case, if a taxpayer has an AMT credit carryover and regular taxable income is greater than AMT income in the current tax year (as a result of the Roth IRA conversion), some or all of the AMT credit carryover could be used to reduce the taxpayer’s current year income tax liability.

Conclusion

By knowing a few simple tax opportunities and doing a little planning on the front-end, one can make a Roth IRA conversion very successful. With the almost certainty of income tax rates rising within the near future, now is the time to convert. Even if one really isn’t much in favor of Roth IRA conversions, don’t be afraid. One can simply undo (i.e. recharacterize) the transaction if it doesn’t work out as well as one expects.

CONTRIBUTOR: Robert S. Keebler, CPA, MST, AEP

TECHNICAL EDITOR: Barry Picker

CITE AS:  LISI Employee Benefits and Retirement Planning Newsletter #591 (January 19, 2012) at http://www.leimbergservices.com Copyright 2012 Leimberg Information Services, Inc. (LISI). Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Permission is Prohibited.  The Ultimate Estate Planner, Inc. has received permission from Leimberg Information Services, Inc. to repost this newsletter.

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Photo Source: Leimberg Information Services, Inc. & Robert S. Keebler, CPA, MST, AEP