Kevin Purcell, Attorney at Law

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Most sophisticated planning professionals are familiar with the concept of a "Stretch" IRA:

A simple example: Client is 76 years old, widowed, and has a $250,000 IRA. Since the client passed April 1st of the year following when he/she turned 70 1/2, the client must take out the "Required Minimum Distribution" from the IRA each year per the appropriate IRS table. Hence, the client has a 22 year life expectancy at age 76, a 21.2 year life expectancy at age 77, and so forth as the numbers on the (unisex) table reveal. Upon the client's death at age 80, however, the client's named beneficiary, his or her nephew Robert, now "inherits" the IRA and must take out the annual "Required Minimum Distribution" from the IRA each year per the IRS "inheritance" table (a different table than the participant had to use).

Now comes the power of the "Stretch" IRA: Robert is, say, 26 years old. Assuming a 6% growth rate during both client and Robert's lifetime, Robert inherits an IRA worth $263,621. (Remember, while the client was having to withdraw RMDs each year, the rest of the IRA was continue to grow tax-deferred). Robert's life expectancy on the inheritance table is a very nice 57.2 years. At Robert's death at age 83, Robert will have withdrawn an astonishing $2,315,288 of distributions from the IRA! Thus the "Stretch" IRA has become a powerful planning tool so long as the IRS rules to qualify the beneficiary of the IRA as a "designated beneficiary" are followed. (We'll save that topic for another article).

But what if Robert has some creditor problems? Well, IRAs are generally exempt from creditors, right? With "inheritance" IRAs such as Robert's, the answer may very well be no.

A recent 2007 bankruptcy case, In Re: Russell Jarboe et al illustrates what some commentators have called the trend to interpret state law in such a way as to make an "inheritance" IRA attachable by creditors. The Court noted that IRAs, unlike most employer-sponsored retirement plans, are regulated by state law. In construing Texas law, the Court ruled that the immunity from creditors enjoyed by the IRA participant is not similarly enjoyed by the IRA beneficiary.

As I read Ohio law, I can see how such a rationale could apply unfavorably to a creditor of Robert in our above hypothetical. Ohio's statute exempts IRAs from attachment by most creditors up to the "[c]ontributions of the person that were less than or equal to the applicable limits of deductible contributions to an individual retirement account." A similar rule applies to Roth IRAs.

Certainly, that language would give a Court enough room to distinguish between the contributing original participant and the  beneficiary who inherited the asset and the right to the distributions. Without doubt, this glaring asset protection issue gives the careful planner cause for reflection...

One commentator, attorney Jim Roberts of the Texas law firm Glast, Phillips & Murray, P.C., suggests that the use of trusts where the Trustee is the "owner" of the IRA rights versus the beneficiary might create a "...IRA-sensitive tax provision...interposed between the decedent-participant and the beneficiary-debtor..." While we will be addressing in future articles the wonderful benefits of IRA Trusts, until the Courts speak on this subject, Mr. Robert's comments leave room for further review.

The point of this trend to blow the asset protection armor off of "inherited" IRAs, however, I believe points to the need for careful planning. If your client's intended beneficiary is a spendthrift, or someone who already has creditor problems, an IRA despite its phenomenal growth potential, might not be the best asset to leave this beneficiary. Remember, you don't want your "Stretch" IRA to become a "Disappearing" IRA!  Why not find another beneficiary or set of beneficiaries--particularly with even longer life expectancies--to be the beneficiary of the IRA and, say, create similar explosive growth in favor of the client's favorite nephew, Robert, with the proceeds of an existing life insurance policy with a change (or partial change) of beneficiaries. (Of course, with a younger client, the purchase of a permanent insurance policy would be indicated.) Paid to an Asset Protection Trust of which Robert is the beneficiary, such a policy could, structured properly, achieve similar results with a similar cash outlay by the client.

Remember, "Stretch" IRAs are wonderful tools. The younger the beneficiary, the stronger the argument for the use of an IRA Trust so that the beneficiary doesn't "blow up" the plan by withdrawing all of the IRA proceeds in a moment of youthful indiscretion thus losing all of the tremendous build up of cash value in the tax-deferred wrapper of the "inherited" IRA.  On the other hand, careful planning requires that we remember the other people who are out there that will love to "reroute" the IRA proceeds long after our client has passed on. 

Copyright 2007 by Kevin Purcell Co., L.P.A.
                          

Dateline May 29, 2007

In an emerging trend of great significance, the Internal Revenue Service, in three recent Private Letter Rulings (200644031, 200703035, and 200717021), allowed a surviving spouse to do a spousal rollover of a decedent's IRA even though the IRA was paid to the decedent's estate, a classic traditional "non-designated beneficiary".

While the scenario of these letters may save several estate plans that unwittingly made the decedent's estate the beneficiary of the decedent's IRA, the boundaries of the PRLs should nonetheless be well noted.

First, of course, a Private Letter Ruling by definition is not to be relied upon as authority except to the person or entity to whom it is addressed. Three PLR's, however, in such close proximity in time, do, I think, at least give us a hint as to the IRS's reasoning and possible future treatment of cases where an estate was for some reason made the beneficiary of an IRA.

Second, one must be very careful to note that all three of these cases bore a similar narrow fact pattern: In all of these cases, the surviving spouse was the executor of the estate and its sole benefiary. As such she had complete control over how the IRAs were to be distributed. This fact is critical as it meant that "...no third party had any authority to preclude [the surviving spouse from] receiving Decedent['s]...IRA" (PLR 200644031).  Presumably, were some third party, such as a non-spousal fiduciary,  given discretion whether or not the surviving spouse could receive the IRA, the Service would have ruled that the IRA was acquired "....from [a] third party and not from the decedent" (PLR 200703035). Such fact would have precluded any opportunity for a spousal rollover.

These PLRs, in my opinion, are possibly helpful in cleanup mode, but they should never be relied upon in planning mode.

An estate is simply a terrible beneficiary for an IRA: It is not a "designated beneficiary", and hence, it ordinarily will shut off any possibility of further "IRA stretch out" over the lives of the estate's beneficiaries. Since it is not a "designated beneficiary"--and the PLRs reinforce this
point---the "penalty" rules apply. That means if the participant dies in a year prior to his turning  70 1/2, the proceeds of the IRA will have to be paid out by December 31st of the fifth year following the decedent's death. If the participant dies in the year in which he turns 70 1/2 or any year thereafter, the proceeds of the IRA will have to be paid out over his remaining life expectancy based on the IRS's actuarial table regardless of how young the beneficiaries of the estate may be.

The lucky spouses who are the subjects of these three Private Letter Rulings slipped through a wormhole: They were the sole beneficiaries and, as sole fiduciaries of the estate, no one else could control the IRAs in question being paid in any other manner. Thus they were allowed to receive distribution of the IRA and do a spousal rollover within 60 days.

One final caveat: Due to what is probably poor wording in the last PLR, 200717021, (what, the IRS would write an opinion lacking clarity???),  the IRS, given the above wormhole, ruled that the spouse, who was not yet 70 1/2, could do a spousal rollover with her deceased husband's IRA, who was over 70 1/2, and wait until she reached her required beginning date i.e. when she turned 70 1/2. However, the ruling does not clearly state that the surviving spouse can use her life expectancy instead of that of her older, deceased husband.

This commentator would find requiring her to use his life expectancy completely inconsistent with the concept of a spousal rollover (where the surviving spouse is for all purposes the new owner of the IRA), but the IRS's language leaves some ambiguity as to whether the use of a non-designated beneficiary such as the decedent's estate locks the after-death distribution phase into the decedent's actuarial remaining life expectancy.

Moral:  IRA beneficiaries should be spouses, other humans, or Trustees of carefully-drafted IRA trusts that allow maximum income tax deferral on the IRA corpus while protecting the IRA proceeds from poor decisions by the trust's beneficiaries. The above PLRs, however, might provide an escape portal if in a moment of "sobriety deficit" a planner (or someone simply not planning at all) made the decedent's estate the beneficiary of an IRA.

Copyright 2007 by Kevin Purcell Co., L.P.A.
                           

• The taxpayer was 88 years old and in poor health when the FLP was established
• The FLP was funded with essentially everything she owned, leaving her impoverished, except for the assets in the FLP which she continued to use (e.g. her condominium)
• She was not actively involved in the creation of the FLP, but left that to her children
• No negotiation of the terms of the FLP were ever undertaken
• The activity inside the FLP was totally passive; hence, there was no legitimate business interest the Court could possibly find
• The FLP kept no books and its partners held no meetings
• The only benefit to the FLP the Court could find was an attempt to claim a lower valued estate for estate tax purposes

Not too surprisingly, the Tax Court ruled that the entire fair market value of the underlying assets contributed by the decedent in the FLP were includible in her taxable estate.

Those who work in this area must confess that we have simply seen too many of these cases where the professionals guiding their client were sloppy and reckless. How COULD the court rule otherwise?

But the bright side is that if the financial adviser, lawyer, and accountant work collaboratively to "dot their i's and cross their t's" FLPs should remain viable planning tools.

It must be recognized that some recent cases have posed a major attack on FLPs over the issue as to whether the decedent taxpayer's control as a general partner, even if cloaked as one of several members of an LLC, will defeat the adjustments to value FLPs afford.  It should also be noted that the Courts are divided on this issue, with some courts simply ruling that the exchange of the partnership units for the contributed assets is enough to consider the "control" issue not to be a problem. I cannot help noticing, however, that even these lines of cases seem divided in large measure by the facts: Sloppy and careless FLP creation and management lead to unfavorable legal holdings; careful, tedious attention to detail lead to the court's typically finding in favor of the taxpayer.

And that, dear friends, is the moral of the story.

Copyright 2007 by Kevin Purcell Co., L.P.A.