Professor Hoyt Takes Issue with ILM 200644020

Professor Hoyt Takes Issue with ILM 200644020

Article posted in Retirement Plans on 9 November 2006| 1 comments
audience: Leimberg Information Services, National Publication | last updated: 16 September 2012
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Summary

In a legal memorandum published earlier this week, the IRS concluded that a partial transfer of a decedent's IRA to charities in satisfaction of a pecuniary bequest via the decedent's trust results in gross income to the estate and fails to qualify for an offsetting charitable deduction. Writing for Leimberg Information Services, UMKC law professor Christopher R. Hoyt takes issue with the IRS's position arguing it could result in double income taxation.

by Christopher R. Hoyt

Executive Summary

The IRS Chief Counsel released a legal memorandum (ILM 200644020) that concluded that satisfying a pecuniary charitable bequest with an IRA will trigger taxable income to the estate. It also stated that the estate cannot claim on offsetting charitable income tax deduction. Respectfully, I believe that the IRS' conclusion is wrong, as illustrated by the analysis at the end of this summary. But you should be aware of its position. One benefit of this controversy is that it may finally draw attention to, and perhaps finally bring resolution to, the issue over whether satisfying a pecuniary bequest with an IRA or a qualified plan account is a taxable event or not.

Facts

The memorandum addressed a situation where a decedent's IRA was payable to a trust that provided for specific pecuniary bequests to three different charities.

The trustee had the power to distribute any asset to any charity, so the trustee instructed the IRA custodian to divide the IRA into shares "each titled in the name of a beneficiary under Trust.

Thus, each of the charities became the owner and beneficiary of an IRA equal in value, at the time of division, to the dollar amount it was entitled to under Trust." That way the trust satisfied the pecuniary bequests by distributing the IRAs from the trust to the charities, and then the IRAs would make cash distributions to the charities at a future time.

The drafter of the memo concluded that the trust had taxable income when the IRA was used to satisfy the pecuniary bequest and that the trust would not be entitled to an offsetting charitable income tax deduction.

The drafter indicated that the employee plan division of the IRS did not object to the conclusion.

The opinion stated:

"The amount of the balance in IRA at Decedent's death, less any nondeductible contributions, is IRD under section 691(a)(1). If an estate or trust satisfies a pecuniary legacy with property, the payment is treated as a sale or exchange. See Kenan v. Commissioner, 114 F.2d 217 (2d Cir.1940). Because Trust used IRA to satisfy its pecuniary legacies, Trust must treat the payments as sales or exchanges. Therefore, under section 691(a)(2), the payments are transfers of the rights to receive the IRD and Trust must include in its gross income the value of the portion of IRA which is IRD to the extent IRA was used to satisfy the pecuniary legacies." ***

"We believe that under Kenan, Trust has received an immediate economic benefit by satisfying its pecuniary obligation to the Charities with property on which neither Trust nor Decedent have previously paid income tax which is a disposition for section 691(a)(2) purposes. We further believe that the language of section 408(d)(1) simply prevents the immediate taxation of IRA recipients on amounts in an IRA which are not currently payable under a theory of "constructive receipt." T:EP:RA, which has jurisdiction over section 408, does not object to our conclusion on this issue."

Background on Tax Trap for Pecuniary Bequests

The potential problem caused by fixed dollar bequests is that an estate must recognize taxable income if it satisfies such a bequest with appreciated property. The distribution of property in satisfaction of the bequest will produce taxable income to the estate as if the appreciated property had been sold.1 (If the governing document had used a fractional share formula instead of a fixed dollar amount, this problem is avoided.)

Pecuniary Amount Example

Cher Holder's will provides that her nephew is to receive $100,000 from her estate. She owned stock that was worth $80,000 at the time of her death that has increased in value to $100,000 during the administration of her estate.

If the personal representative distributes the stock to the nephew in satisfaction of the $100,000 pecuniary bequest, the estate must recognize a $20,000 taxable gain as if it had sold the stock.2

Because of the taxable gain, the nephew's basis in the stock will be the higher $100,000 rather than the original $80,000.3

Fractional Share Example

Ree Tiree's will provides that her niece should receive 10% of her estate. The niece received a pro-rata distribution of stock that was worth $80,000 at the time of her aunt's death but was worth $100,000 at the time of distribution.

There is no taxable gain to the estate.4

Prior Legal Authority on Using IRD to Satisfy Pecuniary Bequests

Things get complicated and ambiguous when income in respect of decedent ("IRD") assets are used to satisfy a pecuniary bequest in a will. There are many sources of IRD assets — savings bonds, royalty payments, etc — but unquestionably the largest source of IRD are distributions from IRAs and qualified retirement accounts.

The big question is, "If IRD is used to satisfy a pecuniary bequest, will there be taxable income to the estate along the lines of the "sale" analogy described above?"

Until this ILM, prior IRS rulings on the subject had been murky. In the early 1990's the IRS issued three private letter rulings that applied the "sale" principle to transfers of installment sale notes and savings bonds (assets with IRD) in satisfaction of pecuniary bequests. 5

These rulings have been criticized on the grounds that several courts have held that the law of IRD trumps the law of DNI.6

Later rulings that involved retirement account distributions to satisfy pecuniary spousal shares did not assert the sale principle.7 Perhaps a factor that explains these later rulings is that the rules of IRD and DNI must also conform to the special subset of rules that apply to IRA and QRP distributions.

For example, the law of constructive receipt does not apply to distributions from IRAs and QRPs; recipients are only taxed upon actual receipt.8 This reduces the chance that the sale principle would apply to such a distribution as it might apply to, for example, an installment sale note.

Comment: Why the Conclusions in the ILM Are Wrong

Respectfully, I disagree with the IRS conclusion here.

Why? As illustrated in the preceding paragraph, the laws of qualified plans trump the general laws under Sec. 661.

If carried to its extremes, much of the qualified plan rules would have to be re-written. Of greatest concern, the conclusion could trigger the double income taxation: first when the trust uses the IRA to satisfy the bequest and again when the IRA makes a distribution to the beneficiary.

Example

Perhaps it would be clearer to illustrate the situation with a beneficiary that is not a charity. Suppose, for example, that a will stated "pay $100,000 to Sarah" and then the probate estate "distributes" an IRA or a 401(k) account with exactly $100,000 in it to Sarah.

We would normally wait for the IRA or the 401(k) plan to make a distribution to Sarah before we said Sarah had taxable income. We would look at the rules of Sec. 691, 402(a) and 408(d)(1) — which tax actual distributions (only) from qualified plans and IRAs; no constructive receipt, etc. — and conclude that those qualified plan rules trump the traditional income tax rules. It would be double-taxation to have taxable income to the estate under Section 661 and then to again have taxable income when the IRA made the distribution to Sarah.

Recall that when appreciated stock is used to satisfy a pecuniary bequest, the stock receives a new tax basis because of the taxable event. Rev. Rul. 67-74; 1967-1 C.B. 194. The stock's appreciation while it was held by the estate is only taxed once at the time of distribution and not again when the recipient eventually sells the stock.

If the position in the ILM is ultimately held valid, will an IRA or a 401(k) account receive a "step-up in basis" to reflect the taxable event so that future distributions are tax-exempt? If so, it is new law and we will need considerable guidance for qualified plan administrators to revise their Form 1099-R distribution disclosures to adequately report the correct amount of taxable income, especially for a "stretch IRA" where distributions can be made over many years. If there is no step-up, then there is the double taxation of income, which is flat wrong.

The laws of qualified retirement accounts have carved out a niche where they exist outside the realm of the usual tax rules that apply to taxable income, such as constructive receipt and Section 661. It would be much better to have these qualified plan laws extended to pecuniary bequests. Taxable income should be limited to situations where a person actually receives a distribution from a qualified retirement plan or under those few special situations identified in ERISA where a person may have taxable income without a distribution (e.g., pledging an account as collateral for a loan triggers taxable income under ERISA and IRA rules — Sec. 72(p)(1)(B)).

Conclusion

Hopefully this controversy can be resolved so that the laws of qualified plans prevail over the provisions of a deemed sale or exchange of Sec. 661. Until then, this ILM demonstrates that practitioners should be cautious using IRAs and qualified plan accounts to satisfy pecuniary bequests.

HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!

Chris Hoyt

Cite As:

Steve Leimberg's Charitable Planning Newsletter # 110 (November 7, 2006) at http://www.leimbergservices.com

CITES:

ILM 200644020 (Dec. 15, 2005). See also Professor Hoyt's article "Debunking the Myth: Pecuniary Amounts on IRA Beneficiary Forms," Trusts and Estates, September 2004 (pp. 47-52).

{C}


  1. Id. and Reg. Section 1.661(a)-2(f).back

  2. Id. See also GCM 39388 (May 25, 1984) in which the IRS concluded that a trust would have to recognize gain when it distributed appreciated stock in satisfaction of a direction in the trust instrument to pay net income to the beneficiary. Note that if the transfer of appreciated property occurs for a charitable distribution, there might be a charitable income tax deduction that could offset the taxable gain. See Rev. Rul. 83-75, 1983-1 C.B. 114, in which the IRS concluded that a distribution of appreciated securities by a charitable lead trust to a charity in lieu of current income resulted in taxable gain to the trust. The trust was entitled to claim an offsetting charitable deduction for the income, since the trust was required to distribute its income to a charity. A similar result was reached in Private Letter Ruling 9044047 (Aug. 4, 1990).back

  3. Rev. Rul. 67-74; 1967-1 C.B. 194.back

  4. See the analysis in PLR 9537005 (June 13, 1995)back

  5. The IRS applied the sale principle to funding pecuniary bequests with assets that have IRD, such as installment sale notes (PLR 9123036 (Mar. 21, 1991) and savings bonds (PLRs 9315016 (Jan. 15, 1993) and 9507008 (Nov. 10, 1994)).back

  6. See Choate, Natalie, "Assignment of the Right-To-Receive IRD", Life and Death Planning for Retirement Benefits (5th ed. 2002), Sections 2.2.05 and 2.2.06, p. 89-94, Ms. Choate analyzes the IRS' application of the sale principle to funding pecuniary bequests with assets that have IRD. Although it is not explicitly stated in the regulation, she points out that Treas. Reg. Section 1.691(a)-4(b)(2) "implies that satisfying a pecuniary bequest with the right-to-receive IRD should be treated as a 'sale' just as satisfying a pecuniary bequest with appreciated property is treated as a 'sale.'" On the other hand, she analyzes court cases that concluded that the law of IRD trumps the law of DNI: citing Edmund D. Rollert Residuary Trust v. Commissioner, 752 F. 2d 112 (6th Cir. 1985); Estate of Jack Dean v. Commissioner, 46 TCM 184 (1983). The New (6th) Edition of Life and Death Planning is out and available: http://www.ataxplan.com !!!!back

  7. Id. Ms. Choate analyzed four private letter rulings where the IRS did not assert there was taxable income when IRAs were used for marital trusts funded with pecuniary formulas. PLRs 9524020, 9608036, 9623056 and 9808043. For analysis of these rulings and disclaimer strategies to use for pecuniary amounts in marital and credit shelter trusts, see Choate, sec 2.2.06 pages 92-94 and Keene.back

  8. In 1981, Congress deleted the words "made available" from Section 402(a) to clarify that qualified plan benefits are only taxable in the year they are actually distributed. See Section 314(c) of the Economic Recovery Tax Act of 1981 ("ERTA"), P.L. 97-34. Section 402(a) emphasizes this by using the word "actually" in the statute ("any amount actually distributed to any distributee...").back

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Comments

IRS Ruling on IRAs for Pecuniary Bequests

Chris's article ought to qualify for some kind of award. It is extremely well-reasoned, and he takes a complex subject and writes in a style that is easily understood.

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