For a discussion of how the community property laws operate on income tax issues, be sure to consult Article III, Section K, “Income Taxation On Distribution of Nonparticipant Spouse’s Community Property interest—Who Pays the Income Tax?,” in addition to this Article VII.
As a general rule, amounts actually distributed from qualified plans and IRAs are taxable to the recipient.[1] The constructive receipt rule does not apply to qualified plans,[2] 403(b) Plans,[3] or IRAs,[4] and therefore the fact that the benefits under a plan or IRA[5] are made available, or that the participant or beneficiary has access to them, is does not result in income taxation.[6]
If the beneficiaries of a nonparticipant’s community property interest in the participant’s community property IRA have the right to demand a distribution of the interest at will[7], are the beneficiaries in constructive receipt for income tax purposes. Arguably yes, but such a conclusion would be so contrary to the authorities cited immediately above that I think not.
I believe that the nonparticipant and the nonparticipant’s heirs and devisees will treated as “beneficiaries” for purposes of the constructive receipt rule. Though I do not have any authority directly on point for this proposition, neither I do not know of any contrary authority, and I would think that if the constructive receipt rule applied in the year of death of the nonparticipant, the issue would have been tried by now.
Qualified plan and IRA proceeds (to the extent not previously taxed) constitute income in respect of a decedent (IRD) under §691(a) of the IRC, and, as "income," such proceeds may also constitute a large source of distributable net income (DNI) if payable to the estate. From this a number of significant consequences follow. These consequences can be quite pronounced given the large sums potentially subject to this special treatment, particularly if the beneficiary of the qualified plan proceeds is the decedent's estate.
IRC §691(a)(1)-(3) provides—
(1) General rule. The amount of all items of gross income in respect of a decedent which are not properly includible in respect of the taxable period in which falls the date of his death or a prior period (including the amount of all items of gross income in respect of a prior decedent, if the right to receive such amount was acquired by reason of the death of the prior decedent or by bequest, devise, or inheritance from the prior decedent) shall be included in the gross income, for the taxable year when received, of:
(A) the estate of the decedent, if the right to receive the amount is acquired by the decedent's estate from the decedent;
(B) the person who, by reason of the death of the decedent, acquires the right to receive the amount, if the right to receive the amount is not acquired by the decedent's estate from the decedent; or
(C) the person who acquires from the decedent the right to receive the amount by bequest, devise, or inheritance, if the amount is received after a distribution by the decedent's estate of such right.
(2) Income in case of sale, etc. If a right, described in paragraph (1), to receive an amount is transferred by the estate of the decedent or a person who received such right by reason of the death of the decedent or by bequest, devise, or inheritance from the decedent, there shall be included in the gross income of the estate or such person, as the case may be, for the taxable period in which the transfer occurs, the fair market value of such right at the time of such transfer plus the amount by which any consideration for the transfer exceeds such fair market value. For purposes of this paragraph, the term "transfer" includes sale, exchange, or other disposition, or the satisfaction of an installment obligation at other than face value, but does not include transmission at death to the estate of the decedent or a transfer to a person pursuant to the right of such person to receive such amount by reason of the death of the decedent or by bequest, devise, or inheritance from the decedent.
(3) Character of income determined by reference to decedent. The right, described in paragraph (1), to receive an amount shall be treated, in the hands of the estate of the decedent or any person who acquired such right by reason of the death of the decedent, or by bequest, devise, or inheritance from the decedent, as if it had been acquired by the estate or such person in the transaction in which the right to receive the income was originally derived and the amount includible in gross income under paragraph (1) or (2) shall be considered in the hands of the estate or such person to have the character which it would have had in the hands of the decedent if the decedent had lived and received such amount.
This tells us how and to whom income in respect of a decedent (or IRD) is taxed, but it does not really answer the question of just what constitutes IRD. The regulations offer some help:
(b) General definition. In general, the term "income in respect of a decedent" refers to those amounts to which a decedent was entitled as gross income but which were not properly includible in computing his taxable income for the taxable year ending with the date of his death or for a previous taxable year under the method of accounting employed by the decedent. See the regulations under section 451. Thus, the term includes --
(1) All accrued income of a decedent who reported his income by use of the cash receipts and disbursements method;
(2) Income accrued solely by reason of the decedent's death in case of a decedent who reports his income by use of an accrual method of accounting; and
(3) Income to which the decedent had a contingent claim at the time of his death.
See sections 736 and 753 and the regulations thereunder for "income in respect of a decedent" in the case of a deceased partner.[8]
In effect, all items of income that would have been recognized by the decedent as of date of death had the cash basis decedent switched to an accrual basis on that date are treated as IRD and taxed accordingly.
The regulations contain a number of helpful examples of what is, and what is not IRD,[9] however, experience has shown that the determination is often not an easy one.
There are several disadvantages to having an item characterized as income in respect of a decedent. First, IRD is an item includible in the gross estate and is therefore, subject to the estate tax as well as the income tax. Further, the income tax that will have to be paid is not a deduction for estate tax purposes (though the opposite may be true). Second, there is no step up in basis to prevent the tax, as there would be if the item was capital gains. IRC §1014 is explicit that the basis adjustment otherwise applicable at death does not apply to IRD:
(c) Property representing income in respect of a decedent. This section shall not apply to property which constitutes a right to receive an item of income in respect of a decedent under section 691.[10]
A transfer at death is not a taxable sale or exchange if the beneficiary is entitled to the interest as a matter of right. Consider, for example, the distribution of a decedent’s property to a residuary beneficiary under a will. Absent an IRC §643(e) election, no gain or loss will be recognized on the “transfer.” More to the point, IRC §691(a)(1) is explicit that the recognition of an IRD item is included in gross income “when received.” Therefore the recipient of the “right to” an IRD item will never be taxed upon receipt of the right, unless the transfer of the right is itself a taxable sale or exchange, such as might be the case, for example, if the transfer is in satisfaction of the right to a pecuniary bequest.
If a right to income in respect of a decedent is transferred by an estate to a specific or residuary legatee, only the specific or residuary legatee must include such income in gross income when received.[11]
(It is important to distinguish a distribution of the right to collect the income in respect of a decedent from a distribution of income collected by the estate which happens to be IRD.)
If there is more than one beneficiary of a general interest in the residuary estate, the beneficiary’s interest will be a fractional share. Even if the fractional share is described by formula (as it might be in the case of a marital deduction or credit shelter formula bequest) there should be no acceleration if a portion of the gift is IRD.[12]
As a general rule, if property other than cash, valued at the date distributed, is used to satisfy a pecuniary bequest, a taxable sale or exchange occurs, because the distribution is being made in satisfaction of an ascertainable fixed dollar obligation of the estate, similar to a debt.[13] Assuming date of distribution values are used to value the distribution ("true worth" funding), the distribution will result in gain or loss to the estate, with a corresponding step up or step down in basis to the beneficiary. The treasury takes the position that this rule applies even if the amount of the pecuniary gift is established under a formula.[14]
Note the possible inconsistency between the theory that payment in kind, in satisfaction of a formula pecuniary bequest, triggers gain or loss due to the fact that it is made in satisfaction of a specific amount, and the rule that the payment of a formula gift carries out distributable net income (DNI) because the formula amount is not a fixed dollar amount.[15]
A different rule from that normally applicable may obtain even if date of distribution values are not used; e.g., if estate tax values are used, or if the property distributed is fairly representative of overall appreciation and depreciation in the estate. If date of distribution values are not used, the conventional wisdom is that the recipient must succeed to the basis of the estate, and thus, no gain or loss will be recognized. Whether or not this rule applies in the case of IRD is an interesting question, since §691 has its own rules about when income in respect of a decedent is and is not recognized. If the IRD does not belong to the beneficiary “as a matter of right” upon the death the decedent, then it may be that it is accelerated, even if date of distribution values are not used; or more ominously, if a pick and choose fractional share is involved.
The will or trust should specify the method of valuation to be used when funding a pecuniary gift with property other than cash. If the will is silent, statutory law may determine the valuation method.
Texas Probate Code §378A(a) provides:
(a) Unless the governing instrument provides otherwise, if an executor, administrator, or trustee is authorized under the will or trust of a decedent to satisfy a pecuniary bequest, devise, or transfer in trust in kind with assets at their value for federal estate tax purposes, in satisfaction of a gift intended to qualify, or that otherwise would qualify, for a United States estate tax marital deduction, the executor, administrator, or trustee, in order to implement the bequest, devise, or transfer, shall distribute assets, including cash, fairly representative of appreciation or depreciation in the value of all property available for distribution in satisfaction of the pecuniary bequest, devise, or transfer.
Accordingly, unless the governing instrument directs otherwise, if a pecuniary gift intended to qualify for the federal estate tax marital deduction is to be funded with property using estate tax values, any property used to satisfy the gift shall be fairly representative of appreciation or depreciation in the value of all property available for distribution. This statutory provision was designed to avoid the inadvertent loss of the marital deduction which might otherwise occur as a result of the position taken by the Revenue Service in Rev. Proc. 64-19.[16]
Note, that §378A only applies when the instrument authorizes the use of estate tax values. If the instrument is silent on the subject of valuation, true worth funding is required. Thus, unless the governing instrument directs otherwise (as it would if it required the fiduciary to fund based upon estate tax values), §378A(b) specifies that date of distribution values are to be used.
Texas Probate Code §378A(b) provides:
(b) Unless the governing instrument provides otherwise, if a will or trust contains a pecuniary bequest, devise, or transfer that may be satisfied by distributing assets in kind and if the executor, administrator, or trustee determines to fund the bequest, devise, or transfer by distributing assets in kind, the property shall, for the purpose of funding the bequest, devise, or transfer, be valued at its value on the date or dates of distribution.[17] [Emphasis added.]
If a “fairly representative” valuation method is employed, it is believed that gain or loss on funding a pecuniary gift in an estate will ordinarily be avoided, and the basis in the hands of the donee will be the same as the basis was in the estate. (This rule, however, may not be applicable if the property being distributed in satisfaction of the pecuniary bequest is income in respect of a decedent (IRD) as described in IRC §691. See below.)
There is little authority for the proposition that “fairly representative” valuation results in no gain or loss on funding, though it seems to be widely assumed. Perhaps the assumption is that this method is a type quasi-fractional share.
In Rev. Rul. 72-295,[18] the satisfaction of a bequest of $x worth of a particular stock did not trigger gain, even though the stock was distributed at date of distribution values. Presumably gain or loss would have been triggered if other assets had been distributed in satisfaction of this obligation.
If IRD, including an interest in a qualified plan or IRA, is used to satisfy a pecuniary obligation of the estate, the IRD may very well be accelerated and recognized by the estate, as in the case of any other taxable transfer.
Query whether §691 may call for acceleration of tax if IRD is used to satisfy a pecuniary bequest using Proc. 64-19 fairly representative values, or if a fractional share gift is satisfied with IRD using a “pick and choose” power. Ordinarily, this would not result in recognition of gain or loss for the reasons given above (if only to give symmetry to the basis rules), but IRC §691(a)(2) might cause recognition here, notwithstanding the normal rule, in any case where the beneficiary’s interest in the IRD was not acquired as “a matter of right.”[19]
What if the only asset available to fund a pecuniary bequest is an IRD item? Perhaps in that case, the legatee would be entitled to it as a matter of right (even though it might have been subject to a power of sale?), in which case 691(a)(1) would prevent acceleration and trump Treas. Reg. §1.661(a)-2(f)(1).
A case can also be made that the taxation of distributions from qualified plans and IRAs is governed solely by IRC §§72, 402 and 408; and that, absent an actual distribution (or some other transaction expressly made taxable under those sections), there can be no income tax recognition under other income tax principles, including those principles found in IRC §691(a). Such a result may even be implied in PLR 9350040.[20] Further, in a 1996 PLR the Service characterized what was clearly a fractional share formula disclaimer as a pecuniary amount, but then held that it would taxed only as and when paid out.[21]
The right to receive income in respect of a decedent has a zero basis at date of death.[22]
There is nothing in the statutes that would clearly exclude a distribution of the right to income in respect of a decedent from DNI, unless the gift of the right to the IRD was specific (Treas. Reg. §1.1014-1(c)(1). ; however, prior to the enactment of §643(e), if the right to IRD carried out DNI in an otherwise tax free distribution (such as would ordinarily be the case in a residuary distribution), the basis in the right to the IRD would be stepped up by the amount of the DNI under Treas. Reg. 1.661(a)-2(f), and, to that extent, no income tax would be paid when the IRD was collected! This was in the too good to be true category, or at least so thought the Tax Court in Rollert Residuary Trust, 80 T.C. No. 30 (1983), aff'd 752 F.2d 1128 (6th Cir. 1985). See also Estate of Dean v. Commissioner, TC Memo 1983-276, 46 CCH TCM 184 (1983), which is in accord with Rollert, and notes the conflict between 661 and 691. The Rollert and Dean cases held that IRD would not carry out DNI. This required a torturing of the applicable IRC provisions in order to achieve a fair result.
IRC §643(e)(1) impliedly revokes Treas. Reg. 1.661(a)-2(f), by providing that the basis of any property received by a beneficiary in a distribution from an estate or trust will be the adjusted basis of such property in the hands of the estate or trust immediately before the distribution, adjusted for any gain or loss recognized to the estate or trust on the distribution. §643(e)(2) provides that in the case of any distribution of property, the amount deductible under the DNI rules of 661(a)(2) and 662(a)(2) will be limited to the lesser of the basis of the property in the hands of the beneficiary or the fair market value of the property. (This rule won't apply if an election under §643(e)(3) is made.)
There are some interesting possibilities associated with a §643(e)(3) election to recognize gain on a distribution of the right to receive payments of income in the future. However, the point to be made is that in the absence of a §643(e)(2) election, or other triggering (recognition) event, the beneficiary of the right to receive IRD will receive a zero basis in the property right,[23] which means that the distribution will carry out zero DNI, pursuant to §643(e)(2). This would seem to cure the problem perceived by the Tax Court in Rollert and Dean, since there is no longer the possibility of a free step up. On the other hand, if there is recognition, then §643(e)(1) would mandate a commensurate step-up.
Common sense and the principles of Rev. Proc. 64-19 would lead one to think that a reduction would be in order. However, there is a technical advice memorandum, TAM 7827008, which holds that there is no reduction in the amount of the marital deduction where the marital gift was satisfied with income in respect of a decedent.[24] Further, in PLR 8929046 the Service ruled that in determining the value of payments receivable from an IRA for marital deduction purposes, the potential income taxes payable by the recipient are not taken into account!
IRC §691(c) allows the recipient of IRD to claim a deduction against income tax for the portion of the estate tax that was attributable to the IRD. The §691(c) deduction is allocated mechanically. This mechanical application of the deduction can mandate results that may seem odd, inequitable or unfair. For example, a person may be entitled to a §691(c) deduction, even though someone else paid the estate tax.
The statute reads, in part, as follows:
(c) Deduction for
estate tax.
(1) Allowance of
deduction.
(A) General rule. A person who includes an amount in gross income under subsection (a) shall be allowed, for the same taxable year, as a deduction an amount which bears the same ratio to the estate tax attributable to the net value for estate tax purposes of all the items described in subsection (a)(1) as the value for estate tax purposes of the items of gross income or portions thereof in respect of which such person included the amount in gross income (or the amount included in gross income, whichever is lower) bears to the value for estate tax purposes of all the items described in subsection (a)(1).
(B) Estates and trusts. In the case of an estate or trust, the amount allowed as a deduction under subparagraph (A) shall be computed by excluding from the gross income of the estate or trust the portion (if any) of the items described in subsection (a)(1) which is properly paid, credited, or to be distributed to the beneficiaries during the taxable year.
Excess
retirement accumulation tax.
For purposes of this subsection, no deduction shall be allowed for the portion of the estate tax attributable to the increase in such tax under section 4980A(d).
(2) Method
of computing deduction.
For purposes of paragraph (1)--
(A) The term "estate tax" means the tax imposed on the estate of the decedent or any prior decedent under section 2001 or 2101, reduced by the credits against such tax.
(B) The net value for estate tax purposes of all the items described in subsection (a)(1) shall be the excess of the value for estate tax purposes of all the items described in subsection (a)(1) over the deductions from the gross estate in respect of claims which represent the deductions and credit described in subsection (b). Such net value shall be determined with respect to the provisions of section 421(c)(2), relating to the deduction for estate tax with respect to stock options to which part II of subchapter D applies.
(C) The estate tax attributable to such net value shall be an amount equal to the excess of the estate tax over the estate tax computed without including in the gross estate such net value.
3. Special
rule for generation-skipping transfers.
In the case of any tax imposed by chapter 13 on a taxable termination or a direct skip occurring as a result of the death of the transferor, there shall be allowed a deduction (under principles similar to the principles of this subsection) for the portion of such tax attributable to items of gross income of the trust which were not properly includible in the gross income of the trust for periods before the date of such termination.[25]
In order to determine the §691(c) deduction it is necessary to first compute what the estate tax would have been but for the net IRD.[26] Next, each recipient of IRD is allowed a deduction equal to his or her proportionate share of the IRD.
For example, if the only asset in the estate were $1 million of IRD, after deductions, the estate tax (after the application of the unified credit and the credit for state death taxes) would be $119,800 in 1995. The income tax would be computed on $880,200 ($1,000,000-$119,800). Even though gross income would be $1 million, the recipients would be entitled to a §691(c) deduction of $119,899. Most cases are not this simple, however.
The regulations describe the method for determining the deduction—
(a) In general. A person who is required to include in gross income for any taxable year an amount of income in respect of a decedent may deduct for the same taxable year that portion of the estate tax imposed upon the decedent's estate which is attributable to the inclusion in the decedent's estate of the right to receive such amount. The deduction is determined as follows:
(1) Ascertain the net value in the decedent's estate of the items which are included under section 691 in computing gross income. This is the excess of the value included in the gross estate on account of the items of gross income in respect of the decedent (see 1.691(a)-1 and paragraph (c) of this section) over the deductions from the gross estate for claims which represent the deductions and credit in respect of the decedent (see 1.691(b)-1). But see section 691(d) and paragraph (b) of 1.691(d)-1 for computation of the special value of a survivor's annuity to be used in computing the net value for estate tax purposes in cases involving joint and survivor annuities.
(2) Ascertain the portion of the estate tax attributable to the inclusion in the gross estate of such net value. This is the excess of the estate tax over the estate tax computed without including such net value in the gross estate. In computing the estate tax without including such net value in the gross estate, any estate tax deduction (such as the marital deduction) which may be based upon the gross estate shall be recomputed so as to take into account the exclusion of such net value from the gross estate. See example (2), paragraph (e) of 1.691(d)-1.
For purposes of this section, the term "estate tax" means the tax imposed under section 2001 or 2101 (or the corresponding provisions of the Internal Revenue Code of 1939 [sic]), reduced by the credits against such tax. Each person including in gross income an amount of income in respect of a decedent may deduct as his share of the portion of the estate tax (computed under subparagraph (2) of this paragraph) an amount which bears the same ratio to such portion as the value in the gross estate of the right to the income included by such person in gross income (or the amount included in gross income if lower) bears to the value in the gross estate of all the items of gross income in respect of the decedent.[27]
Guidance on the specific issue of the IRD deduction for a lump sum distribution from an IRA can be found in Rev. Rul. 92-47.[28]
Note that there is no §691(c) deduction for state inheritance tax; and this is true even in a soak-up jurisdiction, where the state transfer tax equals the IRC §2011 credit for state death tax credit.
The estate tax must generally be paid within 9 months of death. The 691(c) deduction, however, may not be available for many years after the estate tax is paid, if the IRD is not recognized until then. No allowance is given for the time-value use of the estate tax enjoyed by the government between the time the tax is paid, and the time the deduction for the tax is realized.
This is a rather difficult concept to fathom, and is best illustrated by taking an example.
The idea behind the 691(c) deduction is to put the decedent’s estate in roughly the same situation that it would have been in if the decedent had recognized the IRD immediately before death. For the reasons given in the three preceding paragraphs, this ideal is seldom reached.
Here is the ideal: Assume that the estate tax rate is a flat 50%, that there is no unified credit and no state death tax, and that the income tax rate is a flat 25%. In that case, a taxpayer with $1 million in IRD as his or her only asset would have a choice between paying the income tax during life, or immediately after death, and the choice would make no tax difference.
Under alternative one, the taxpayer pays the tax during life, dies with a $750,000 estate; the estate pays $375,000 in estate taxes, and no income taxes, leaving a net $375,000 left after all taxes. Under alternative two, the taxpayer does not pay the tax during life, dies with a $1,000,000 estate, the estate pays $500,000 in estate taxes, and (after the 691(c) deduction), $125,000 in income taxes; again leaving a net $375,000 left after all taxes. So here, the 691(c) deduction did what it should have done: it completely vitiated the effect of having to pay both an estate and an income tax on the same property.
In the real world, however, there are other, more subtle factors at work. In the example given earlier, the only asset in the estate was $1 million of IRD. If the decedent had recognized the income during life and paid 39.6% of it ($396,000) to the IRS, he or she would have died with an estate of $604,000, and thus, would owe no estate or inheritance tax. However, if the decedent dies (in 1998) without having recognized the income during life, there would have been $110,550 in Federal Estate Tax and $33,200 in State Inheritance Tax (assuming the state was a soak-up jurisdiction, otherwise the situation would be worse). The total transfer taxes would be $143,750.
The 691(c) deduction would equal the FET of $110,550, and so income taxes on the $1 million of IRD would be imposed on only $889,450. Thus, the IRD recipient would only pay $352,222, instead of $394,000, which is good. However, the difference between $394,000 and $352,222 is only $41,778 and that is not enough to compensate for the $143,750 in transfer taxes. The estate comes up short by the difference between $143,750 and $41,778, i.e. the estate is $101,972 worse off than if the income tax had been recognized during life.
Instead of $606,000 left over after tax, only $504,028 (a difference of $101,972) is left after taxes. Why? The answer is in part because of the $33,200 in state inheritance tax which would not otherwise have been owed. Even if there were a 691(c) deduction for it (which there is not), the income tax savings would only have been $13,147 (39.6% of the tax). But that is not the whole picture. There is another $68,772 in taxes that would not have been incurred, but for the fact that the IRD was taxed twice. How is this possible?
Since I am not so sure of the answer myself, I am tempted to leave the question unanswered, for you to ponder. (If I was good at math, I would not have chosen law as my profession.) However, I will hazard a possible explanation. I believe that the 691(c) deduction fails to compensate for the difference in brackets between the FET that would have been incurred had the tax been paid during life and the higher bracket into which the estate is forced by reason of the inclusion of the IRD (where the tax is not paid during life).
If an estate tax deduction for the income tax were allowed, rather than the other way around, parity would be achieved. But since the estate tax brackets are not uniform, the 691(c) deduction fails to achieve a complete mitigation of the effect of double taxation.
After applying the unified credit, the estate can be said to be paying a FET at a flat 11.055% average rate. If 11.055% were in fact a flat rate, a decedent who paid income tax during life, would pay estate an 11.055% tax on the $606,000 remaining at death, and we would have parity. But the rate on the first $625,000 was zero, in effect. And the rate on the next $375,000 is 29.48%.
For reasons that I cannot articulate very well (at least yet), the 691(c) deduction will not compensate for the difference between the lower and higher marginal estate tax rates, at least in the case of estates under $21,225,000. Curiously, the effect of the IRC §2001(c)(3) adjustment may give parity to the extremely wealthy taxpayer.
The application of the §691(c) deduction in practice has proven elusive, particularly where the IRD qualifies in whole or in part for the marital deduction, and more particularly, where the marital deduction gift is determined under a formula.[29]
The regulations provide that “any estate tax deduction (such as the marital deduction) which may be based upon the gross estate shall be recomputed so as to take into account the exclusion of such net value from the gross estate.”[30] Rev. Rul. 67-242 is less ambiguous.[31]
If the will contains a reduce to zero formula clause, then obviously there will be no IRD deduction because there will be no tax. In the case of a fixed gift of an IRD item to a spouse in a taxable estate, the IRD will be removed from the gross estate under the recomputation procedure, but this will not necessarily cause the recomputed estate tax to change, because of the operation of the marital deduction under the actual estate tax computation. Therefore, the §691(c) deduction attributable to the IRD that qualified for the marital deduction could be zero. Ironically, even if the deduction is lost, the spouse may still share in the allocation of the deduction of other items of IRD.
Complicating things still further, if the will contains a formula marital deduction clause that does not reduce estate taxes to zero, or if, as was the case under pre-ERTA law, the marital deduction could not exceed a percentage of the (recomputed) gross estate, then there may be estate tax attributed to the IRD even though a marital deduction was available. If the formula clause calls for a stated percentage of the estate to pass in a manner qualifying for the marital deduction, and if the application of that clause does and would (after removal of the IRD items) result in tax, then reasonable minds can differ as to the proper application of §691(c).
In Estate of Kincaid,[32] the Tax Court posited the following example:
|
|
Actual |
Petitioner’s |
Respondent’s |
|
Gross estate |
$1,000,000 |
$900,000 |
$900,000 |
|
Adjusted gross estate |
1,000,000 |
$900,000 |
$900,000 |
|
Marital deduction |
(500,000) |
(450,000) |
400,000 |
|
Exemption |
(60,000) |
(60,000) |
(60,000) |
|
Taxable estate |
440,000 |
390,000 |
440,000 |
|
Estate tax |
126,500 |
100,500 |
126,500 |
|
Sec. 691(c)(1)(A) deduction |
- - - |
16,000 |
0 |
The assumptions were that “(1) the actual gross estate was $1 million; (2) the actual adjusted gross estate was $1 million; (3) the actual marital deduction was $500,000; (4) the right to the KFC payments (which was in the form of an outright bequest) was worth $100,000 and was the only item of income in respect of a decedent in the gross estate.”[33] Apparently, it is also assumed that the $100,000 item of IRD would have passed to the widow regardless of the formula clause, as a specific gift. Thus, under the facts, the widow received $100,000 of IRD and $400,000 under the formula clause.
The will contained a formula clause (typical of pre-ERTA law, before the advent of the unlimited marital deduction) calling for a marital deduction gift of 50% of the adjusted gross estate. The taxpayer’s position was essentially that the recomputation of the estate tax should be literal. If the IRD did not exist, the formula clause would have left the spouse $450,000 of probate assets (instead of the $400,000 actually provided under the formula). The Service, relying on Treas. Regs. §1.691(c)-1(a)(2) and §1.691(d)-1(e) Ex. 2, and on Rev. Rul. 67-242, 1967-2 C.B. 227, contended that since the IRD qualified for the marital deduction, its removal should not affect the recomputed estate tax.
The Tax Court disagreed with the Service and agreed with taxpayer’s contention that the recomputation should be literal. The Tax Court found the taxpayer’s approach to be consistent with the cited regulations, and noted that Revenue Rulings do not have the effect of a Treasury Regulation.[34]
If some of the IRD does not qualify for the marital deduction, because it passes to someone other than the spouse, there will be a §691(c) deduction to allocate. Under the statute, the allocation of IRD is shared among the recipients of the IRD prorata.[35] This appears to be true even though, because of the operation of the marital or charitable deduction, a portion of the IRD did not increase estate taxes. Therefore, a spouse would be entitled to a portion of the deduction (even though a marital deduction was obtained for the spouse's interest), at the expense of the persons whose share of the IRD resulted in estate tax. This is clearly anomalous, but it is not the only example of the “rough justice” approach taken by the statute.
To illustrate, if Wife and number 1 son each received $100,000 of IRD and if the estate tax rate at the margin was 50%, then the estate tax attributable to the IRD would be 50% of $100,000 ($200,000 less the $100,000 that qualified for the marital deduction), or $50,000. Wife and number 1 son would each be entitled to claim an IRD deduction of $25,000.
If charity receives a part of IRD and non charities receive the rest, presumably a portion of the deduction may have to be allocated to the charity (even though the gift to charity had no effect on the recomputed estate tax) in a manner similar to that described above when the IRD was split between a marital and non-marital gifts. This is obviously an unfortunate result if true, but it appears to be mandated by the prorata allocation sharing approach taken in the regulations.[36]
A Charitable Remainder Trust (CRT) is a tax exempt entity. Is the deduction lost? It could be, or it could be reduced.
IRA or qualified plan benefits paid to a CRT are income in respect of a decedent (IRD). As previously discussed, a 691(c) deduction for estate taxes paid on IRD is supposed to be available to the recipient. Unlike the case where the IRD was payable to a charity outright, the 691(c) deduction may be of some benefit here, both because there is a noncharitable beneficiary who could use the income tax deduction, and because the estate tax charitable deduction attributable to the IRD will be less than 100% (and may be as small as 10%). However, for reasons that will be shown, the benefit of the deduction is likely to be considerably muted.
Even though a CRT is tax exempt, it still computes its income in order to be able to characterize the distributions to the noncharitable beneficiary. For this purpose, the CRT ought to be able to reduce its “income” by the amount of the 691(c) deduction. However, under the tier system, all distributions will be income to the noncharitable beneficiary until such time as the current and accumulated income of the CRT has been exhausted. If the CRT distributes more than its current and accumulated income (less the 691(c) deduction), the excess is tax free to the noncharitable beneficiary. But —and here is the problem— all of the IRA or qualified plan proceeds are income for purposes of the tier system (even if treated as corpus for fiduciary accounting principles),[37] so these benefits (less the 691(c) deduction), plus the other income of the trust will have to be paid out first, before the benefits of the 691(c) deduction are realized. This could take many years at best. At worst, the benefits of the 691(c) deduction will be entirely lost.
This is an important ruling on the subject discussed immediately above. The IRS position appears to be that the IRD (in this case, proceeds from a retirement plan) is first tier ordinary income of the CRT designated as beneficiary. Of course, if the trust is a valid CRT with no unrelated business taxable income, the CRT will not be taxable on the income. The amount of first tier income attributable to the IRD is reduced by the 691(c) deduction. The problem, as discussed above, is that the 691(c) deduction will be of no benefit to the noncharitable beneficiary until all of the current and accumulated income is first paid out, which generally won’t happen for quite a while, if ever.
Upon receiving the proceeds from the qualified retirement plan, section 691(a)(1)(B) requires Trust to include the IRD in its gross income (whether or not the trust is exempt from tax under section 664(c)). Under section 691(a)(3) the ordinary income character of the IRD is retained. Further, these amounts constitute ordinary income for purposes of section 664(b)(1). Under section 691(c)(1)(A) Trust is entitled to a deduction for the estate tax attributable to the IRD. Therefore the IRD that constitutes ordinary income described in section 664(b)(1) is the amount of the IRD net of the deduction provided in section 691(c)(1)(A). This deduction is reported as an “other” deduction on line 11 of Form 5227. The section 691(c)(1)(A) deduction is not directly made available to the income beneficiaries under section 664(b).[38]
The IRS made seven enumerated conclusions, the last five of which are perhaps worth setting forth verbatim:
(3) When the proceeds from the qualified retirement plan are distributed to Trust, the proceeds will be included in the gross income of Trust under section 691(a)(1)(B), and will not be includible in the gross income of X's estate.
(4) Because the proceeds of the qualified retirement plan are IRD, they will be includible in the gross income of Trust for the taxable year the distribution is received by Trust as the designated beneficiary of X's qualified retirement plan. Provided Trust is a charitable remainder unitrust within the meaning of section 664(d)(2), Trust will not be taxable on its income for that year unless, for that year, it has unrelated business taxable income within the meaning of section 512.
(5) In computing the hypothetical estate tax (that is, excluding the IRD items) described in section 691(c)(2)(C), the estate must also exclude the charitable deduction resulting from the contribution of the qualified retirement plan amounts to Trust.
(6) Provided that Trust is a charitable remainder unitrust within the meaning of section 664(d)(2), the amounts from the qualified retirement plan that are IRD will be “first tier” income, described in section 664(b)(1).
(7) The deduction provided by section 691(c)(1)(A) reduces the amount of IRD that Trust includes in its first tier ordinary income. Therefore, the amount of first tier ordinary income from the IRD is the net of the IRD under section 691(a)(1)(B) less the deduction under section 691(c)(1)(A). The section 691(c)(1)(A) deduction is not directly made available to the income beneficiaries under section 664(b).[39]
Rev. Rul. 92-47[40] tells us that post death income is not IRD, but does not answer the question of what portion of a distribution will be deemed to include that post death income. In the case of an annuity distribution, §691(c)(2) appears to provide that the entire annuity payment, to the extent includible in income under §72 and received during the annuitant's life expectancy, is IRD and subject to the deduction.
(c) Amounts deemed to be income in respect of a decedent. For purposes of allowing the deduction under section 691(c), the following items are also considered to be income in respect of a decedent under section 691(a):
* * * *
(2) Amounts received by a surviving annuitant during his life expectancy period as an annuity under a joint and survivor annuity contract to the extent included in gross income under section 72. See section 691(d).[41]
Clearly, the 691(c) deduction is not allowed to exceed the amount included in income from the payment in question; and under §72 a portion of an annuity payment might be tax free. The same principal applies where a portion of an installment payment is not included in income because it is treated as a return of capital under the installment sale rules.[42]
If $1 million is in an IRA at date of death, and if the beneficiary is not a spouse (so that there are no marital deduction issues), and if the IRA is ratably distributed over a ten year period, how much of each payment is considered to be a part of the original $1 million, the receipt of which can be offset under §691(c) for the estate tax paid, and how much represents post death income and appreciation for which the §691(c) deduction is not allowed? Is one entitled to recover the $1 million in IRD first, or is a ratable allocation between the original corpus and post death income and appreciation required? Can we use a “first in, first out” approach?
The logic of Treas. Reg. §1.691(c)-1(c) discussed above suggests that all amounts included in income are subject to the deduction. However, the sources footnoted below suggest that post death income and appreciation must be accounted for, because post death income and appreciation is not income in respect of a decedent. [43] The question is whether we can account for it, but claim we left it in the IRA, distributing only the IRD. The cases cited are not helpful to the taxpayer. Moreover, a close reading of the regulations suggests that a deemed pro rata characterization will be required. The regulations contain an example in which an estate makes a partial distribution of the distributable net income (DNI) for the year. The DNI includes both IRD and taxable interest (we are not told the source of the interest). In the example, the portion of the distribution attributable to the IRD, and for which a 691(c) deduction is allowable, is determined mechanically, pro rata.[44]
The 691(c) deduction is not a tax preference item.[45] If it were, the deduction would be disallowed in computing the alternative minimum tax (AMT).
IRC §56(b)(1)(A)(i) provides:
“(b) Adjustments applicable to individuals. In determining the amount of the alternative minimum taxable income of any taxpayer (other than a corporation), the following treatment shall apply(in lieu of the treatment applicable for purposes of computing the regular tax):
“(1) Limitations On Deductions. No deduction shall be allowed—
“(A) In General. No deduction shall be allowed—
“(i) for any miscellaneous itemized deduction (as defined in section 67(b)) . . . “
IRC §67(b) defines miscellaneous itemized deductions for purposes of applying the 2-percent floor on those deductions. §67(b)(7) provides
“(b) For purposes of this section, the term miscellaneous itemized deductions means the itemized deductions other than—
* * * *
“(7) the deduction under section 691(c) (relating to deduction for estate tax in case of income in respect of the decedent.” [Emphasis added.]
The Committee Reports for the Revenue Act of 1978 and the Tax Reform Act of 1986 confirm that the 691(c) deduction is not a tax preference item.[46]
Since the 691(c) deduction does not reduce adjusted gross income under §62, and since it does not reduce taxable income under §63(b), it is an itemized deduction under §63(d).
Generally the 691(c) deduction will be listed on line 10 (estate tax deduction) of the Beneficiary’s K-1, which instructs the beneficiary to carry it over to line 8 (deduction for other taxes paid) of the Schedule A (itemized deductions) to the Form 1040.
However, if lump sum averaging is elected, the deduction is taken on the Form 4972 and is not carried over directly to the Form 1040, so that the tax computed on the 4972 is net of the 691(c) deduction —which deduction, incidentally, will always apply at the same time, because the 691(c) deduction is taken in the year the IRD is recognized. Query whether the forms take into account the limitation under §68 (infra). I haven’t checked this, but suspect that, since the deduction is taken separately, the Form 1040 instructions would have to be fairly sophisticated to recognize this issue.
As indicated above, IRC §67(b)(7) exempts the 691(c) deduction from the IRC §67(a) 2% floor on itemized deductions.
IRC §68(a) provides:
§68 Overall
limitation on itemized deductions.
(a) General rule. In the case of an individual whose adjusted
gross income exceeds the applicable amount [adjusted for inflation; $121,200 in
1997], the amount of the itemized deductions otherwise allowable for the
taxable year shall be reduced by the
lesser of --
(1) 3 percent of the excess of adjusted gross income over the applicable amount, or
(2) 80 percent of the amount of the itemized deductions otherwise allowable for such taxable year.
In most cases, 3% of AGI will be less than 80% of itemized deductions, which is a mitigating factor worth noting. A wealthy taxpayer with $2 million in income above the applicable amount would have itemized deductions reduced by $60,000 (3% of $2 million), assuming itemized deductions were at least $75,000 (80% of which is $60,000).
If such a taxpayer received, as a beneficiary, an IRA distribution of $120,000 on which estate taxes of $60,000 had already been paid, the taxpayer would, but for §68, have been entitled to an itemized deduction under §691(c) of $60,000. §68, in the example given, effectively eliminates the deduction, from one point of view. If the taxpayer had no other itemized deductions, this point of view might be correct. On the other hand, if the taxpayer had $75,000 of other itemized deductions, $60,000 in deductions would have been lost anyway. Viewed from the first perspective, at least two taxes would be incurred on the $120,000, a 50% estate tax and a 39.6% income tax. Viewed from the second perspective, the 691(c) deduction is not really lost —it is other itemized deductions that would be lost and they would be lost anyway. If the 691(c) deduction obtains, the combined taxes would be 69.8% or thereabouts: 50% plus 50% of 39.6%.
It follows from the example that it is theoretically possible to imagine a case where the combined income, estate and excise taxes on a distribution would exceed 100%: If the estate tax were 55% and the income tax 39.6%, the combined tax would be 94.6%. If state income taxes and inheritance taxes in a non “soak-up” jurisdiction exceeded 6.4%, the total taxes would exceed 100% if §68 operated to eliminate the 691(c) deduction —which from one point of view can only happen if there are no other itemized deductions that would have been lost anyway. Back when §4980A was still the law, this could happen even more easily, since that tax could effectively cost 7% by itself.
What will ordinarily keep the combined estate and income taxes from exceeding the amount of the distribution in the average case is 691(c), which allows for a deduction against income taxes for the estate tax paid. It is only in those cases, admittedly rare, where §68 operates to eliminate the 691(c) deduction that the disaster illustrated can operate with full force.
However, what if the taxpayer is a trust! Trusts are not subject to the §68 3% limit. The lesson is that in some cases, it may be advantageous to use a trust as the taxpayer, where the trust beneficiary is a high income taxpayer.
Consider the consequences of allocating all of the IRD to the spouse under the will, but making compensating gifts to persons other than the spouse. There would be no §691(c) deduction. What if, instead, the spouse were entitled to only a percentage of the estate, but the executor allocated all of the IRD to the spouse under a pick and choose power to make nonprorata distributions? Do the normal rules that appear to allow nonrecognition of gain under a pick and choose allocation apply in the case of IRD?
What if the spouse were allocated a pecuniary amount, but this was satisfied with a distribution of the right to receive the IRD? The full §691(c) deduction ought to be available to the estate, but at the price of the IRD being recognized on funding. See below.
The Service takes the somewhat questionable position that because a formula pecuniary bequest, such as a formula marital deduction bequest, is dependent upon elections and other matters not ascertainable at death, such a gift is not of a specific sum of money for purposes of IRC §663(a)(1). Accordingly, a distribution in satisfaction of a formula pecuniary bequest carries out DNI.[47]
Since plan proceeds can be a potentially large source of DNI, and since formula pecuniary gifts can also be quite large, the tax consequences of a distribution in satisfaction of a pecuniary bequest can be striking, significantly affecting the economic bottom line value to the beneficiary of a distribution in satisfaction of the gift. The reason is that the beneficiary will have to pay income tax on the amount distributed if the distribution carries out DNI, which could, in effect, cut the economic value of the gift in half, raising touchy issues as to the appropriateness of an equitable adjustment and fiduciary liability for abuse of discretion.
In some cases, however, funding the marital bequest with DNI may be beneficial, since it will enhance the value of the bypass trust. For instance, if the estate had a million dollars in income, the estate could pay close to a half a million in tax (or whatever), and then use what remains to fund the pecuniary marital in the following year (when distributable net income would be at a minimum) making up the difference with property which would have otherwise gone to the residuary estate. Result: spouse gets $1,000,000 tax free.
Alternatively, the estate could distribute the $1,000,000 of DNI to the spouse in the year of receipt and take a distribution deduction. Result: spouse gets $1,000,000 immediately subject to income tax, and nets $500,000 (or whatever), a rather dramatic difference in the bottom line. Contrariwise, the bypass trust (or residuary estate) is enhanced by the amount of tax the estate did not have to pay. Since the bypass will be sheltered from further taxes, this may be a good plan, at least so long as the surviving spouse is a beneficiary of the bypass trust (or residuary estate) or so long as the beneficiaries are the surviving spouse's children. Otherwise, you have an unhappy spouse.
In most cases even a large estate will not have distributable net income of this magnitude. The paradigm exception would be in the year of a lump sum distribution to the executor of the decedent's qualified plan interest.
Although it is probably impossible to transfer an IRA or qualified plan interest to charity during life, charity can be a particularly attractive death beneficiary.
Consider that since distributions on account of death are fully taxable to the recipient (i.e., they have a zero basis), naming a charity as a beneficiary of plan assets or IRA proceeds may be far superior to using other assets for this purpose. In the case of a lifetime gift of an interest in a qualified plan or IRA, there is no way to get an income tax deduction without incurring the tax (unlike a gift of appreciated property), but at death this is not the case. The Service has confirmed this favorable tax treatment in a private letter ruling.[48] In this same ruling the Service confirmed that the IRC §4940(a) excise tax on net investment income would not apply to the distribution. (The charity was a private foundation.)
If the distribution is to a QTIP trust, income to spouse for life, remainder to charity, the minimum distribution rules of 401(a)(9) may operate to require that the distribution take place to the trust within five years of the participant’s death (if death occurs prior to April 1 of the year following age 70&1/2—the RBD) or on the basis of the participant’s life expectancy (if death occurs after the RBD and recalculation of life expectancy was not elected). In other words, it may be that the QTIP cannot be treated as a “designated beneficiary” for purposes of the minimum distribution rules, by looking the life expectancy of the spouse to determine the amount required to be distributed. The reason: the trust might be considered to have multiple beneficiaries at least one of whom is not an individual or qualifying trust.[49]
A charitable remainder unitrust may be an excellent death beneficiary. The primary reason is that a charitable remainder trust (CRT) will not recognize the income when received, and can then dribble it out under the CRT payout rules, rather than the §401(a)(9) minimum distribution rules. Sometimes the CRT payout rules may allow for a longer payout, and a larger after tax accumulation in the hands of the beneficiaries, than if the §401(a)(9) rules were operating. The most obvious candidate for a CRUT as death beneficiary is where death occurs after the participant’s RBD, i.e., the required beginning date (April 1 after the calendar year the participant reaches age 70&1/2), where the participant’s spouse also survived the RBD but predeceased the participant, and where the participant was recalculating both life expectancies.
As discussed at length in this outline, IRA or qualified plan distributions are income in respect of a decedent (IRD). It is significant that the receipt of IRD by a CRT is not ordinarily treated as unrelated business taxable income (UBTI).[50]
See the materials under the heading “Allocating the 691(c) Deduction to a Charitable Remainder Trust” for a discussion of the issues involving the deduction for estate taxes on income in respect of a decedent that arise when a CRT is a beneficiary of an IRA or qualified plan.[51]
IRC §101(b) used to provide an exclusion from gross income for
amounts received by the beneficiaries or the estate of an employee that are
paid by reason of the employee’s death.[52]
The exclusion is still available for decedents dying before
The Small Business Job
Protection Act repealed the §101(b) was repealed with respect to decedents
dying after
With one notable exception (lump sum distributions), the exclusion only applies to amounts that, but for the death, would otherwise have been forfeitable. “[The exclusion] shall not apply to amounts with respect to which the employee possessed, immediately before his death, a nonforfeitable right to receive the amounts while living.”[54]
Treasury regulations make it clear that the employee is considered to possess the right to an amount which would have been available immediately before death if the employee terminated employment (even though the employee was still working at the time and in-service distributions were not permitted).[55] In other words, the exclusion is really computed solely with respect to otherwise forfeitable benefits. Thus, if the benefit was 100% vested prior to death, the exclusion is not available at all (unless the lump sum exception to the exception applies). If a beneficiary with an $8000 account balance was 50% vested at death, but became 100% vested on account of death, the exclusion would be $4000.
If a portion of the benefit represents life insurance proceeds that are not excludable under IRC §101(a) (such as the cash value of life insurance) may be subject to the $5000 exclusion.[56]
The notable exception to the rule requiring the benefit to be otherwise forfeitable is for distributions that qualify as a lump sum distribution, as defined in IRC §402(d)(4).[57] IRC §402(d)(4)(D) defines a lump sum distribution for purposes of that paragraph as having “the meaning given such term by IRC §402(d)(4)(A) (without regard to subsection (d)(4)(F) [which otherwise required 5-years of active participation, but which has been repealed]).” The IRC §402(d)(4)(A) definition of a lump sum distribution is discussed ad nauseam below. Suffice it to say that death is a triggering event that will always apply for purposes of this exception, which means that the primary other requirement is that the benefit be the balance to the credit from a qualified plan (e.g., not an IRA) paid in one taxable year of the recipient. It does not appear that the 10-year averaging election available for certain lump sum distributions actually be made or even be available.
There are two other exceptions to the exclusion. Under IRC §101(b)(2)(C) the exclusion does not apply to amounts received by a surviving annuitant under a joint and survivor’s annuity that was in pay status prior to death. If the benefit is being paid as an annuity or other periodic payment (including payments representing cash value of life insurance) described in IRC §72, the $5000 exclusion (if otherwise available) is taken over time, as if the $5000 represented basis (an investment in the plan).[58]
A normal distribution from the residuary estate to the heirs entitled to the property under a will or trust will ordinarily not be considered a taxable sale or exchange (although it would carry out DNI), since the beneficiaries “acquired the property from the decedent” and, in effect, own or are treated as owning the residuary estate from date of death.[59] This is implied in IRC §643(e). However, IRC §643(e)(3) now gives the executor an election whether or not to recognize gain or loss on such distributions. In fact, it may be that the election described in §643(e)(3) only applies to distributions out of the residuary estate which would otherwise not trigger sale or exchange treatment.
If there is more than one residuary beneficiary, and the distributions are made on a prorata basis, the principles remain the same as with any other residuary distribution, and gain or loss should not be recognized or realized.[60]
Beneficiaries having equal shares of the residuary estate are generally entitled to a prorata share of each asset, in the absence of a direction in the will to the contrary. It is often more practical, however, to make nonprorata division. For example, instead of giving A and B (equal residuary beneficiaries) an undivided one-half interest in Universal Widgets, Inc., and Blackacre, both being assets of the residuary estate, A and B may prefer that A gets all of the stock in Universal Widgets, Inc., and B gets all of Blackacre, with any difference in value being made up with other residuary assets. However, such a nonprorata partition has all of the earmarks of a sale or exchange between A and B, each exchanging his undivided one-half interest in the one asset for the other's one-half interest in the remaining asset.
According to Rev. Rul. 69-486, 1969-2 C.B. 159, a nonprorata distribution out of the residuary estate will ordinarily be treated as a taxable sale between or among the beneficiaries. However, Rev. Rul 69-486 implied that if the will authorizes a nonprorata distribution, such a distribution would not result in sale or exchange treatment for tax purposes. This has been confirmed by two private letter rulings (which of course, have no precedential value).[61]
A technical advice memorandum involving a distribution from a
trust described the following facts: The trust was to accumulate income until
the beneficiary was age 21, and then distribute the accumulated income. At age
25, the trust was to distribute 1/4 of the corpus. The trustee had the power to
make distribution in cash or in kind or partly in each. The trustee distributed
appreciated stock in satisfaction of the right to accumulated income, and cash
and stock in satisfaction of the right to 1/4 of the corpus. A technical advice
memorandum was first issued on
The Service, on reconsideration, concluded that the right to all of the trust income was a right to receive a fixed dollar amount, within the meaning of Treas. Reg. §1.661(a)-2(f)(1). The "beneficiary had a right to all of the income, the specific amount of which was fixed at the time of each distribution." Therefore, gain was recognized when property other than cash was distributed in satisfaction of this right. Citing Rev. Rul. 67-74, 1967-1 C.B. 194, the Service construed the transaction as the equivalent of a distribution of cash followed by a purchase of stock from the trust, despite the authority in the trust to make distributions in kind.
"Section 1.661(a)-(2)(f)(1) makes no distinction pertaining to the source of a trustee's authority to make a non-cash distribution. It literally applies whenever property is conveyed in satisfaction of a right to receive a distribution in a specific dollar amount."
On the other hand, the nonprorata distribution of corpus in satisfaction of the beneficiary's right to receive 1/4 the trust estate at age 25 did not trigger gain:
"The present case is nearly identical to Rev. Rul. 55-117. Although Article First, paragraph (2) of the trust agreement provides that the trustees must distribute an amount equal to one-fourth of the principal of Trust, this direction does not substantively differ from a direction to pay one-fourth of the trust principal. Therefore, this provision is similar to a residuary formula clause in a will rather than a pecuniary formula clause. As illustrated in Rev. Rul. 60-87, appreciation and depreciation of the assets of a trust or estate will cause the economic right of a beneficiary to fluctuate under a residuary formula. The economic right under a pecuniary formula will remain unaffected. Because the right of Beneficiary fluctuated from the date Trust was created until the date of distribution, Beneficiary had a right under a residuary clause, that was not a right to receive a fixed amount. As in Rev. Rul. 55-117, the distribution of an amount equal to one-fourth of the value of the principal was in the nature of a partial distribution of a share of the trust principal rather than a satisfaction of a right to receive a fixed dollar amount. Thus, there is a long standing position that a distribution of a portion of principal or residue, whether pro-rata or nonprorata, valued at the time of distribution is not a taxable event. Accordingly, Trust did not realize gain on the distribution."
First of all, if we had clear authority, we wouldn’t need to discuss the issue in depth, but since, we don’t, we must. What little authority that we do have includes the following:
PLR 8505006, PLR 8037124, PLR 8016050, PLR 8119040, PLR 8029054 and PLR 9422052.
IRC §1041. Rev. Rul. 76-83, 1976-1 C.B. 213. Rev. Rul. 81-292, 1982-1 C.B. 158.
Rev. Rul. 74-347, 1974-2 C.B. 26. Beth W.
Corporation v. U.S., 350 F. Supp. 1190 (S.D. Fla. 1972) aff’d per curiam, 481 F.2d 1401 (5th
Cir. 1973). Cofield v. Koehler, 207
F. Supp. 73 (D.
PLR 9422052 is probably the most significant recent ruling on this issue, and it is very favorable to the taxpayer; i.e., it held that a nonprorata division of a sole proprietorship among three trusts —of which one was a grantor trust belonging to the surviving spouse— did not result in a taxable sale or exchange.
The issue of whether or not a nonprorata distribution or partition of community or jointly held separate property will trigger gain or loss is unclear; however, given the favorable letter ruling position in the case of nonprorata residuary estate distributions, maybe the Service will allow a post death nonprorata partition of community property between the estate and the surviving spouse to likewise escape taxation, particularly if the will authorizes it. What little authority there is on this question would indicate that the Service will probably not require recognition of gain or loss in this situation, although, again, there is no authority directly on point.[62]
If the will or state law did not authorize such a division,
taxation is likely.[63]
It may make a difference whether or not the community property sought to be partitioned is under administration. If the property is in the name of the survivor (and consequently under the sole control and management of the survivor in the absence of a Probate Code §177(b) election), the property may or may not be subject to administration.
The issue could be framed as being whether or not the principles of Rev. Rul. 76-83, 1976-1 C.B. 213 survive the termination of the community by death. Rev. Rul. 76-83 held that no gain or loss will be recognized from the approximately equal division of the fair market value of community property in a community property state under a divorce settlement agreement that provides for transfer of some assets in their entirety to one spouse or the other. The transaction, rather than being characterized as a taxable sale or exchange, was characterized as a nontaxable division of the joint interests in the property as an entity. To the same effect see Carrieres v. Commissioner, 64 T.C. 959 (1975), acq. in result, 1976-2 C.B. 1, aff’d per curiam, 552 F.2d 1350 (9th Cir. 1977), and Walz v. Commissioner, 32 B.T.A. 718 (1935).
Rev. Rul. 81-292, 1982-1 C.B. 158 reached the same conclusion where the property was jointly held separate property. (This situation was distinguished from U.S. v. Davis, 370 U.S. 65 (1962), where the wife had only an inchoate interest in property transferred to her by her husband incident to a divorce.) See also Beth W. Corporation v. U.S., 350 F. Supp. 1190 (S.D. Fla. 1972) aff’d per curiam, 481 F.2d 1401 (5th Cir. 1973) and Cofield v. Koehler, 207 F. Supp.73 (D. Kan. 1962), and Rev. Rul. 74-347, 1974-2 C.B. 26.
Since the enactment of IRC §1041[65] by the 1984 Tax Reform Act (exempting interspousal transfers from income taxation), Rev. Rul. 76-83 is no longer as important as it once was. However, it is hoped that the same rationale will be applied to exempt post death partitions from taxable sale or exchange treatment.
Given the liberality that the Service has shown in its private letter rulings to the effect that no gain or loss will be recognized to an estate on a non prorata residuary division (assuming that the division is not contrary to law), given the unequivocal language of Rev. Rul. 76-83 and Rev. Rul. 81-292, and given the Congressional policy evidenced by the enactment of §1041, it seems reasonable to conclude that post death partitions between a surviving spouse and the estate will not result in taxable sale or exchange treatment.
In PLR 9422052 the decedent died owning a community property interest in a sole proprietorship held at date of death in a revocable living trust. The executors were authorized to allocate the assets in the sole proprietorship among three trusts, a marital trust, a bypass trust, and a trust for the surviving spouse to hold the surviving spouse’s community property interest.
The taxpayer estate specifically requested a ruling that “In making a non-pro rata allocation from the Trust to the successor trusts, a sale or exchange does not occur under section 1001 of the Code, and, thus, the allocation does not result in a taxable transfer.” The IRS ruled in favor of the taxpayer, holding that the nonprorata division was not a taxable transfer. In response to this request the ruling stated:
“A partition of jointly owned property is not a sale or other disposition of property where the co-owners of the joint property sever their joint interests, but do not acquire a new or additional interest as a result thereof. Thus, neither gain nor loss is realized on a partition. See Rev. Rul. 56-437, 1956-2 C.B. 507, which held that the severance of a joint tenancy in stock of a corporation under local law by partition and the issuance of two separate stock certificates in the names of each of the joint tenants, in order to eliminate the survivorship feature of the joint tenancy that operates in favor of each joint tenant, is a nontaxable transaction as there was no sale or exchange of property.
“In Rev. Rul. 69-486, 1969-2 C.B. 159, a non-pro rata distribution of trust property was made in kind by the trustee, although the trust instrument and local law did not convey authority to the trustee to make a non-pro rata distribution of specific property in kind. The distribution was effected as a result of a mutual agreement between the trustee and the beneficiaries. Because neither the trust instrument nor local law conveyed authority to the trustee to make a non-pro rata distribution, the beneficiaries were viewed as having an absolute right to a ratable in-kind distribution of trust property. Accordingly, Rev. Rul. 69-486 stated that the transaction was equivalent to a pro rata distribution followed by an exchange between the beneficiaries and was subject to the provisions of section 1001 and 1002 of the Code.
“The present case is distinguishable from Rev. Rul. 69-486 because it has been represented that the trustees of the Trust are authorized to make pro rata and non-pro rata distributions of trust property under the trust instrument and under local law. Thus, the beneficiaries of the Trust are not required to receive pro rata distributions for each asset of the Trust. Because the trustees of the Trust have the authority to make non-pro rata distributions based on fair market values, the proposed division of the Trust into the Exemption and Martial Trusts and the Survivor's Trust will not be treated as pro rata distributions followed by an exchange of assets among the beneficiaries of the Trust with respect to the non-pro rata distribution of real property interests. In this regard, see also Rev. Rul. 83-61, 1983-1 C.B. 78. Accordingly, based on the facts submitted and the representations made, the beneficiaries of the Trust, the Exemption Trust, the Martial Trust, and the Survivor's Trust will not realize gain or loss under section 1001 of the Code as a result of the proposed transaction to divide the Trust.
* * * *
“4) In making a non-pro rata allocation from the Trust to the Exemption, Martial, and Survivor's Trusts, a sale or exchange does not occur under section 1001 of the Code and the beneficiaries of those trusts do not realize gain or loss under that section.” [Emphasis added.]
In PLR 199912040 the decedent died after his RBD. He left his IRA to his revocable living trust. All of his property was community property. The trust provided for a pecuniary gift to children, followed by a division into a survivor’s share and a decedent’s share. The decedent’s share remaining after satisfaction of the pecuniary gifts was to be used to fund a credit shelter trust, with the remainder going to the survivor’s share. The wife (the survivor) was the trustee of all of the trusts. The trustee had the power to revoke or amend the survivor’s trust. State law and the trust instrument permitted nonprorata allocations among the trusts. The ruling was favorable on all points. The nonprorata division of the IRA was not a taxable event because it was authorized by state law, and, moreover, the spouse was free to rollover amounts she elected (as trustee) to allocate to the survivor’s share.
Significantly, the ruling does not address MRD issues, such as whether the power to freely allocate the IRA proceeds among various potential beneficiaries would have caused the beneficiaries to have been unascertainable or otherwise ineligible for the life expectancy method of payout.
The following is taken directly from the ruling:
1. As sole successor trustee to Trust X, Individual A will allocate the assets of the IRA entirely to the Survivor's Trust.
2. Upon receipt of a favorable ruling from the Internal Revenue Service Individual A will withdraw the 1997 [N.B: e., the MRD for the year of death, presumably computed as if death had not occurred] minimum required distribution from the decedent's IRA and distribute it to the Survivor's Trust.
3. As surviving trustor and successor trustee of the Survivor's Trust, Individual A will distribute the assets of the IRA from the Survivor's Trust to herself as surviving spouse. Such distribution will exclude the amount of the 1997 minimum required distribution.
4. As surviving spouse Individual A will place the assets into an IRA in her own name within sixty (60) days of distribution from the decedent's IRA. [N.B. It looks as if the spouse gets to rollover the 1997 MRD, contrary to the literal reading of the rollover regulations.]
It has been represented that, during the one-year period ending on the date of the distribution of the IRA assets to Trust X, there will have been no other tax-free rollover from an IRA through Individual A.
Based on the above facts, Individual A requests the following three-part letter ruling:
1) In making a non-pro rata allocation from Trust X to the successor Trusts and the pre-division gifts, a sale or exchange does not occur under section 1001 of the Code, and, thus, the non-pro rata allocation of the IRA to the Survivor's Trust does not result in a taxable transfer.
2) Individual B's IRA does not represent an inherited IRA to the surviving spouse within the meaning of section 408(d)(3)(C) of the Code.
3) Pursuant to section 408(d)(3)(A)(i) of the Code, Individual A will not be required to include in income for federal income tax purposes for the year in which Individual B's IRA was distributed the amounts received and reinvested in Individual A's IRA so long as such reinvestment is accomplished within 60 days from the date of distribution from the IRA to Trust X.
With regard to the first ruling requested, section 61(a)(3) of the Code provides that gross income includes gains derived from dealings in property.
Section 1001 of the Code provides that “the gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in section 1011 for determining gain, and the loss shall be the excess of the adjusted basis provided in such section for determining loss over the amount realized.”
Section 1.1001-1(a) of the Income Tax Regulations provides that “except as otherwise provided in subtitle A of the Code, the gain or loss realized from …the exchange of property for other property differing materially either in kind or in extent, is treated as income or as loss sustained.”
Rev. Rul. 69-486, 1969-2 C.B. 159, holds that a non-pro rata distribution of trust corpus in kind by mutual agreement of the beneficiaries is subject to gain or loss treatment under section 1001 of the Code. The trust instrument cited in the ruling did not contain a provision allowing the trustee to make a non-pro rata distribution and local law did not convey authority on the trustee to make a non- pro rata distribution of property in kind. Where neither the trust instrument nor local law convey authority on the trustee to make a non-pro rata distribution, the beneficiaries are viewed as having an absolute right to a ratable in-kind distribution. Accordingly, the distribution was equivalent to a ratable distribution to the beneficiaries followed by an exchange between the beneficiaries that was subject to section 1001.
Cottage Savings Ass'n v. Commissioner, 499 U.S. 554 (1991), concerns the issue of when a sale or exchange has taken place that results in realization of gain or loss under section 1001. In Cottage Savings, a financial institution exchanged its interests in one group of residential mortgage loans for another lender's interests in a different group of residential mortgage loans. The two groups of mortgages were considered “substantially identical” by the agency that regulated the financial institutions.
The Supreme Court in Cottage Savings, 499
In defining what constitutes a “material difference” for purposes
of section 1001(a) of the Code, the Court stated that
properties are “different” in the sense that is “material” to the Code so long
as their respective possessors enjoy legal entitlement that are different in
kind or extent. Cottage Savings, 499
It is consistent with the Supreme Court's opinion in Cottage Savings to find that the proposed non-pro rata distribution of assets to the By-Pass Trust and the Survivor's Trust will not differ materially from the required funding pursuant to the terms of Trust X so as to give rise to a realization event under section 1001(a) of the Code. The provisions of Trust X require that the By- Pass Trust be funded with so much of Individual B's one-half of community property, there being no separate property, as is required to fund the unified credit and pay for Individual B's applicable expenses, with the remainder going to the Survivor's Trust. It has been represented that Individual A's one-half of community property is sufficient in amount to fully fund the unified credit and pay for Individual B's applicable expenses. Accordingly, the proposed distribution does not give rise to a realization event under section 1001(a).
In addition, the present case is distinguishable from Rev. Rul. 69-486 because it has been represented that Trust X and the applicable state law authorize the Trustee to make a non-pro rata distribution of property. Thus, the By-Pass Trust and Survivor's Trust are not required to receive pro rata distributions for each asset of Trust X. Accordingly, the proposed transaction will not be treated as a pro rata distribution followed by an exchange of assets between the By-Pass Trust and Survivor's Trust.
We conclude that the proposed distribution, whereby Individual A, as sole Trustee of Trust X, makes a non-pro rata allocation of the IRA to the Survivor's Trust, is not a taxable event under section 1001 of the Code.
* * * *
Generally, if a decedent's IRA proceeds pass through a third party, e.g. a trust, and then are distributed to the decedent's surviving spouse, said spouse will be treated as acquiring them from the third party and not from the decedent. Thus, generally, said surviving spouse will not be eligible to roll over the IRA proceeds into her own IRA.
However, in a situation where the surviving spouse has the power to allocate the assets as well as the power to revoke the trust, and cause the assets of the trust to revert to himself or herself, then, for purposes of section 408(d)(3) of the Code, the Service will treat the surviving spouse as having acquired the IRA proceeds from the decedent and not from the trust.
In this case, Trust X is the beneficiary of Individual B's IRA. Subsequent to the death of Individual B, Individual A, Individual B's surviving spouse, became the sole trustee of Trust X. Pursuant to the provisions of Trust X, Individual A, as the surviving trustee, has the sole and uncontrolled discretion to allocate Trust X assets to either the Survivor's Trust or the By-Pass Trust created under the provisions of Trust X. Individual A intends to allocate Individual B's IRA to the Survivor's Trust. Pursuant to the provisions of the Survivor's Trust, Individual A, as trustee, has the power to pay the principal of the Survivor's Trust to herself as Individual B's surviving spouse, and also has the power to terminate the Survivor's Trust. Individual A, as trustee, will pay the IRA assets, less an amount sufficient to satisfy the required distribution rules for 1997, to herself as Individual B's surviving spouse. Individual A will then roll over the IRA distribution into an IRA set up and maintained in her name. Said rollover will occur within 60 days of the date the IRA assets were distributed to Trust X.
Under these circumstances, we do not believe that the general rule above should apply. In such a situation, for purposes of section 408(d)(3) of the Code, the Service will treat the surviving spouse as having acquired the IRA from the decedent and not from the trust.
Thus, with respect to your second and third ruling requests, we conclude that Individual A's IRA account does not represent an inherited IRA within the meaning of section 408(d)(3)(C) of the Code; and that, pursuant to section 408(d)(3) of the Code, Individual A is not required to include in income for federal tax purposes proceeds of Individual B's IRA which will be transferred to an IRA in her own name within 60 days after the date of the distribution from Individual B's IRA to Trust X.[66] [Emphasis added.]
PLR 199925033 is a very important ruling. A died. He was survived by his wife B. A named a revocable living trust as beneficiary of his IRA. All the property in the IRA was community property. A and B were co-settlors of the trust. At A’s death, B became the sole trustee. At A’s death, the trust was to be divided into a survivor’s trust and a credit shelter trust. B was given the power to make nonprorata allocations among the shares and subtrusts. B had the power to revoke or amend the survivor’s trust. The ruling held that the nonprorata allocation of the right to receive the IRA benefits was a nontaxable event. (Note that the ruling does not address the MRD issues at all.)
The following is taken directly from the ruling:
B, as trustee of Trust, intends, as part of an equal, non- prorata partition of the former community property of A and B, to allocate the entire interest in IRA X to Survivor's Trust, and to allocate the entire interest in the other community property assets of equal value (with the values to be determined as of the date or dates of distribution) exclusively to A's one-half share of the former community property. A's partitioned share of the former community property will then be further partitioned and distributed non-pro rata to Decedent's Trust and Residual Trust.
B further intends to exercise B's power of revocation over Survivor's Trust and completely revoke Survivor's Trust. Thus, after IRA X has been allocated to Survivor's Trust, B, as trustee of Trust, will cause the IRA X proceeds to be distributed to herself as her separate property. Upon receipt of the IRA X proceeds, B will then contribute said proceeds into an IRA, set up and maintained in her name, within 60 days of the date of their distribution. B represents that the rollover IRA will meet the requirements of section 408(a) of the Code.
Ruling Request No. 1
Section 691(a)(1) of the Code provides that the amount of all items of gross income in respect of a decedent which are not properly includable in respect of the taxable period in which falls the date of his death or a prior period shall be included in the gross income, for the taxable year when received, of: (A) the estate of the decedent, if the right to receive the amount is acquired by the decedent's estate from the decedent; (B) the person, who, by reason of the death of the decedent, acquires the right to receive the amount, if the right to receive the amount is not acquired by the decedent's estate from the decedent; or (C) the person who acquires from the decedent the right to receive the amount by bequest, devise, or inheritance, if the amount is received after a distribution by the decedent's estate of such right.
Section 691(a)(2) of the Code provides that if a right, described in section 691(a)(1), to receive an amount is transferred by the estate of the decedent or a person who received such right by reason of the death of the decedent or by bequest, devise, or inheritance from the decedent, there shall be included in the gross income of the estate or such person, as the case may be, for the taxable period in which the transfer occurs, the fair market value of such right at the time of such transfer plus the amount by which any consideration for the transfer exceeds such fair market value. For purposes of section 691(a)(2), the term “transfer” includes sale, exchange, or other disposition, or the satisfaction of an installment obligation at other than face value, but does not include transmission at death to the estate of the decedent or a transfer to a person pursuant to the right of such person to receive such amount by reason of the death of the decedent or by bequest, devise, or inheritance from the decedent.
Section 1001(c) of the Code provides that gain or loss generally must be recognized upon the sale or exchange of property. Section 1.1001-1(a) of the regulations provides that the gain or loss realized from the conversion of property into cash, or from the exchange of property for other property differing materially either in kind or in extent, is treated as income or as loss sustained.
Rev. Rul. 76-83, 1976-1 C.B.
213, holds that no gain or loss will be recognized from the approximately equal
division of the fair market value of community property in a community property
state under a divorce settlement agreement that provides for transfer of some
assets in their entirety to one spouse or the other.
The non-pro rata partition into equal shares
of A and B's community property pursuant to the terms of the Trust is in
substance the same as the division of the community property described in Rev. Rul. 76-83. Accordingly, the non-pro rata
partition of A and B's community property in Trust and the allocation of B's
share (the IRA X) to the Survivor's Trust is neither a sale or exchange for
purposes of section 1001, nor a transfer for purposes of section 691(a)(2).
Ruling Request No. 2
Section 676(a) of the Code provides that a grantor will be treated as the owner of a trust, where at any time the power to revest in the grantor title to such portion is exercisable by the grantor or a nonadverse party, or both.
Rev. Rul. 85-13, 1985-1 C.B. 184, holds that if a grantor is treated as the owner of an entire trust, the grantor is the owner of the trust's assets for federal income tax purposes. Therefore, a transfer of trust assets to a grantor who owns the entire trust is not recognized as a sale for federal income tax purposes.
In this case, B is considered to be the grantor of Survivor's Trust, the assets of which represent her partitioned share of Trust's assets. Additionally, B holds a power to revoke Survivor's Trust, and, therefore, will be treated as the owner of Survivor's Trust under section 676(a). Therefore, because B is treated as the owner of the IRA X, the transfer of the IRA X to B is not a transfer for purposes of section 691(a)(2) and will not result in the recognition of gain under section 691(a)(2).
* * * *
In this case, B, the surviving spouse of A, became the sole trustee of Trust and, under the terms of Trust, had the “full power” to allocate the assets of Trust among Survivor's Trust, Decedent's Trust, and Residual Trust.
At his death, A held IRA X with Custodian which A and B classified as community property under the terms of the Agreement. B, as sole trustee of Trust, will allocate A's 50% interest in IRA X and B's 50% community property interest in IRA X to Survivor's Trust. B is empowered to revoke Trust 2, and B intends to do so. As a result, the assets of Survivor's Trust, including the proceeds of IRA X maintained in the name of A at his death, will pass to B. B then intends to request distribution from IRA X and, upon receipt, roll over the distribution into an IRA set up and maintained in B's name.
Generally, if a decedent's IRA proceeds pass through a third
party, e.g., a trust, and then the proceeds are distributed to the decedent's
surviving spouse, the spouse will be treated as acquiring them from the third
party and not from the decedent. Thus, generally, the surviving spouse will not
be eligible to roll over the IRA proceeds into her own IRA.
In this case [however], B, the surviving spouse of A, has the power under the provisions of Trust to allocate IRA X to Survivor's Trust. B intends to exercise that power. Upon allocation, B will terminate Survivor's Trust which will result in IRA X passing to B. B will then request a distribution of IRA X and roll over the IRA X proceeds into an IRA set up and maintained in her name. Thus, in this case, control over the assets of IRA X will at all times lie exclusively with B. As a result, the general rule does not apply.
Based on the foregoing, we hold that, for purposes of section 408(d)(3) of the Code, B will be treated as the beneficiary of IRA X. Thus, B will be treated, for purposes section 408(d)(3), as receiving the IRA funds from the decedent and not from the decedent's estate.
Accordingly, we conclude that IRA X does not constitute an “inherited IRA” within the meaning of section 408(d)(3)(C) of the Code, and pursuant to section 408(d)(3), B will not be required to include in B's taxable income the value of the IRA proceeds of IRA X which are distributed to her, so long as they are transferred into the rollover IRA within 60 days of their distribution.
We believe that the Employee Retirement Income Security Act of
1974 (“ERISA”) preempts state community property laws with respect to qualified
plans. See Boggs v. Boggs, 520
In this case, B's right to A's benefits under Plan Y or Plan Z consisted of B's right to receive a joint and survivor annuity under each plan. As noted above, B waived her right to joint and survivor annuities before A received lump sum distributions from qualified plans and rolled those distributions over into his IRA. There were no conflicting claims to the benefits under the qualified plans.[67] [Emphasis added.]
Aside from the question of whether or not a nonprorata division of community property is a taxable sale or exchange, there is the independent issue, applicable in the case of IRD, of whether assignment of income principles would operate to cause taxation to the person or estate doing the assigning.[68] This is an issue that is as intriguing as it is unclear.
For instance, what if there is a prorata division; i.e., the estate takes half and the survivor takes half. Any problem with assignment of income here? Has the IRA owner made an assignment of income? In order to answer that question, it is probably necessary that one be able to answer the question of who would be taxed for income tax purposes in the case of a distribution during life.
IRC §408(d)(1) states—
Except as otherwise provided in this subsection, any amount paid or distributed out of an individual retirement plan shall be included in gross income by the payee or distributee, as the case may be, in the manner provided under section 72. [Emphasis added.]
IRC §408(g) states—
This section shall be applied without regard to any community
property laws.
It is well known that the meaning of 408(g) may depend on its context and that, depending on that context, 408(g) is not always interpreted literally.[69]
If, during lifetime, a distribution of community property from the participant’s IRA would be taxed to both spouses equally, if separate returns were filed, then in a prorata distribution, at least, the income would follow the distribution. Obviously, however, if one concludes that 408(g) is to be applied literally during life, such that the participant, if filing separately, would recognize all of the IRA distribution, community or no, then only a nonprorata division in favor of the participant could escape the charge of assignment of income.
Perhaps whoever receives the proceeds should be taxed on it, since whoever receives the proceeds is the “payee” under 408(d)(1). See, for example, PLR 8040101, where the IRS said that the statement found in IRC §408(g) that the IRA rules “shall be applied without regard to any community property laws,” relates solely to the deduction rules found in IRC §219.[70]
PLR 8040101 was concerned with the income tax treatment afforded a living participant, half of whose IRA was getting ready to be distributed to his wife’s siblings under applicable community property law as a result of her death. The IRS said that the wife’s beneficiaries ought to pay the income tax on the distributions received by them on account of the wife’s death, not the still living participant husband. What if, instead, it was the husband/participant who died first, leaving the wife’s community property interest to the husband’s siblings (or to charity)? There the case is stronger, it seems to me, for the conclusion that the beneficiaries (rather than the wife) ought to be taxed on the distribution to them for income tax purposes; and in this case, the wife will argue that 408(d)(1) specifically taxes the payee or distributee —and she is neither. Moreover, 408(g) simply reaffirms 408(d)(1) in this context, in case there was any doubt. Again, however, as with so many other income tax issues involving community property, authoritative guidance is lacking with respect to the many permutations to which death and marriage can give rise when an IRA is distributed.
This section is somewhat repetitive of the above discussion, but it also deserves separate consideration. If the spouse of an IRA owner dies, leaving a residuary estate in trust, it is probably fairly common in practice to allocate the decedent’s community half interest in the IRA to the surviving IRA owner, despite the concerns about possible income acceleration discussed above. Of course, the trust will have to be made whole, presumably out of the IRA owner’s community interest in other assets under administration. But what if it is the IRA owner who died, leaving the IRA to the estate or to a trust?
If the trust or the will makes it clear that the deceased IRA owner was not attempting to deprive the surviving spouse of the spouse’s community interest in the IRA despite the designation, then the spouse is arguably entitled to at least half the IRA, and is probably entitled to roll that half over. If that is true, can the trustee or the executor allocate the decedent’s entire IRA to the surviving spouse, so that the spouse can rollover the entire IRA, even though the estate or trust was the named beneficiary of at least the decedent’s half? Acceleration of income ought not to be a problem if followed by a rollover. Still, this is a fairly aggressive technique. If this works, is there any way that a similar technique could be employed in a non community property state?
The idea makes even more sense in the context of an inter-vivos joint revocable trust, where the trustee is directed to divide the trust on death of one of the settlors into a survivor’s share and a decedent’s share. If the survivor’s share gets the IRA proceeds, and if the survivor has complete control over the proceeds, there is precedent for allowing the survivor to roll the proceeds over.
In that case, the trust instrument can make it clear that the trustee has the authority to make nonprorata divisions, without the consent of the beneficiary. As previously pointed out, acceleration of IRD upon disposition of an interest in an estate is more likely if consent of the owner is required than if it is not. Contrast the income tax treatment that obtains in a case where the residuary beneficiary must consent to a nonprorata division, with the case where the executor has unilateral authority under the instrument or state law to make the nonprorata division. The trust can give that authority to the trustee. This is arguably a better income tax position to be in than where it is the survivor’s IRA (sole management community property), and the survivor’s consent is required to place the property under management by the executor in the first place before it can be allocated back.
A word about the citations used in this section: §402 has been amended over the years more frequently than any other section of the IRC of which I am aware. What is worse, it has not merely been re-written and added to, the sections have all changed, in some instances several times, so that, for example, a previous reference to 402(d), is now a reference to 402(e); and as a result of the most recent legislation, a whole group of references will all change in 2000. I have not had the time to cross-reference all the changes that have taken place since 1986, and therefore I warn you that there may be citations to the IRC in this section that are no longer be accurate.
The determination of whether or not a distribution qualifies as a lump sum distribution for averaging purposes has always been difficult, but now we must take into account the new rules enacted by TRA '86 and The Small Business Job Protection Act of 1996[71] (SBJPA).
Most of the references to §402(d) would have been references to 402(e) prior to the TRA.[72] The Small Business Job Protection Act of 1996 (the SBJPA) repeals 402(d) effective in the year 2000. The provisions of §402(d)(4) defining a “lump sum distribution will then become §402(e)(4)(D).
Under IRC §402(e)(4)(A), a "lump sum distribution" for purposes of IRC §§402 and 403 means the distribution or payment within one taxable year of the recipient of the balance to the credit of an employee which becomes payable to the recipient-
(i) on account of the employee's death,
(ii) after the employee attains age 591/2,
(iii) on account of the employee's separation from service (this rule doesn't apply if the employee is a self-employed individual), or
(iv) after the employee becomes disabled (this rule only applies if the employee is a self-employed individual).
As indicated above, a self-employed individual cannot separate from service for purposes of the lump sum averaging rules.[73]
Further, it has long been the position of the IRS that an employee who continues in the same job has not “separated from service,” even though the employee technically works for a different employer as a result of a merger, liquidation or other reorganization.[74] This is sometimes referred to as the “same desk rule.”
In service distributions are generally not permissible in the case of a pension plan. Note however, that for this purpose, the same desk rule does not apply with the same rigor.[75]
Effective for tax years beginning after 1986, TRA '86 amended IRC
§402(d)(4)(B) to provide that even if the requirements of IRC §402(d)(4)(A)
are met, 10-year averaging is now only
available if the lump sum distribution is received after age 591/2, and no more than one election can be made on behalf of
any one employee. There is an exception for persons who were 50 on
TRA §1122(h)(3)(ii) provides that the age 591/2 requirement found
in IRC §402(d)(4)(B) does not apply to a participant who was age 50
before
The TRA grandfather rule appears only to address §402(d)(4)(B). This means that the Participant would still have to satisfy §402(d)(4)(A). Therefore, if the participant has not separated from service, the participant would probably still need to have attained 591/2 in order to be eligible for averaging.
Even though the SBJPA repealed five-year forward averaging, it did specifically did not repeal TRA §1122(h)(3) or (5), except to state that only 10-year, and not 5-year, averaging would be available to grandfathered participants.[77]
A "lump sum distribution" for purposes of IRC §§402 and 403 must be a distribution or payment of the "balance to the credit" of an employee on account of one of the triggering events listed above. A determination that this requirement has been met is not as easy as it may first appear.
Problems arise where there have been distributions in previous years. For instance:
A lump sum distribution upon the employee's death after periodic payments have commenced may qualify for 10 year averaging in the hands of the employee's beneficiary.[78]
A lump sum distribution when the employee attains 591/2 may qualify for 5/10 year averaging even though annuity payments commenced upon the employee's previous separation from service.[79]
A lump sum in satisfaction of future payments on an annuity distribution will usually not qualify for 10 year averaging in the absence of a new triggering event.[80]
DECs aren't included in the determination of the "balance to the credit."
The balance to the credit probably does not include contributions and trust earnings credited to the account after the distribution.[81]
“For purposes of determining whether any distribution which becomes payable to the recipient on account of the employee’s separation from service is a lump sum distribution, the balance to the credit of the employee shall be determined without regard to any increase investing which may occur if the employee is reemployed by the employer.”[82]
The term "balance to the credit" includes amounts not forfeited at the end of the recipient's taxable year within which the distribution is made, except that if the employee has separated from service and incurs a break in service, the term does not include an amount that is forfeited (by reason of the break) at the close of the plan year beginning with or within the recipient's taxable year.[83]
If a partially vested participant separates from service, elects lump sum averaging, is rehired, and advances on the vesting schedule, income taxes in the year in which the increased vesting occurs shall be increased by the reduction in tax resulting from 10-year averaging, but the original one time election to average shall be disregarded for purposes of determining entitlement to any future election.
If a partially vested participant rolls over her distribution, 10-year averaging is not available with respect to a subsequent distribution from the employer if the participant returns to employment and moves up on the vesting schedule. IRC §402(a)(6)(G)(ii)
To determine the balance to the credit, the following are aggregated:[84]
(i) All the trusts of a single plan;
(ii) All the pension plans (money purchase and defined benefit) the employer maintains;
(iii) All the profit sharing plans the employer maintains;
(iv) All the stock bonus plans the employer maintains.
Note that the related party rules of §414 do not apply to §402; therefore the plans of related employers do not have to be aggregated.
The recipient must elect lump sum distribution treatment in order to receive it. It is probable that prior to TRA '86, such election had to be made with respect to all distributions from all plans made during the same taxable year and which are eligible for lump sum treatment, even if the plans are of different types.[85] But see Prop. Reg. §1.402 (e)(2)(e)(1)(iii) Example (1). The 1986 IRC is now explicit that the taxpayer must elect averaging with respect to all lump sum distributions received in the year of the election.[86]
The election is made on Form 4972.
Under TRA '86, no more than one election can be made on behalf of any one employee.
The proposed regulations clearly state that a death distribution made to more than one beneficiary will not qualify for lump sum averaging (unless all the beneficiaries are trusts).[87] However, although the proposed regulation has not been withdrawn, the Commissioner changed his mind over 15-years ago within months of issuing the regulations.[88] Form 4972, on which lump sum averaging distributions are reported, contemplates that each beneficiary will pay his prorata portion of a tax that is computed on the entire distribution. However, there is no requirement that all the beneficiaries make the election: each death beneficiary may separately elect whether or not to utilize lump sum averaging.[89]
If a lump sum distribution is payable on account of the death of a participant, the 5-year active participation requirement discussed below is inapplicable.[90]
IRC §402(d)(4)(B) provides that no more than one election may be made with respect to any “employee”; however, the beneficiary is not that employee. Therefore the beneficiary may make a lump sum averaging election without regard to whether he has or will make another election in his capacity as an employee.
A distribution to two or more trusts is treated as a distribution to one recipient.[91] If two or more trusts are recipients of the lump sum distribution, the personal representative of the taxpayer is to make the election.[92] It would appear, therefore, that the same election must be made with respect to all trusts; and further, if there is more than one trust, 402(d)(4)(B) might be read as requiring that the same election must be made with respect to the entire distribution on behalf of all beneficiaries (whether or not trusts) by the taxpayer's personal representative.
10-year averaging can be elected by a death beneficiary despite the fact that the participant if living could not have made the election. An example in point is the 5-year active participation requirement mentioned above. However, the Tax Court has held that the requirement that the participant be at least 59 1/2 applies in the case of death, as in life.[93]
The employee must have actively participated in the plan for at least 5 taxable years before the taxable year in which he receives the distribution.[94] (This rule does not apply to distributions on the death of the employee.)[95] Assuming that active participation under §402(d)(4)(F) has the same meaning as under Treas. Reg. §1.219-2, the following rules will apply. I believe that this rule has been repealed for all purposes(!) but as I am not sure of how the Grandfathering rules work here, I have not taken the time to re-write this section.
But see Notice 87-13!!
An employee will be considered an active participant in a defined benefit plan if for any portion of the plan year ending with or within his taxable year he is not excluded under the eligibility provisions of the plan. However, if an individual is a participant but does not accrue a benefit because of integration with social security, he will not be considered an active participant.
An employee will be considered an active participant in a money purchase plan if under the terms of the plan employer contributions must be allocated to the employee's account with respect to the plan year ending with or within his taxable year. This rule applies even if an individual is not employed at any time during the individual's taxable year.
An employee will be considered an active participant in a profit sharing or stock bonus plan if a forfeiture is allocated to his account as of his taxable year. An individual will also be considered an active participant if an employer contributions is added to his account during such taxable year. A contribution is added to a participant's account as of the later of the following two dates: the date the contribution is made or the date on which it is allocated. Thus if a contribution is made in an individual's taxable year 2 and allocated as of a date in individual's taxable year 1, the later of the relevant dates is the date the contribution is made. Consequently, the individual is an active participant in year 2 but not in year 1 as a result of that contribution.
If an employee makes a voluntary or mandatory contribution to a plan, such employee is an active participant in the plan for the taxable year in which such contribution is made.
Applying the foregoing rules, if the plan is a profit sharing plan, the employee will not be considered an active participant with respect to any year in which there was no employer contribution made, no forfeitures allocated, and no voluntary nondeductible contribution made by the employee.
The regulations key the determination of the active participant to
the plan year ending with or within the individual's taxable year. In a profit
sharing plan it is the taxable year of
the individual in which the employer actually
made the contribution, or the allocation date of a forfeiture, that is used
to determine the year of active participation. For example , if a contribution
was made in March of 1986 on behalf of a 1985 calendar year plan, the
individual would be an active participant for 1986. If a forfeiture was
allocated as of
Note however, that Gary I. Boren, in §13:35 of Qualified Deferred Compensation Plans, says that, unless a profit sharing plan is frozen, the employee must only have been entitled to a contribution if a contribution had been made. He cites PLR 8447056.
The employee may include his years of active participation in a prior plan where the trustee of the prior plan transferred the employee's interest to the distributing plan.[96]
The distribution must not be subject to the penalty tax applicable to certain distributions to 5% owners under §72(m)(5)(A)(ii). (This rule will hardly ever apply.)
The question of what qualifies as a lump sum distribution for averaging and capital gains purposes is often not an easy one. See above. Assuming, however, that the distribution is a "lump sum distribution" within the meaning of the IRC, the following special rules apply:
Recipients of distributions qualifying for lump sum treatment are afforded a special tax opportunity. Under certain circumstances, the participant may divide the distribution by 5, add this amount to an amount equal to the zero bracket amount for an unmarried taxpayer, compute what the tax would be if this were the participant's only income, and multiply by 5 to determine the total tax.[97] On most distributions, this can achieve substantial tax savings, since the distribution is subject to a lower tax rate than would have otherwise been the case if income tax were computed on the basis of the entire distribution added to the taxpayer's other income.
If a portion of the distribution was also subject to capital gains treatment on account of pre 1974 years of participation, then the tax computed is multiplied by a fraction, the numerator of which was the number of calendar years of active participation by the employee in such plan after December 31, 1973, and the denominator of which was the number of calendar years of participation by the employee in such plan.[98]
If the distribution is less than $70,000, the total taxable amount is reduced by a "minimum distribution allowance." The minimum distribution allowance is the lesser of $10,000, or 1/2 of the total taxable amount. The allowance is then reduced by 20% of the excess of the total taxable amount above $20,000.[99] The operation of the arithmetic insures that the minimum distribution allowance will disappear entirely in the case of a distribution over $70,000.
Prior to 1988, 5-year averaging was 10 year averaging. TRA §1122(h) provides that a participant who was age 50 before January 1, 1986 may elect either 5-year averaging under the new rules or 10 year averaging under the old rules using 1986 tax rates.[100] If this election is made the general averaging rules cannot be used.
The following com
Amount of
Lump Sum 1986 Tax 1987 Tax 1988 Tax
$25,000 $1,801 $2,040 $2,400.00
$50,000 $5,874 $6,540 $6,900.00
$75,000 $10,305 $10,890 $11,250.00
$100,000 $14,471 $16,720 $16,397.50
$125,000 $19,183 $23,720 $23,397.50
$150,000 $24,570 $31,770 $30,397.50
$175,000 $30,422 $40,520 $37,397.50
$200,000 $36,922 $49,270 $44,397.50
$250,000 $50,770 $66,770 $60,110.00
$300,000 $66,330 $85,320 $76,610.00
$400,000 $102,602 $123,820 $109,610.00
$500,000 $143,682 $162,320 $142,610.00
In 1990, ten-year averaging will be more favorable than five-year averaging for a single taxpayer on distributions less than $465,700.
According to the TAMRA[101] Conference Agreement, a spouse who is an alternate payee under a QDRO should be able to elect 5/10 year averaging under certain circumstances:
The conference agreement makes income averaging available with respect to distributions to an alternate payee who is a spouse or former spouse of the employee. In particular, the conference agreement provides that if a distribution of the balance of the credit to the employee would constitute a lump-sum distribution, then a distribution of the balance of the credit to the alternate payee constitutes a lump-sum distribution. In determining whether the distribution consists of the balance to the credit of the alternate payee, only the interest of the alternate payee is taken into account.
Prior to TRA '86, the portion of a distribution which is attributable to pre 1974 participation years may be eligible for capital gains treatment. This rule has been repealed by TRA '86, subject to a transition rule and a grandfather rule.
Until 1992, a portion of a distribution which would have been subject to capital gains treatment prior to TRA '86 is taxed at 1986 capital gain rates, generally 20%. That portion of a distribution which would have been subject to capital gains treatment prior to TRA '86 is multiplied by a "phase out percentage" as follows:[102]
In the case of distributions The Phase-out
during calendar year: percentage is:
1987..................... 100
1988....................... 95
1989....................... 75
1990....................... 50
1991....................... 25
TRA §1122(h)(3) provides that a participant who was age 50[104] before January 1, 1986 may forever elect the 1986 capital gains rules without regard to the 5-year phase out, using a 20% capital gains rate.[105] If this election is made the general averaging rules cannot be used.[106]
IRC §402(a)(2), prior to its repeal by the 1986 Tax Reform Act,
provided that so much of a lump sum distribution as was attributable to pre
1974 years of participation was eligible for capital gains treatment. This
portion was computed as a fraction, the
numerator of which was the number of calendar years of active participation by
the employee in such plan before
The 5-year active participation test ordinarily applicable for lump sum distribution treatment did not apply in order to receive capital gain treatment.[109] Moreover, capital gain treatment was automatic, no election being necessary unless the employee was self-employed.[110]
However, under Pre TRA IRC §402(d)(4)(L), the employee could elect to treat all calendar years of an employee's active participation in all plans in which the employee has been an active participant as years of active participation by such employee after December 31, 1973. The election is irrevocable and applies to all lump sum distributions received by the taxpayer with respect to the employee. The special treatment does not apply if the taxpayer received a lump sum distribution in a previous taxable year of the employee beginning after December 31, 1975 if any portion was treated as long term capital gains under repealed IRC §402(a)(2) or 403(a)(2). A taxpayer might want to make this election in order to avoid the alternative minimum tax under IRC §55, or to achieve more favorable rates under 5/10 averaging.
Often an employee will have made nondeductible contributions to a qualified retirement plan. When this happens he acquires a basis in the benefit (an investment in the contract). When the benefit is later paid to the employee there needs to be some allocation between that portion of the benefit which represents the recovery of basis and the ordinary income component which is attributable to employer contributions.
The subject to be discussed under this heading is the taxation of true employee after-tax contributions. I may also make mention of the long-since discontinued deductible employee contribution (DEC) just to complicate things considerably. DECs were only allowed between 1982 and 1986 (inclusive), and are taxed under §72(o).
Unless this subject is of great importance, I suggest that the reader skip this portion of the outline, and read instead a summary from a tax handbook, perhaps. The summaries made for popular consumption serve a very useful purpose, and some of them are quite good. However, if one takes the time to really explore the statute itself and the regulations, one will be surprised to find that this area is much more complicated than a general summary would suggest. What follows under this heading does not even begin to do the subject justice, but even then I find it daunting and the reader may find it so too. Before passing judgment, read §72 and the regulations under it. Then, perhaps, you will appreciate the nature of this beast.
When I began to write this portion of the outline, I was going to simply regurgitate the general rules that most of us know. Unfortunately, my compulsive instinct took me to the statute itself, which I found to my horror to be riddled with so many exceptions, amendments, and unmarked cross-references as to be all but incomprehensible. My approach is to rely on original source materials, primarily the IRC and the regulations for my conclusions. This approach, in this case, does not make for easy reading.
§72 is a complex statute. Not as complex as §402, perhaps; but close. Among other things, one must first distinguish constantly between employer contributions, voluntary deductible employee contributions and voluntary nondeductible employee contributions, all of which may have accrued at different times under different rules and subject to different grandfathering provisions, and under different plans and contracts, which may or may not be required to or allowed to be aggregated, assuming the necessary records are there; and all of which accounts (within this context) may have been invested in employer stock at various times, with various basis, all subject to different sets of rules depending inter alia on the form the distribution takes.
Part of the reason for the complexity in this area is that §72 serves two very different purposes. One the one hand, the statute is designed to tax conventional annuities under conventional insurance arrangements. On the other hand, it is used to determine the timing of income inclusion for qualified plan distributions described in §402 and IRA distributions described in §408. Much of this is done by cross-reference, so one cannot just read §72 without simultaneously consulting §402 or §408 (as the case may be) in order to determine the meaning of the terms used, exceptions to general rules, etc. Since all three statutes are amended at least bi-annually and often more frequently, quite a bit of mental juggling is called for. The dual role of §72 may account for its somewhat unusual nomenclature. There are odd terms the meaning of which is defined in ways sometimes contrary to everyday usage. For example, employee deferrals are not employee contributions, an annuity contract does not always imply the existence of an annuity, and employee after-tax contributions are referred to as an investment in a contract, where the contract is the right to a benefit under a qualified plan —a synonym for an account under a profit sharing plan, perhaps.
To make matters worse, §72 draws a distinction between annuity distributions and other distributions, and between distributions that are before the annuity starting date and distributions after the annuity starting date which, in turn may or may not be identical to distributions before and after separation from service, even though in some cases it is obvious that the usage is intended to be synonymous. These distinctions are the basis for a statutory scheme that is often difficult to follow. As a result, the statute does not always make sense or even necessarily mean what it says.
The basic statutory scheme is that qualified plan distributions are taxed under §402 and IRAs under §408, but both look to §72 primarily to determine the timing of income recognition (in the main) where the employee has made after-tax contributions to the plan in which he or she has a basis to recover.
Except as otherwise provided in this section [§402], any amount actually distributed to any distributee by any employees' trust described in section 401(a) which is exempt from tax under section 501(a) [i.e., distributions from qualified plan] shall be taxable to the distributee, in the taxable year of the distributee in which distributed, under section 72 (relating to annuities).[111]
* * * *
Except as otherwise provided in this subsection [§408(d)], any amount paid or distributed out of an individual retirement plan [IRA] shall be included in gross income by the payee or distributee, as the case may be, in the manner provided under section 72.[112]
* * * *
§72(a), in turn, provides:
Except as otherwise provided in this chapter [Ch. 1, Normal Taxes, e.g., income taxes], gross income includes any amount received as an annuity (whether for a period certain or during one or more lives) under an annuity, endowment, or life insurance contract.[113] [Emphasis added.]
As a general rule, unless the employee has made contributions (constructively or otherwise) to the plan, the taxation timing rules are simple: the employee (or beneficiary) is taxed in full as and when payments are received. We are concerned here with the “except as otherwise provided” situations referred to in the statute.
§72 and the regulations together make up around 100 pages of “otherwise provideds,” much of which is concerned with the timing recognition rules of employee contributions. But before delving into these rules, we must first address the terminology.
Salary reduction or cash or deferred contributions under a 401(k) plan are not employee contributions. They are treated for tax purposes as having been made by the employer in exchange for an agreement by the employee to take a smaller salary or less wages.
(3) Elective contributions. The term “elective contribution” means employer contributions made to a plan that were subject to a cash or deferred election under a cash or deferred arrangement (whether or not the arrangement is a qualified cash or deferred arrangement under paragraph (a)(4) of this section). No amount that has become currently available to an employee or that is designated or treated, at the time of deferral or contribution, as an after-tax employee contribution may be treated as an elective contribution. . . .[114]
* * * *
(ii) Treatment of elective contributions as employer contributions. Except as provided in paragraph (f) of this section, elective contributions under a qualified cash or deferred arrangement are treated as employer contributions.[115]
Most of §72 (particularly (a)-(d)) is concerned with annuity distributions. If the distribution is not in annuity form, we look to §72(e).
72(e) applies to “any amount which — (i) is received under an annuity . . . contract, and is not received as an annuity.”[116] (Received under an annuity contract and not received as an annuity?) The regulations explain the general scheme:
(b) Amounts to be considered as a return of premiums. For the purpose of determining the extent to which amounts received represent a reduction or return of premiums or other consideration paid, the provisions of section 72 distinguish between “amounts received as an annuity” and “amounts not received as an annuity”.[117]
The statute does not really tell us what an annuity is, but the regulations do.
In general, “amounts received as an annuity” are amounts which are payable at regular intervals over a period of more than one full year from the date on which they are deemed to begin, provided the total of the amounts so payable or the period for which they are to be paid can be determined as of that date. See paragraph (b)(2) and (3) of §1.72-2. Any other amounts to which the provisions of section 72 apply are considered to be “amounts not received as an annuity”. See § 1.72-11.[118]
Under this unusual nomenclature, a payment of a person’s fixed account balance in two annual payments would be an “annuity.” Do give but one example of the problems with this odd bifurcation of distribution types: Is a large sum payable in one year, followed by lesser amounts payable in each succeeding year part of an annuity? Probably not.[119] But it could be argued that it fits the definition nevertheless.
Another important concept is that of the “annuity starting date.”
The “annuity starting date” is a term of art. It used in the IRC 27 times, and 11 times in Subchapter D (§§401-424). It is used in the regulations 82 times, in §1.72 for the most part. It is defined [sic] in IRC §72(c)(4) generally as “the first day of the first period for which an amount is received as an annuity.”[120] Interestingly, the §401 regulations define the phrase to mean “the first day of the first period for which an amount is paid as an annuity or any other form.”[121]
If the employee has no investment in the plan (e.g., after-tax employee contributions), the taxation timing rules of §72 are simple. As indicated by §72(a), quoted above, “except as otherwise provided . . . gross income includes any amount received as an annuity.” If not received as an annuity, §72(e) will also tax it immediately, though the statutory language under which this conclusion is reached is not so straight forward.
The employee’s “investment in the contract” is generally exempt from further taxation. In theory, the investment in the contract represents property on which the employee has already paid income tax. An employee’s after-tax contributions are the most common form of investment in the contract.
In the insurance arena, the idea of an investment in the insurance contract makes sense. This terminology as applied to qualified plans is less intuitive, though it made more sense when insured benefits played a greater role in securing pension benefits. In the context of the conventional trusteed qualified plan one could consider (rightly) that the employee’s rights to benefits under the plan are contractual in nature.
Accordingly, to the extent the employee has contributed to the plan (made and investment in the contract) with money that has already been taxed. The employee therefore has a basis in the plan that can be used to offset the amount of the distribution that is treated as ordinary income. Although the employee’s investment in the contract usually includes only after-tax employee contributions, certain employer contributions that are taxed to the employee (e.g., PS-58 cost of life insurance) are treated as employee contributions.[122]
The basic definition of “investment in the contract” is found in §72(c)(1), where payments are being received in the form of an annuity. An almost identical definition is found in 72(e)(6), where payments are not in the form of an annuity. The investment in the contract is defined in 72(c)(1) as:
(A) the aggregate amount of premiums or other consideration paid for the contract[123], minus
(B) the aggregate amount received under the contract before such date [i.e., the annuity starting date], to the extent that such amount was excludable from gross income under this subtitle or prior income tax laws.[124]
In the case of a distribution that is not in annuity form —see IRC §72(e)(6))—, the “date” referred to is the distribution date.[125]
An extremely important notion is that of the “separate contract.”
For purposes of applying section 72 to such distributions and payments (other than those described in subdivision (iii) of this subparagraph), each separate program of the employer consisting of interrelated contributions and benefits shall be considered a single contract. Therefore, all distributions or payments (other than those described in subdivision (iii) of this subparagraph) which are attributable to a separate program of interrelated contributions and benefits are considered as received under a single contract.[126]
Employee contributions under a defined contribution plan are separate contracts by definition:
(2) Treatment of employee contributions under defined contribution plans. For purposes of this section, employee contributions (and any income allocable thereto) under a defined contribution plan may be treated as a separate contract.[127]
(10) Determination of investment in the contract in the case of qualified domestic relations orders. Under regulations prescribed by the Secretary, in the case of a distribution or payment made to an alternate payee who is the spouse or former spouse of the participant pursuant to a qualified domestic relations order (as defined in section 414(p)), the investment in the contract as of the date prescribed in such regulations shall be allocated on a pro rata basis between the present value of such distribution or payment and the present value of all other benefits payable with respect to the participant to which such order relates.[128]
It is tempting, but possibly misleading, to look first at §72(b):
Gross income does not include that part of any amount received as an annuity under an annuity, endowment, or life insurance contract which bears the same ratio to such amount as the investment in the contract (as of the annuity starting date) bears to the expected return under the contract (as of such date).[129] [Emphasis added.]
§72(b)(1) was quoted because the methodology suggested by it is
instructive and because it still applies where the annuity starting date is
prior to November 19, 1996. However, §72(b)
does not apply to distributions from
retirement plans having annuity starting dates after
(1) Simplified method of taxing annuity
payments.
(A) In general. In the case of any amount received as an annuity under a qualified employer retirement plan —
(i) subsection (b) shall not apply, and
(ii) the investment in the contract shall be recovered as provided in this paragraph.[131]
However, we cannot dismiss §72(b) quite so readily:
(ii) Certain rules made applicable. Rules similar to the rules of paragraphs (2) and (3) of subsection (b) shall apply for purposes of this paragraph.[132]
§72(c)(3) describes how the “expected return” is to be determined.
(3) Expected return. For purposes of subsection (b), the expected return under the contract shall be determined as follows:
(A) Life expectancy. If the expected return under the contract, for the period on and after the annuity starting date, depends in whole or in part on the life expectancy of one or more individuals, the expected return shall be computed with reference to actuarial tables prescribed by the Secretary.
(B) Installment payments. If subparagraph (A) does not apply, the expected return is the aggregate of the amounts receivable under the contract as an annuity.[133]
The basic thrust of the statute needs no paraphrasing:
(B) Method of
recovering investment in contract.
(i) In general. Gross income shall not include so much of any monthly annuity payment under a qualified employer retirement plan as does not exceed the amount obtained by dividing —
(I) the investment in the contract (as of the annuity starting date), by
(II) the number of anticipated payments determined under the table contained in clause (iii) (or, in the case of a contract to which subsection (c)(3)(B) applies, the number of monthly annuity payments under such contract).
(ii) Certain rules made applicable. Rules similar to the rules of paragraphs (2) and (3) of subsection (b) shall apply for purposes of this paragraph.
(iii) Number of anticipated payments. If the annuity is payable over the life of a single individual, the number of anticipated payments shall be determined as follows:
|
If the age of the annuitant on the annuity starting date is: |
The number of anticipated payments is: |
|
Not more than 55 |
360 |
|
More than 55 but not more than 60 |
310 |
|
More than 60 but not more than 65 |
260 |
|
More than 65 but not more than 70 |
210 |
|
More than 70 |
160. |
(iv) Number of anticipated payments where more than one life. If the annuity is payable over the lives of more than 1 individual, the number of anticipated payments shall be determined as follows:
|
If the combined ages of annuitants are: |
The number is: |
|
Not more than 110 |
410 |
|
More than 110 but not more than 120 |
360 |
|
More than 120 but not more than 130 |
310 |
|
More than 130 but not more than 140 |
260 |
|
More than 140 |
210. |
§72(c)(2) contains an adjustment where there is a refund feature;
for instance, where the expected return depends on life expectancy, but there
is a term certain feature. However, this adjustment does not apply to
distributions from qualified plans after
A ceiling has been placed on the deduction. The basis (the investment in the contract) is the outer limit on the amount that can be excluded, even if the annuitant outlives his life expectancy:
(2) Exclusion limited to investment. The portion of any amount received as an annuity which is excluded from gross income under paragraph (1) shall not exceed the unrecovered investment in the contract immediately before the receipt of such amount.[136]
If the annuitant dies and benefits cease prior to complete recovery of basis, the unrecovered basis may be deducted on the final return.
(3) Deduction where
annuity payments cease before entire investment recovered.
(A) In general. If —
(i) after the annuity starting date, payments as an annuity under the contract cease by reason of the death of an annuitant, and
(ii) as of the date of such cessation, there is unrecovered investment in the contract,
the amount of such unrecovered investment (in excess of any amount specified in subsection (e)(5) which was not included in gross income) shall be allowed as a deduction to the annuitant for his last taxable year.
(B) Payments to other persons. In the case of any contract which provides for payments meeting the requirements of subparagraphs (B) and (C) of subsection (c)(2), the deduction under subparagraph (A) shall be allowed to the person entitled to such payments for the taxable year in which such payments are received.
(C) Net operating loss deductions provided. For purposes of section 172, a deduction allowed under this paragraph shall be treated as if it were attributable to a trade or business of the taxpayer.[137]
(E) Exception. This paragraph shall not apply in any case where the primary annuitant has attained age 75 on the annuity starting date unless there are fewer than 5-years of guaranteed payments under the annuity.[138]
If, in connection with the commencement of annuity payments under any qualified employer retirement plan, the taxpayer receives a lump sum payment —
(i) such payment shall be taxable under subsection (e) as if received before the annuity starting date, and
(ii) the investment in the contract for purposes of this paragraph shall be determined as if such payment had been so received.[139]
(D) Investment in the contract before 1987. In the case of a plan which on May 5, 1986, permitted withdrawal of any employee contributions before separation from service, subparagraph (A) shall apply only to the extent that amounts received before the annuity starting date (when increased by amounts previously received under the contract after December 31, 1986) exceed the investment in the contract as of December 31, 1986.[140]
If the Grandfather rule applies, the employee may ignore the new
rule requiring the prorata inclusion of income, and may instead exclude all
amounts received until the investment in the contract as of
For other grandfather rules, see 72(e)(5). This outline does not begin to address all of the grandfather rules in this area.
This ought to be quite simple, but §72(e) is very obscure on this point, making distinctions that are difficult to follow.
(e) Amounts not received as annuities.
(1) Application of
subsection.
(A) In general. This subsection shall apply to any amount which —
(i) is received under an annuity, endowment, or life insurance contract, and
(ii) is not received as an annuity,
if no provision of this subtitle (other than this subsection) applies with respect to such amount.
(B) Dividends. For purposes of this section, any amount received which is in the nature of a dividend or similar distribution shall be treated as an amount not received as an annuity.[141] [Emphasis added.]