Advanced Underwriting Consultants

Ask the Experts – June 20, 2014

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers. Here’s the question of the day.

Question: Can my client invest his IRA funds in real estate?

Answer: It depends on the IRA custodian. As long as the rules prohibiting self-dealing are followed, there’s nothing in the tax code that disallows an IRA from investing in non-traditional investments like land or a business. However, as evidenced by a recent Tax Court case, Dabney v. Commissioner, T.C. Memo. 2014-108 (6/5/14), the IRA custodian will have the last word as to what the IRA may purchase.

In Dabney, the taxpayer owned a traditional IRA which he rolled over to a self-directed IRA with Charles Schwab. The taxpayer was interested in buying a piece of real estate with the funds in his IRA, but Charles Schwab did not allow what it referred to as “alternative investments,” including real property.

The taxpayer was aware of Charles Schwab’s refusal to allow investments in real estate, but he nevertheless transferred the IRA funds directly to the seller of the real estate, who was instructed to name his IRA as the owner of the property. (The seller accidentally titled the property to the taxpayer himself, but the court held that either way, the transaction results in an early distribution of the IRA funds.)

The court held that although IRAs are perfectly capable of investing in real estate, a trustee typically has broad powers that are only limited by statute or the terms of the trust, and “IRA trustees and custodians generally have broad latitude to direct or limit the investment of funds in an IRA.” Since Charles Schwab has the power to prohibit the purchase of real property, the taxpayer’s IRA was not capable of holding real property, and therefore the IRA did not purchase the property.

The result is that the money transferred to the seller of the real property was treated as a normal distribution, subject to both income taxes and the 10% penalty since the taxpayer was younger than 59 ½.

The Tax Court noted that if the taxpayer had instead transferred the IRA funds from Charles Schwab to a different IRA that permitted the purchase and holding of real property, he would have achieved his goal without any unintended tax consequences.

Have a question for the professionals at AUC? Feel welcome to submit it by email. We may post your question and the answer as the question of the day.

Ask the Experts – May 21

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question: My client wants to give 10% of his estate to his church when he dies. Should he simply change his will or is there something else he can do?

Answer: Your client could make an appointment to visit your attorney to draft a codicil stating, for example, that a percentage of his estate will pass to the church. Codicils are typically brief, but you should nevertheless have it drafted by your estate planning attorney to make sure everything is done correctly. Here’s an example:

I, [name], a resident of [county, state], declare that this is a codicil to my last will and testament, which is dated [date].

Whereas, I now desire to make certain changes to my last will and testament:

I give, devise, and bequeath to [the church] the sum of [amount to leave to the church], to be used for such purposes as the governing body may designate.

He could also direct how the money should be spent by the church, or specify a certain percentage of your estate that will pass to the church (as opposed to a lump sum).

Another way to leave a portion of his estate to the church is to name the church as the beneficiary (or partial beneficiary) of his IRA or other qualified plan. This is much quicker and easier than drafting a codicil because he only has to contact the IRA administrator to change the beneficiary. There’s also no charge to changing the beneficiary of your IRA, so he avoids attorney fees this way.

Possibly the greatest reason for leaving an IRA to the church as opposed to other property is to maximize heirs’ tax savings. When money is withdraw from an IRA, it is typically taxed as ordinary income to the person making the withdrawal. However, churches, as tax-exempt entities, wouldn’t pay taxes on IRA distributions, resulting in taxes never being paid on that income.

Here’s an example to illustrate the tax savings. Your client dies leaving an estate worth $1 million, which includes, among other assets, an IRA worth $100,000 and a bank account with $100,000 cash.

Your client wants to leave 90% of his estate to his son and the remaining 10% to the church. If he leaves the bank account, which is 10% of his estate, to the church, the church is $100,000 richer. While his son inherits $900,000, the IRA has a tax liability attached to it. Assuming his son’s marginal tax bracket is 25%, he would incur a $25,000 tax over time as he takes distributions from the IRA. Here’s the bottom line:

    • Church: $100,000
    • Son: $875,000
    • Federal Government: $25,000

If, on the other hand, your client designated the church as the beneficiary of his IRA, the church would still be $100,000 richer because it could cash out the IRA without incurring federal income taxes. Additionally, his son receives his full $900,000 inheritance without incurring any federal income taxes. Here’s the final score under this situation:

    • Church: $100,000
    • Son: $900,000
    • Federal Government: $0

Not only are the tax consequences better for your client’s son, but by leaving the church the IRA, your client saved his son from the trouble of dealing with the pesky required minimum distribution rules for inherited IRAs. In the first situation, regardless of whether the son wanted to withdraw funds from the IRA, he would be required to take a distribution based on his life expectancy. For example, if his life expectancy was 20 years from the date he received the IRA, he must withdraw a minimum of $5,000 ($100,000 divided by 20 years) in the first year that he owns the IRA.

When you die, you typically want to make things as easy as possible for your heirs, and send as little as possible to the government. Leaving an IRA to the church or other charitable organization is a simple way to achieve both of these results.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.  

Ask the Experts – May 13

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question: My client’s father has Alzheimer’s and will one day be unable to make decisions for himself, so my client will need to step in and help. Should my client be made power of attorney or some other designation like guardian or conservator? What are the differences?

Answer: While we don’t know enough about your client’s and his father’s circumstances to be able to advise on what he should do, we can provide some general advice on powers of attorney, guardianships, and conservatorships. However, for most clients it makes sense to opt for a power of attorney rather than a guardianship or conservatorship. Keep in mind that once the client becomes incapacitated, he can no longer enter into a valid power of attorney agreement.

Guardianships and conservatorships are essentially the same thing. In both situations, a court will appoint a person to act on behalf of the incapacitated person. As with any court proceeding, this can be costly, time-consuming and difficult. The court process usually involves a petition to the court, a committee of physicians, nurses or social workers, an attorney representing the incapacitated person, and a judicial hearing. Once appointed, the conservator or guardian can make decisions and manage the affairs of the incapacitated person.

On the other hand, a power of attorney is a legal document where one person (the “principal”) gives another person (the “agent”) the power to act in the principal’s name. The principal can specify the rights given to the agent, which can be narrow or broad. The agent’s rights and duties are determined based on the legal document as opposed to the judge under a conservatorship.

Both a conservatorship/guardianship and a power of attorney can have limited scopes. For example, a person could be a guardian of the estate, meaning he only can manage finances; or a guardian of the person, where he manages medical and personal decisions with no authority over the person’s assets. Similarly, powers of attorneys are generally separated into a medical POA and a financial POA.

Conservators must seek court approval for some types of transactions, such as selling real estate owned by the incapacitated person. The conservator must also post a bond which acts as insurance for mishandling the person’s finances. Both of these limitations can be avoided by entering into a power of attorney agreement.

Since POAs are easier to implement, less costly and less difficult, when would a conservatorship be the preferred action? In most circumstances, we would suggest having the parties enter into a power of attorney agreement. However, if the relationship lacks trust, the extra difficulty and cost from going through a court proceeding might make sense to ensure the person’s assets are being managed properly.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.  

Ask the Experts – April 30

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question: My client is the executor of an estate, and the estate itself is the beneficiary of an IRA and a deferred annuity. How does an executor decide when and to whom to make distributions from these retirement accounts?

Answer: Since the estate is the beneficiary of the deferred annuity, the deferred annuity must be liquidated within 5 years from the original owner’s death. The same rule applies to the IRA if the deceased was younger than 70 ½ at her death. If older, the estate has the option to stretch distributions over the life expectancy of the deceased based on her age at her death using the single life table published by the IRS.

The executor should make sure these distribution rules are met to ensure that these two accounts aren’t hit with RMD penalties. Additionally, the estate is liable for income taxes on these distributions, and estates are typically taxed at higher rates than individuals.

The next step is getting the annuity and IRA funds from the estate to the estate’s beneficiaries. The executor must work with the probate court to figure out who receives what portion of these distributions. Once it’s determined, the executor can make the proper distributions.

On a related note, estates often incur various bills. The executor can seek permission from the probate court to apply estate funds to such bills.

This may seem troublesome and potentially costly, but it could have been avoided by not naming the estate as beneficiary of the deceased’s IRA and annuity. Keep in mind that this choice was made when the deceased named her estate as the beneficiary to her retirement accounts.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.  

Ask the Experts – April 14

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question: My client owns a life insurance contract where he is the insured and his daughters are the beneficiaries. Can he make a Section 1035 exchange so that an ILIT becomes the owner of the policy? If so, does the three-year rule that would bring the full death benefit back into his estate still apply?

Answer: Section 1035 requires consistent ownership before and after the exchange for it to be tax-free. Since an ILIT is a legally distinct entity, the ownership change would generally disqualify it for Section 1035 treatment, and it would simply be a surrender of the old policy followed by the purchase of a new policy in the name of the ILIT.

It could be argued that if the ILIT is a grantor trust, the grantor/original policy owner is still the constructive owner of the life insurance policy; therefore Section 1035 would apply. However, if this analysis is true, Section 1035 would apply, but the individual would not avoid the rule bringing the death benefit back into his estate if he dies within three years from the transfer.

As you can see, the bottom line is that an individual cannot make a Section 1035 exchange into an ILIT and avoid the three-year rule. If he wants to get the life insurance policy inside an ILIT, he would either have to (1) take the risk of the full death benefit being brought back into his estate if he dies within three years, or (2) surrender the policy for its cash value, pay income taxes on any gain, transfer money to the ILIT, and have the ILIT purchase a policy on his own life.

If he chooses the latter, he faces gift taxes on the transfer of money to the ILIT if such transfers are more than the $14,000 exclusion amount in 2014. He also faces potential problems with the policy being considered a modified endowment contract (MEC). Both options have risks or costs, and so it’s up to the client to decide which option suits him best.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.  

Ask the Experts – April 11

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question: My client transferred his life insurance policy to an ILIT to avoid having the death benefit included in his gross estate. I’ve heard that if he dies within three years from the transfer, the death benefit will be brought back into his estate. Is this correct? Does the fact that he paid a gift tax based on the cash value affect the amount he would owe for estate tax purposes?

Answer: Yes, under Section 2035, the entire death benefit will be included in your client’s gross estate if he dies within three years from the date of the transfer to the ILIT. However, the fact that your client paid a gift tax (or used a portion of his unified credit to pay the tax) would lower the amount he owes for estate taxes.

For example, let’s say your client has given away enough money that he’s already used up his $5.34 million lifetime exclusion amount (as of 2014). Also suppose he owns a life insurance policy with a cash value of $600,000 and a death benefit of $1 million. If he transfers the policy to his ILIT in 2014, he will incur a $240,000 (40% of $600,000) gift tax in 2014. If he survives for three more years, the entire $1 million death benefit will be excluded from his gross estate.

On the other hand, let’s say he dies within three years from the transfer. Section 2035 brings the full value of the death benefit back into his gross estate, and ordinarily the $1 million death benefit would incur a $400,000 estate tax (40% of $1 million); however, your client would get credit for the $240,000 gift tax he has already paid, resulting in an estate tax of $160,000 ($400,000 less $240,000).

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.  

Ask the Experts – February 27

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax questions posed by producers.  Here’s the question of the day.

Question: A client’s husband died in 2011 leaving his entire estate to her. His estate was small enough that no estate tax return was filed. Does the deceased husband’s unused estate tax exclusion amount automatically transfer to his surviving spouse? If not, is it too late to elect to have it transfer?

Answer: The deceased spouse’s unused exclusion amount (or “DSUE amount”) doesn’t transfer to his surviving spouse automatically—she must file an estate tax return (Form 706) on behalf of the deceased spouse’s estate. However, she should still have until the end of 2014 to make the portability election.

Portability is an estate planning option that allows a deceased spouse to transfer his unused estate tax applicable exclusion amount ($5.34 million in 2014, indexed for inflation) to his surviving spouse.

For example, if your client’s husband died in 2011 without having used any of his $5 million exclusion amount, his wife can add her husband’s full $5 million unused exclusion amount to her own current $5.34 million exclusion amount. Therefore, when the wife dies, she can pass up to $10.34 million.

Generally, to make the portability election, an estate tax return must be filed within 9 months from the deceased spouse’s date of death. Since no estate tax return was filed on behalf of her deceased spouse’s estate, she missed the 9-month window.

Ordinarily, your client would be out of luck, but the IRS recently issued Revenue Procedure 2014-18, extending the 9-month deadline for spouses who died in 2011, 2012 or 2013 and who were not required to file a federal estate tax return—qualifications your client probably meets.

Therefore, for taxpayer in the same position as your client, instead of the 9-month deadline, the deceased spouse’s estate has until the end of 2014 to file Form 706. For a spouse who died this year (or who dies thereafter), the ordinary 9-month rule still applies.

For those filing Form 706 late pursuant to Revenue Procedure 2014-18, the following language must be included at the top of the form in capital letters:

FILED PURSUANT TO REV. PROC. 2014-18 TO ELECT PORTABILITY UNDER § 2010(c)(5)(A).

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.

Question of the Day – May 20

Ask the Experts!

Here’s the question of the day.

Question:  What is probate and what are its drawbacks?

Answer:   Probate is the court supervision of the transfer of assets at the owner’s death.  On its face, that seems OK.  In particular, where the family members don’t get along, the idea of having a probate judge act as referee seems like a good idea.

While each state has its own rules about how probate works, those rules are similar with regard to the drawbacks of the probate process:

  • It’s structured, and it takes a while to finish.  Since probate is a court procedure, there are rules and forms for everything.  Also, in most jurisdictions for most estates, the process takes months to run from start to finish.  Sometimes heirs will have to wait a year or more before they get their complete inheritances.
  • It can be expensive.  Since probate involves going to court, most personal representatives opt to hire a lawyer to guide them through the process.  The probate court charge fees for paperwork filings.  Under certain circumstances, the personal representative may need bonding to be able to act on behalf of an estate.  The costs vary widely depending on the jurisdiction, how well the heirs get along and the complexity of the estate.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day. 

Question of the Day – August 13

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question: I have a client who is doing estate planning.  The client has net assets worth $10 million, with a farm making up $9 million of net worth.  If the farm is left to charity, is its value included in the client’s estate for federal estate tax purposes?

Answer: A taxpayer’s gross estate consists of the fair market value of all assets in which the client has an ownership interest at death.

To arrive at the value of a decedent’s taxable estate, certain deductions are permitted against the value of the gross estate, including:

  • The client’s share of debt against assets included in the gross estate
  • Certain final expenses
  • Certain expenses associated with settling the estate
  • The value of qualified charitable gifts

In the example, the gross estate would include all the value of the client’s assets–$10 million.  The estate would be entitled to a deduction of the amount left to a qualified charity–$9 million in the example.  That would make the taxable estate $1 million.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.

Question of the Day – May 9

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax questions posed by producers.  Here’s the question of the day.

Question: I had a single client die last year leaving his estate the beneficiary of his IRA.  The client had not started taking RMDs.  Can the estate beneficiaries stretch out the income tax result?

Answer: Probably not, based on the reasoning in several private letter rulings the IRS issued in recent years.

In PLR 200945011, the IRS said that when the estate is the beneficiary, an IRA account can be sub-divided into multiple estate beneficiary accounts and transferred tax-free.  However, the PLR also specifically says that the distribution of the accounts to the nonspouse beneficiaries must be done in conformance with the five year rule—since the estate was the original beneficiary.

PLR 201203033, while contemplating slightly different facts, seems to be consistent with that.  PLR 201210045 reaches a different result in similar circumstances, but only with regard to a surviving spouse.

If we treat the private letter rulings as law, an account naming the estate the beneficiary can be divided into separate accounts for the beneficiaries of the estate by way of tax-free transfer.  However, the RMD rules for each account must be consistent with estate as beneficiary.  Where the decedent had not started taking RMDs, that means the entire account must be distributed—and taxed—by the end of the fifth year following the original owner’s death.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.