Advanced Underwriting Consultants

Question of the Day – September 30

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

Question: What’s the deadline for my client, who has inherited an IRA from a nonspouse, to elect to stretch out payments from the IRA based on the client’s life expectancy?

Answer: Under Treasury Regulations 1.401(a)(9)-3, a nonspouse beneficiary choosing to take payments based on the life expectancy method must begin payments by the end of the calendar year following the taxpayer’s death.

For nonspouse beneficiaries who inherit an IRA from a decedent who had not yet begun RMDs, the choice is usually between the stretch based on life expectancy, and complete distribution within five years.  Where the beneficiary does not choose the life expectancy method, complete distribution within five years is usually chosen.

The IRS, in Private Letter Ruling 200811028, said that even when a nonspouse beneficiary failed to elect stretch for several years after the taxpayer’s death, the beneficiary could still make a late stretch election.  The beneficiary would have to pay the 50% penalty tax for failure to take the prior RMDs due for the year after the taxpayer’s death and any following years.

Why would the beneficiary voluntarily pay such a hefty tax penalty?  In some cases, the value of preserving the option to pay out the IRA over the beneficiary’s life expectancy—and deferring taxes on those required payments—would more than offset the penalty tax on the undistributed RMDs.

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 – September 29

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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 believe that my client contributed too much to her IRA in 2010.  What are the penalties associated with the excess contribution?

Answer: For 2010, the maximum contribution an individual can make to a traditional and/or Roth IRA(s), if under age 50, is the lesser of $5,000 or earned income.  An individual age 50 or older may contribute the lesser of $6,000 or earned income.  A contribution greater than these maximums is excessive.

An excessive contribution will also result if an attempted rollover from another IRA or qualified plan proves invalid. A defective rollover could occur, for example, because the 60-day limit for rollovers was exceeded, a portion of the rolled amount was subject to minimum distribution requirements and thus not eligible for rollover, or for numerous other reasons. Of course, a properly executed rollover will not be considered an excessive contribution no matter how large in amount.

If a taxpayer does not make a corrective distribution, a 6% penalty tax will be imposed on the excessive amount, for the current year and for every subsequent year, until the excess contribution is eliminated.

A taxpayer can correct an excessive contribution, and thus avoid a 6% penalty tax, by taking a corrective distribution on or before the due date of his tax return, including extensions, for the tax year during which the excessive contribution was made.  To make a corrective distribution, the individual must withdraw the excess contribution plus any income attributable to the excess amount (or minus any loss so attributable).

The portion of the corrective distribution representing the return of the excess contribution itself is not included in taxpayer’s taxable income.  However, that part of the distribution which constitutes earnings, if any, on the excess contribution, will be taxed.  If taxpayer is under age 59 1/2, this taxable portion of the distribution will also be subject to the 10% early withdrawal penalty, unless an exception applies.

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 – September 28

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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 recently passed away, leaving a deferred annuity to a nonspouse beneficiary.  Is the annuity subject to both estate taxes and income taxes?

Answer: Yes.

The gain portion of a nonqualified annuity is potentially subject to both income tax and estate tax.  This occurs because the gain is considered income in respect of a decedent.  Income in respect of a decedent (IRD) is property which the decedent had a right to receive during life and would have been included in gross income if so received.  Taxation of IRD is governed by Section 691 of the IRC.

To soften the blow of the potential double taxation, a deduction is allowed on the beneficiary’s income tax return for the amount of estate tax paid which was attributable to inclusion of the taxable gain in the decedent’s gross estate.  The amount of the deduction is determined by comparing the actual estate tax paid to a hypothetical estate tax calculation made without including the gain in the contract.

For example, assume Mother dies with an estate subject to estate tax.  Among her property is a non-qualified deferred annuity with cash value of $200,000, for which she paid a premium of $100,000.  Suppose Mother’s estate pays an estate tax of $1 million.  Say also that if the estate tax had been calculated excluding the gain in the contract, the estate tax would have been only $961,000.  The difference, $39,000, is allowable as a deduction on the beneficiary’s return.

Thus, the beneficiary, Daughter, receives $200,000, lists $100,000 as taxable income, and takes a deduction of $39,000.  Effectively, she pays tax, at her marginal bracket, on $61,000.

What if Daughter chooses to take a settlement option rather than a lump-sum?  If she receives $15,000 in the first year and its determined this consists of $10,000 return of premium and $5,000 taxable gain, then she would take a deduction of $5,000/$100,000 x $39,000 or $1,950.  The formula, in words, is taxable gain distributed divided by total taxable gain included in estate times allowable deduction.  Each year this step would be repeated until the allowable deduction is exhausted.

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 – September 27

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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 recently passed away.  The client was receiving payments under a period certain immediate annuity.  Is the annuity included in the client’s estate for estate tax purposes?

Answer: Yes.

If an immediate annuity contains a refund or period certain feature, the post-death payments are includable in the gross estate for federal estate tax purposes under Revenue Code Section 2033 if payable to the estate, or Revenue Code Section 2039 if payable to a named beneficiary.  Where the death benefit is payable as periodic payments over some time period, the present value of the remaining payments is included.  Present value is determined by reference to IRS regulations and applying its relevant discount rate.

The same Revenue Code Sections reach the annuity death benefit paid when death occurs prior to annuity starting date.  Where the death benefit is paid in a lump-sum, that figure is included in the gross estate.

In case of a joint and survivor annuity purchased with the decedent’s premium payment, the value included in the gross estate will be an amount equal to the premium an insurance company would charge on the date of death for an identical single life annuity on the survivor.  Of course, remaining payments to a surviving spouse might qualify for the unlimited marital deduction.

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 – September 26

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QUESTION: What’s a planned gift?

ANSWER: A planned gift is a charitable gift that coordinates with the donor’s financial, tax, or estate planning. The gift might be immediate, or planned for some future date, such as the donor’s death.

Under the right circumstances, a planned gift can help the donor’s favorite charities, while also

  • Generating income for the donor and the donor’s family,
  • Reducing taxes, and
  • Adjusting the timing of a gift to its best advantage.

Making a planned gift can be as simple as designating one of the donor’s charities a beneficiary of an IRA.  Or a planned gift can involve using a sophisticated charitable remainder trust, coupled with life insurance as a wealth replacement tool.

To help your client decide whether a planned gift is right in the client’s situation, enlist the help of the client’s tax preparer and estate planning attorney.

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 – September 25

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Here’s the question of the day.

Question: I have a client who has been receiving “substantially equal payments” from her IRA since she has been age 50.  I am proposing setting her up in an immediate annuity with part of her IRA that will pay her the exact same amount she is getting now for a 5 year period which will take her beyond age 59 1/2.  Will this still qualify under the “substantially equal payments” rule?

Answer: There’s not a 100% certain answer to the question, unfortunately.

The proposed action makes logical sense, and seems consistent with the spirit of the 72(t) “substantially equal series of payments based on life expectancy” exception.  However, there is some troubling language in Revenue Ruling 2002-62, which the IRS could apply to the situation in an adverse way.

Here’s the language from the Revenue Ruling:

a modification to the series of payments will occur if, after such date, there is

(i)              any addition to the account balance other than gains or losses,

(ii)            any nontaxable transfer of a portion of the account balance to another retirement plan, or

(iii)      a rollover by the taxpayer of the amount received resulting in such amount not being taxable.

An annuitization of a portion of the account might be considered a “nontaxable transfer of a portion of the account balance,” invalidating the entire set of 72(t) distributions.  It’s not clear that the IRS would decide that way, but we can’t predict for sure.

The only way to get a sure opinion is for the client to ask for a private letter ruling.  The second best way is for the client’s CPA to think over the issues, review my analysis above, and decide that the CPA is comfortable with the client taking the tax risk.

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 – September 23

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Here’s the question of the day.

Question: My client died naming his estate the beneficiary of his IRA.  The surviving spouse is the only beneficiary of the estate.  Can the IRA qualify for spousal rollover?

Answer: Maybe, although it may require seeking a private letter ruling to achieve tax certainty.

Most people assume that if a trust or the estate is the beneficiary and a surviving spouse is the trustee or executor of the estate, the surviving spouse can just take a distribution and roll it into his/her IRA.

It is IRS policy to allow such a rollover provided

  • the surviving spouse is the only beneficiary of the trust or estate and
  • the surviving spouse has the right as trustee or executor to cause the IRA to be distributed to himself/herself without the consent of a third party.

Any other set of circumstances would defeat the ability of a surviving spouse to do a spousal rollover.

As if this were not bad enough, the above is merely an IRS policy spelled out in Private Letter Rulings.  The regulations or published IRS rulings do not give any citable authority for the position.  Numerous PLRs have allowed for the spousal rollover, but it was necessary for the surviving spouse to go to the time and expense to get a PLR.

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 – September 22

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Here’s the question of the day.

Question: Why would a business owner consider key employee life insurance?

Answer: Key employee life insurance can meet a number of business needs.

A key employee is anyone who affects the overall success and profitability of the business.  A key employee could be a manager whose judgment and leadership are crucial to the business; a sales representative with knowledge of the product and customers; or any other worker who has unique technical experience or good rapport with customers, creditors, or fellow workers.

The death of a key employee may cause the loss of management skill and experience.  This could be particularly traumatic for small companies with only a few managers.  The death of a key sales representative could cause the loss of customers loyal to that particular individual, and will affect sales in general.  The death of a key employee could hurt the company’s credit rating and the ability to obtain credit in the future.

The death of a key employee will cost the business the expense of hiring and training a replacement.  The business owner may feel morally obligated to provide a substantial death benefit to the key employee’s family.

The premiums on a key employee life insurance policy are usually small compared to the death benefit. If a permanent policy is used, the cash values are shown as a business asset on the company books.  This may increase the company’s credit rating and can be a source of money in a financial crisis.

If the key employee is also an owner, a key employee policy death benefit can be used to fund a buy-out of the deceased owner-employee’s interest in the business.

Determining the amount of key employee insurance is not a precise process; it will depend upon the facts and circumstances of each situation.  Here are some broad guidelines.

In the case of sales representatives, product designers and research persons whose loss might directly cause a measurable loss of sales or earnings, advisors recommend using a multiple of lost sales or earnings.  For example, suppose a business owner estimates that the loss of a key sales rep would cause a drop in sales of $100,000 per year for five years, while a new sales rep learned the product and territory.  A key person policy of $500,000 would be in order.

Where key managers or financial officers are involved, the direct impact on sales and earnings may be harder to measure.  Many advisors recommend using a multiple of salary in those cases.  For instance, if a key manager is making $100,000 a year and the owner estimates it will take three years to recruit, train, and bring a new manager up-to-speed, a $300,000 policy would be advisable.

With key person coverage, the business applies for and is the owner and beneficiary of a policy insuring the key employee’s life.  The business pays the premiums.  The premiums are non-deductible when paid, but the death proceeds are generally tax-free to the business.

In some cases, businesses with over $5 million per year of revenue may be subject to alternative minimum tax on death proceeds.  Also, Section 101(j) of the IRC requires special notice and waiver rules to be followed to preserve the tax free death benefit.

A key employee life insurance policy has no tax effect on the insured employee.

If a cash value policy is surrendered by the employer, the proceeds are tax-free to the extent of premiums paid; any gain will be taxed as ordinary income.  Policy loans are available to the employer and are usually tax-free as long as the policy stays in force.  Loan interest may be deductible by the loan business on a limited basis.

While key employee insurance seems like a simple idea, it can help a business owner client protect his investment.

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 – September 21

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Here’s the question of the day.

Question: What are the deadlines for an employer to establish a SEP IRA or a SIMPLE IRA?

Answer: A SEP is funded with employer contributions only.  It can be set up and funded for a year as late as the due date (including extensions) of the business’s income tax return for that year.

SIMPLE IRA plans accept both employer and employee contributions.  They are always calendar year plans and ordinarily can be set up any time between January 1 and October 1 of a year.

There are two exceptions to the rule: if the employer is a new business that comes into existence after October 1 of a particular year, the SIMPLE IRA can be set up as soon as administratively feasible.  Also, if the business has ever maintained a SIMPLE IRA in the past, a new SIMPLE IRA can be established only on January 1.

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 – September 20

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Here’s the question of the day.

Question: What are the consequences of dying without a will?

Answer: The main consequence is that the rules of the state or the decedent’s residence will control who gets the person’s personally-owned, non-beneficiary assets.

Is that a bad result?  Probably,  For example, if the decedent was Tennessee resident, would he or she have wanted a will with the following provisions?

I, TESTATOR, of Nashville, Tennessee, hereby declare this to be my Last Will.

I give my spouse one-third of my assets, and I give my three children the remaining two-thirds.  This includes my interest in my business, even though only my son has any clue how to run the thing.

Should my spouse remarry, I encourage her new spouse to help spend everything he can get his hands on, including the assets of the business.

Even though I was active in my church during my lifetime, I think it has plenty of funds and I make no provision to support the church after my death.  My other charitable interests are out of luck, too.

I direct the Probate Court to select an executor for my estate. If the court wants to appoint a stranger, that’s OK by me.

Finally, since I love the state and federal governments as much as I love my family, I direct that no effort be made to lower taxes.

Other states have similar default provisions.  If our clients don’t want an unexpected distribution of assets at death, we should make sure they have effective and up-to-date estate planning documents.

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.