From the May 2005 issue of Investment Advisor • Subscribe!

May 1, 2005

Taxing Time

Three late March rulings by the IRS provide insight into the agency's thinking that could affect your clients for years to come

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The recent tax season has been busy for all concerned. Even the IRS has industriously issued rulings on questions facing taxpayers and, by extension, their planners. We spoke with Michael Kitces, director of financial planning for Pinnacle Advisory Group, a private wealth management firm in Columbia, Maryland, who spends much of his time on tax issues, not only as a planner but also as a speaker, writer, and peer reviewer. In this Q&A with freelance business journalist Marlene Satter, Kitces shares his insights on three rulings made on three successive days by the IRS, and explains how those rulings can affect you and your clients far into the future.

The first of these rulings, issued on March 29, concerns the "Tax Gap"--the difference between the amount taxpayers are supposed to pay, and what they actually do pay. How big a problem is this? The [figure] that's always wowing is how much the government is not managing to collect--in the low $300 billions. That would make quite a dent in our budget deficit problems.

The IRS cites three main sources of non-compliance: non-filing of returns, underreporting of income, and underpayment of taxes. How does this uncollected money break down? As opposed to what we classically think of as the problem, deductions, the driving force is underreporting of income--specifically, underreporting of individuals' income, two thirds of the total. And more than 80% of individual tax underreporting comes from understating income, not overstating deductions. Compliance from collecting taxes on wages and income, in areas where third-party reporting is involved, is actually quite good. It's less about whether people take appropriate deductions and more about whether they report what they get, and what third-party reporting systems can better track when people are earning income.

What does this mean for advisors? I think ultimately that the IRS will step up enforcement. Three, five, and 10 years down the line, as the IRS tries to figure out where to focus enforcement efforts, those efforts may get a boost as Congress tries to figure out how to deal with the budget deficit. It's easier to get revenue by enforcing laws already on the books than by raising taxes. If the IRS comes to Congress and says, "We'd like money to do this enforcement project to improve taxpayers' compliance record," they may get it.

How might advisors see underreporting by clients in their practices? The primary areas in which we see underreporting are self-employment [cash] income--also small to moderate, and occasionally large, business income [taken] as cash under the table--or when people sell appreciated assets that aren't investment assets, such as a stamp or coin collection, don't report it, and don't get caught. Personal asset sales are rarely reported appropriately.

This makes for lots of interesting discussions with clients--not about the tax side, but about the investment world and the economic picture. It raises questions about how the IRS and Congress might respond to close [the tax gap], what economic consequences there would be if we could get rid of the gap, and the impact on the markets and interest rates.

The second ruling had to do with charitable remainder trusts (CRTs) as an estate planning technique. Can you tell us about that? This ruling [Revenue Procedure 2005-24] outlines new procedures that all future clients must comply with when establishing CRTs. The regulations apply for trusts created on or after June 29, 2005, and provide details about "grandfathering provisions" applicable to trusts established prior to this date.

The IRS is trying to address a problem with a rule that says that when someone passes away, the spouse generally has a statutory right to 50% of the [deceased] spouse's estate in lieu of whatever the will says. [This process is also known as "taking against the will" or "dower and curtesy."] A lot of people started to avoid the rule by not leaving assets via a will, and saying, "I'll pass it all along in trusts, and beneficiary designations, and joint titling with right of survivorship to someone other than my spouse." The response, state by state, was to change statutory elections so that an election to take against the probate estate would be replaced by an election to take against an "augmented estate" [the state would "augment" the probate estate with some of the decedent's other property] to keep spouses from being disinherited.

What came to the IRS's attention was that under some state responses, a grantor charitable remainder trust could become part of the estate. If the grantor creates a CRT that says, "I'm going to take income for my lifetime and the balance will go to charity," and then dies, the spouse can come in and say, "I'll take against the will, and I will take money back out of the CRT." The grantor originally got a big tax deduction, because the money was supposed to go to charity. With a claim against an augmented estate, the grantor got the deduction but the money still stayed in the family. RP 2005-24 is meant to be the solution. For any CRT created on or after June 29, 2005, at the time of creation of the CRT, the spouse must sign a waiver, valid under state law, to any right she might have to elect against the property in the CRT, to guarantee that later she won't make an election to draw money out under the state's augmented estate rule.

Technically it's only an issue if the client lives in a state with a right of election including augmented estates. But there are two problems: first, what if the state currently doesn't have a rule, but implements one later? And second, what if the client currently doesn't live in an augmented estate rule state, but moves to one in the future? If the possibility exists, the whole CRT will be invalidated retroactively. It doesn't matter whether that possibility didn't exist at the time [the CRT was created].

There's a new document that has to be filed with every CRT created. You have to decide if it's [relevant] in your state. (For a complete list of states with augmented estate rules, see sidebar at right.)

Any trusts in existence before June 29 will be grandfathered in, and the right of election only becomes an issue if the spouse actually exercises it and takes money out of the trust.

The third ruling is on inherited IRAs. Can you tell us about that? On April 1, the IRS released private letter ruling 200513032, concerning a financial institution [that gave] bad advice to a taxpayer on an inherited IRA. Because of how the rules work for inherited IRA accounts, the IRS declined to grant relief to the taxpayer for bad advice, and wouldn't even let him simply "undo" the mistaken transaction (ostensibly leaving him no choice but to sue for bad advice!). This ruling is a reminder that [in this] area, if you make a mistake, you can't even take it back.

The IRS has been willing to hear arguments if a taxpayer made a mistake and wants to roll money back into an IRA after the 60-day deadline. In cases of mental illness, extreme health problems, or other reasonably tragic and unfortunate situations, it's not the taxpayer's fault. If the taxpayer acted in good faith but got bad guidance from a financial institution, the IRS has tended to allow the rollover.

But this particular situation was different: It dealt with an inherited IRA. There are two fundamental ways to do an IRA transfer. One is by rollover--the old financial institution writes you a check, and you write a check to the new financial institution. The other way is trustee-to-trustee transfer. The IRS has treated these not as IRA rollovers, but as direct behind-the-scenes transfers that change custodians.

The problem here was that the taxpayer had an IRA left to a trust, and wanted to complete the trust so that a new IRA could be set up in a new institution on behalf of the trust. Normally this would be titled "Inherited IRA of John Smith for the benefit of John Smith's trust." But it wasn't done trustee to trustee; instead, the trust took a distribution, with the plan of subsequently rolling it over into a new inherited IRA account on behalf of the trust. The rules are very specific, and no rollovers are allowed. You cannot complete a rollover of an inherited IRA. Period.

The taxpayer decided that it should have been done trustee to trustee, and asked for an extension to fix it--not unlike extensions other folks have asked for. However, since the tax code says that no rollovers are allowed [for an inherited IRA], the IRS said it couldn't give an extension. The distribution stands and the taxes are due.

The takeaway here is that with IRAs in general, you need to be careful not to make a mistake. The IRS is generally willing to let you fix a mistake, if you go through a private letter ruling. But on an inherited IRA, as a professional giving guidance, you can't make a mistake. If you make a distribution and didn't need to, you can't roll it over later or get an extension. So if the taxpayer can't get relief from the IRS, they'll try to get it from your E&O insurance.

These transactions are not uncommon, with more inherited IRAs as boomers age and older people die. The private letter ruling is not a change to existing law; it's one of the first times that this exact situation came up and explicitly asked the IRS, "Can we put the money back?" and the IRS said no. The rules don't allow that. It's not new law, but it is one of the most resounding clarifications we've had. If you make a mistake, you're stuck with it.

Marlene Satter can be reached by e-mail at msatter@erols.com.

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