With much anticipated Roth conversion activity in 2010, it is important to keep in mind that a Roth IRA owner is always treated as having died before his or her required beginning date ("RBD") when applying the required minimum distribution ("RMD") rules. Treas. Reg. 1.408A-6, A-14 (b). This means that with Roth IRAs, the 5-year rule (the alternative to a stretch-out when death occurs pre- RBD) is always lurking in the background. Failure to comply with the 5-year rule, which requires liquidation of the account by the end of the year containing the fifth anniversary of the date of death, would result in a 50% penalty on the amount not withdrawn at that time - an especially harsh result for an otherwise tax-free account, for which a hefty conversion tax likely had already been paid.

But what are the chances of a failure to take from the account for five straight years? Probably nil. And what are the chances of a designated beneficiary's (individual's or "see-through" trust's) failing to qualify for the life expectancy method, the default under the final regulations? Also nil, as long as the custodial agreement is silent. But if the custodial agreement is not silent and defaults (in absence of an election to the contrary) to the 5-year rule - even for a designated beneficiary - then the chances of a lost stretch-out, or worse, the 50% excise tax described above, rise significantly. All that is needed is the wrong custodial agreement and a beneficiary who misses one or more RMDs.

Consider PLR 200811028, where the stretch-out was saved, but only because the custodial agreement did not default to the 5-year rule. Had it, the beneficiary who missed the first two RMDs from her inherited traditional IRAs (pre-RBD death), would likely have been treated as having elected against the life expectancy method and therefore been stuck with the 5-year rule. As it turned out, good fortune was on her side.

Therefore, when it comes to Roth conversions, it is imperative to confirm not only that the "right" beneficiaries have been named, but also that the custodial agreement says "the right thing" - i.e., that it defaults to the life expectancy method. If it does, should Roth RMDs be missed due to beneficiary negligence or error, good fortune will not be needed to preserve the very valuable Roth IRA stretch-out.

For more information regarding this topic, please e-mail your requests to Salvatore J. LaMendola, or call Sal at (248) 457-7204.

In 1980, a son and daughter purchased from New England Mutual a whole life insurance policy with the face amount of $200,000.00 insuring their mother's life. For the first 7-9 years, payments were made by the son and daughter. At some point, the son became the only owner of the policy. After the 8th or 9th year, premiums were automatically paid from dividend accumulations and loans taken against the cash value of the policy. There were no other loans taken against the cash surrender value.

In 2005, the carrier sent various letters to the son explaining certain tax consequences regarding the policy, along with a statement of gain. The son was advised that the net investment in the policy was $225,390.14, the total cash value was $361,353.50, and the total indebtedness was $354,399.25. Therefore, if the policy were surrendered at that time, there would be a taxable gain of $135,916.44.

Later in 2005, the son received a letter that the policy was in "over loan", which occurs when the total indebtedness exceeds the total cash value of the policy. The son was informed that he needed to pay both the over loan amount and the premiums due. The son was also informed that, should the policy terminate through failure to pay the over loan amount and premium, the carrier was required by Federal law to report any taxable gain to the Internal Revenue Service. Previous correspondence informed the son that gain must be recognized as taxable income to the extent any cash received or loan extinguished exceeds the total net investment - which would certainly be the case in the event the son allowed the policy to terminate or upon surrender.

Apparently, after speaking with his mother, the son decided to terminate the policy through surrender at the end of 2005. In 2006, the son received Form 1099- R from the carrier showing a gross distribution in taxable amount of $135,962.44. The son and his wife failed to include this amount on their 2005 joint Federal income tax return. The return was audited and the IRS determined a $39,608.00 deficiency in the son's and his wife's 2005 Federal income taxes and a $7,922.00 (20%) accuracy-related penalty under IRC Section 6662(a).

The son and his wife ended up in tax court where the Court concluded that the son is taxable under IRC Section 72(e) on the $135,962.44 "gross distribution" from the insurance carrier as reported to the IRS on Form 1099-R. The Court further ruled that the income recognized by the son was ordinary income, not capital gain, because the surrender of a life insurance contract does not constitute a "sale or exchange" of a capital asset.

There are several things to take away from this case. First, clients must be advised that ordinary income tax consequences could result if the policy is surrendered or terminated before the death of the insured. Secondly, the decision in this case (Barr v Commissioner, T.C. Memo. 2009-250 (November 3, 2009), is consistent with the approach taken in IRS Notice 2009-13 which deals with both surrenders of life insurance contracts to insureds and with sales to life settlement companies and other parties with no insurable interest in the insured. In the Notice, the Service determined that, upon a policy surrender, there is "no sale or exchange" and, therefore, there can be no capital gains. However, there is a provision of the Tax Code which is inconsistent with Barr and IRS Notice 2009-13. Under a 1997 amendment to IRC Section 1234A, capital gain can be recognized even if no sale or exchange of a life insurance policy occurs. Section 1234A was enacted to provide that gain or loss attributable to cancellation, lapse, expiration of a right or obligation with respect to a capital asset would be treated as a gain or loss from the sale of a capital asset. Life insurance is defined in the Code as a capital asset. Unfortunately, neither the Court in Barr nor the Service in IRS Notice 2009-13 explain why IRC Section 1234A no longer applies to the surrender of a life insurance policy.

For more information regarding this topic, please e-mail your requests to Thomas P. Cavanaugh, or call Tom at (248) 457-7218.

On December 8, 2009, the House of Representatives passed a plan that will create a statewide protocol for investigating cases of elder abuse and makes it easier for victims to testify against their abuser. This plan is part of a larger effort to strengthen protections for seniors and increase penalties for those who physically abuse or financially exploit them. The Elder Abuse Protection Plan, which the House began moving in August, increases penalties for those who cheat or defraud seniors, empowers concerned citizens to file criminal complaints to stop and prevent abuse cases in nursing homes, and requires financial institutions to do more to disclose the rights of seniors and create new safeguards against fraud. In addition, in October, the House unanimously passed a plan that creates the "Mozelle Alert" to notify the public in cases of missing seniors, named in honor of Estella Mozelle Pierce, a senior who died after wandering from her Southwest Detroit home.

For more information regarding this topic, please e-mail your requests to Brenna D. Mansfield, or call Brenna at (248) 457-7227.

Defined value clauses are most often used in connection with an installment sale to a grantor trust. The IRS's position is that defined value clauses should not be recognized for tax purposes on public policy grounds because they reduce the IRS's incentive to audit returns. To support its position, the IRS relies on Commissioner v. Proctor, 142 F. 2d 824 (4th Cir. 1944). In that case, the transfer instrument provided that if any part of the transfer was subject to gift tax, the gift portion of the property would be deemed not to be included in the conveyance. In other words, Proctor imposed a condition subsequent to the transfer. In contrast, a defined value clause does not undo a transfer upon audit, but instead allocates property to a taxable and nontaxable beneficiary from the onset - similar to an acceptable reduced-to-zero marital/credit shelter trust formula.

In Estate of Christiansen v. Commissioner, (November 13, 2009), the Eighth Circuit Court of Appeals rejected the IRS's public policy argument. Among the three reasons for doing so the Court said:

"First, we note that the Commissioner's role is not merely to minimize tax receipts and conduct litigation based on a calculus as to which cases will result in the greatest collection. Rather, the Commissioner's role is to enforce the tax laws."

The other two reasons cited by the Christiansen court in upholding the defined value clause dealt with the fact that the nontaxable beneficiary was a charity. First, the Court said that Congressional intent to encourage charitable donations (by allowing deductions for such donations) was "clearer" than the Congressional intent to maximize incentives for the IRS to challenge or audit returns. Second, the Court said there are "countless other mechanisms in place to ensure that fiduciaries...accurately report estate values".

Shortly after the Christiansen decision, the Tax Court in Petter v. Commissioner, T.C. Memo 2009-290, determined in a memorandum opinion that the taxpayer's defined value gift clause was enforceable under state law and respected for gift tax purposes. Like Christiansen, the nontaxable beneficiary in Petter was a charity. Judge Holmes went through a history of defined value gift/sale jurisprudence, beginning with Proctor and ending with Christiansen, and made the following distinction - "savings clauses [like Proctor] are void, but formula clauses [like Christiansen] are fine".

Commissioner and Petter do not resolve all questions about the effectiveness of defined value clauses (particularly where the nontaxable beneficiary is not a charity). But these two cases appear to pave the way for upholding defined value clauses despite IRS attacks on public policy grounds.

For more information regarding this topic, please e-mail your requests to Julius H. Giarmarco, or call Julius at (248) 457-7200.