Several weeks ago, the IRS issued a version of draft Form 8939. The purpose of this form was to allow Executors and Trustees to comply with the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA") for decedents who died in 2010 with gross estates in excess of $1.3 million. A spokesman for the IRS stated, "It will be thoroughly revised and an official draft will probably be published on the IRS website by the end of the year."

Under EGTRRA, assets received by a person who died in 2010 will not receive the historical step-up in basis to the fair market value for estate tax purposes because there is no Federal estate tax. Rather, the decedent's basis in the assets, or its date of death fair market value if less, will be carried over from the decedent to the recipient. The decedent's Executor/Trustee is permitted to allocate a $1.3 million increase in basis to certain appreciated property passing to any person (including spouses) and may allocate an additional $3 million increase in basis to property that passes only to the decedent's surviving spouse (or to certain marital trusts), who is a US citizen.

As soon as we receive the official draft, we will notify you and make it available for download on our website. If you would like to see the preliminary draft of IRS Form 8939, please go to our website and look under the "Advisor Resources" tab.

For more information regarding this topic, please e-mail your requests to Julie L. Cavanaugh, or call Julie at (248) 457-7228.

Since we last reported on inherited IRA creditor attacks in our April 2010 E-Update, 3 more losses for non-spouse IRA inheritors (in Texas, Indiana and Florida) and 3 more wins (in Ohio, Pennsylvania and California) have occurred. But even the Ohio and California cases are only "half-wins", since the judge in each indicated that had state law applied, the result would have been a loss. A summary of all cases to date and the law they were decided under can be found here. For completeness, the California and Kansas cases have been included, even though they are unpublished decisions (weaker precedential value). The Kansas case, where an IRA left to a revocable living trust was lost, is the reason many practitioners now make their standalone IRA trusts irrevocable from the start.

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

In the first decade of the century, there were several Notices and a Revenue Procedure issued by the Internal Revenue Service with respect to allowing partial 1035 exchanges with subsequent withdrawals from the new annuity contract. The objective of the IRS was to avoid actions by taxpayers which were designed solely to avoid taxes. The following is a tax avoidance scheme that the IRS saw to address:

Taxpayer holds a $100,000.00 annuity with a fifty percent (50%) cost basis. You wish us to withdraw $60,000.00 from the annuity, which would normally be fully taxable as a "gains - first" withdrawal under IRC Section 72(c). Rather than taking the withdrawal, the taxpayer would instead complete a $60,000.00 partial 1035 exchange to a second annuity contract. In doing so, he would receive a forty percent (40%) pro-rata allocation of basis ($24,000.00). Once the 1035 exchange has been completed, the taxpayer would then cash out the annuity. In doing so, since he would have a $24,000.00 basis, his reportable gain would only be $16,000.00. This would save him $24,000.00 in taxes than if he had never executed a 1035 exchange and simply withdrawn $40,000.00 from the original annuity contract.

The most recent ruling from the IRS is Revenue Procedure 2008-24 which permits taxpayers to take withdrawals from a 1035 exchanged annuity within one year of such an exchange, if certain exceptions were satisfied. In particular, if a withdrawal (made with in the first twelve months after the partial 1035 exchange) satisfies any of the conditions set forth under IRC Section 72(q)(2) (exceptions to the 10% early withdrawal penalty), then the exchange will still be considered valid.

In PLR 201038012, a taxpayer who was over 59 1/2 completed a 1035 exchange. Within one year of the exchange, the taxpayer took withdrawals from the annuity contract. The reason for the withdrawal was to continue an annual gifting strategy by the taxpayer. This withdrawal occurred within one year of the 1035 exchange. The question in this Private Letter Ruling is whether or not the taxpayer satisfied one of the exceptions. If one of the exceptions under Revenue Procedure 2008-24 was not satisfied, then the entire partial 1035 exchange itself would be treated as an invalid 1035 exchange and, thus, retroactively taxable.

In PLR 201038012, the Internal Revenue Service held that the taxpayer had satisfied an exception since he was over 59 1/2 at the time that the withdrawal was taken from the new annuity contract.

Therefore, to the extent that the IRS's interpretation of Revenue Procedure 2008-24 (as memorialized in this recent PLR) appears to be solid, it would also appear that partial 1035 exchanges followed by partial or complete withdrawals, which would partially avoid and defer recognition of taxable gain would be available, provided the taxpayer is over age 59 1/2 at the time of the conversion. However, caution should be taken by taxpayers contemplating such a strategy since it appears to fly in the face of the IRS's intent outlined in Revenue Procedure 2008-24.

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

As of September 27, 2010, eligible 401(k) and 403(b) participants can convert all or a portion of their plans to Roth accounts within the same plan. But if they do so, they take on the risk of paying too much tax should a downturn later occur. This is because in-plan converters cannot reverse the transaction via a recharacterization. Only converters to Roth IRAs have that option.

To get around this problem, a conversion by direct transfer to a personally-owned Roth IRA could be done. However, that is merely trading the recharaterization problem for a potential creditor protection problem. 401(k) and 403(b) plans that are covered by ERISA are generally protected from creditors in all 50 states. But if a 401(k) or 403(b) plan participant converts to a Roth IRA to keep the recharacterization option open, he or she probably downgrades the level of creditor protection, because state law would then apply. In Michigan, there is no limit to the protection afforded IRAs (Roth or traditional). The only question is whether such unlimited protection applies to only one or more than one IRA (Roth or traditional).

To get the best of both worlds, could a 401(k) or 403(b) plan participant convert to a Roth IRA and then direct transfer the Roth IRA to a Roth 401(k)/Roth 403(b) after the recharacterization period is over? That would be a nice solution, but it is currently not allowed. Roth 401(k)s and Roth 403(b)s cannot accept rollovers from Roth IRAs. They can only accept elective deferral contributions and rollovers from other Roth 401(k)s/Roth 403(b)s, thus leaving 401(k) and 403(b) plan participants (who have creditor concerns) between a Roth and a hard place.

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