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Unintended Tax Consequences from Mishandling of Inherited IRA: A Case Study
Last Updated September 21, 2016
(Written for financial/tax/legal professionals)
If one of your clients inherits a Traditional IRA and wants to share that IRA with a sibling, steps can be taken to ensure that the sibling is responsible for any income tax due on the amount he or she receives.
However, if proper procedures are not followed, the tax burden could be borne solely by your client, despite sharing the amount with others.
Such was the case in Morris v. Commissioner, TC Memo 2015-82, wherein the Tax Court found that the individual who inherited an IRA was responsible for paying income tax on a lump sum distribution of over $95,000, despite having given a portion of the amount to his siblings.
In this case, the IRS determined a federal tax deficiency of $27,037 and an accuracy-related penalty on underpayments of $5,387, because the beneficiary did not include the amount in his income for the year.
Generally, an individual who inherits a Traditional IRA will owe ordinary income tax on distributions of any pre-tax amounts from the account. The income tax is owed for the year in which the distribution occurs.
Sharing Inherited IRAs and the Resultant tax Burden with Others
An individual who inherits an IRA might be able to share that IRA with another party, if that party is a named beneficiary on the IRA as of the IRA owner’s death, or becomes a beneficiary under the default provisions of the IRA agreement. This sharing process is referred as a disclaimer. Note: A disclaimer must meet certain specific requirements, and is USUALLY a recommended strategy if the result is consistent with the objective of the beneficiary on record at the time of the IRA owner’s death.
The Case: Morris v. Commissioner, TC Memo 2015-82
Elroy Morris inherited an IRA from his father, who died on June 4, 2011.
Elroy was the sole primary beneficiary of the IRA.
Elroy withdrew the entire balance of more than $95,000 in 2011; and, as is required by the IRS, the IRA custodian reported the amount on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., as a taxable death distribution.
Elroy served as the personal representative of his father’s estate, and in accordance with what he believed to be his father’s wishes, he issued checks for $37,000 to each of his two siblings in 2011, subsequent to him receiving the distribution from the inherited IRA.
In his role as personal representative for his father’s estate, he engaged the services of a local law firm. A paralegal who worked for the law firm informed him that “there would be no tax due on the IRA distribution”. According to the Tax Court Memo, “By this she evidently meant that there would be no Federal estate tax or Michigan inheritance tax due”. However, Elroy’s understanding was that no tax of any kind would be due. As a result, he did not report the IRA distribution as income on his tax return.
Observation: This is a classic case of IRA rules getting lost in translation, and underscores the importance of using the proper terminology when discussing IRAs. When it comes to the matter of taxes, a distinction must be made for the different types of taxes, such as income tax, the additional 10% tax (early distribution penalty), Federal estate tax, and State inheritance tax. It would be unreasonable to expect consumers to understand and/or be aware of the different types of taxes that apply. This is where the assistance of a professional is necessary. However, professional assistance is worthwhile only if the professional has a complete understanding of the matter, and is able to translate that understanding in ‘plain English’ to the taxpayer.
On September 30, 2013, the IRS sent Elroy a notice of deficiency in which they determined that the IRA distribution constituted taxable income. Elroy petitioned the Tax Court on the basis that he did not “… solely owe this debt and should not be held solely responsible for it.”
The Issue: Traditional IRA distributions are Taxable
Generally, IRA distributions must be included in the recipient’s ordinary income for the year in which the distribution occurs. This includes distributions from inherited IRAs. Exceptions apply to amounts representing basis, amounts that are properly rolled over, and in cases where distributions are exempted from taxable income such as those amounts that qualify as qualified charitable distributions.
Elroy did not dispute the fact that the amount was taxable. It is possible that, by the time he filed the petition, he understood that the amount should be treated as ordinary income.
Elroy Claims No Fair! Tax Court Says That’s Nice but…
In his petition, Elroy contended that it would be inequitable to hold him solely liable for the income tax owed on the distribution, because he voluntarily shared the amount with his siblings, and it was unlikely that he would recover anything from them.
Since Elroy had given a total of $74,000 to his two siblings, his position may seem fair and logical to him. However, the issue here is that, while he did share the amount with his siblings, the method he used did not result in a sharing of the tax burden with them.
As such, the Tax Court determined that, despite his ‘honorable’ intentions, he was still required to include the entire IRA distribution amount in his 2011 income.
Elroy Claims Bad Advice Tax Court Says Tough…
As part of his claim, Elroy contended that the law firm gave him bad advice, which put him at a disadvantage. Tax Court responded that the advice from the law firm does not change the fact that the distribution is taxable.
What Elroy Should Have Done
If Elroy wanted his siblings to pay the income tax on the amount that they received, he could have used either of the following methods.
The disclaimer method, but only if the desired results would be achieved
The disclaimer method works only if the disclaimer would result in his two siblings being the beneficiary of the disclaimed amount. The steps for the disclaimer would include the following:
- Check the IRA beneficiary designation form to determine if there are contingent beneficiaries named. If so, and his siblings are the only contingent beneficiaries, they would become the beneficiaries for any amount that he properly disclaims. If another party is the contingent beneficiary, the disclaimer method would not work for Elroy, as it would result in that other party being the beneficiary of the disclaimed amount.
- If there is no contingent beneficiary, check the default provisions of the IRA Agreement & Disclosure Statement (IRA Agreement). Some IRA Agreements provide that if no beneficiary is named, or survives the IRA owner, the beneficiary would, by default, be the IRA owner’s surviving spouse. And, if there is no surviving spouse, then the surviving children of the IRA owner would be the beneficiary. If such is the case with the IRA in question, the surviving spouse would need to disclaim the amount, if she was alive, so that it would go to his siblings.
- If the IRA does not include such a provision, and the siblings are not contingent beneficiaries, the disclaimer option would not be a solution for Elroy.
If the siblings would become beneficiaries under the disclaimer method, Elroy would need to ensure that the disclaimer is valid. The requirement for a valid disclaimer includes:
- It must be a written irrevocable and unqualified refusal to accept the disclaimed amount
- The disclaimer must be received by the IRA custodian no later than nine months after the later of:
- None of the IRA should be ‘accepted’ before the disclaimer, and
- The disclaimed amount must pass without any direction on the part of the person making the disclaimer.
Ideally, an estate planning attorney should be consulted to determine if a disclaimer satisfies regulatory and other requirements. The IRA custodian should also be consulted to ensure that it satisfies their operational requirements.
The ‘Net of taxes’ Method
The inherited IRA can also be shared outside of a disclaimer. Under this option, the beneficiary would take a distribution, and give the siblings the amount. However, unlike a disclaimer, where the sibling would owe income tax on any amount received through a disclaimer, the beneficiary would owe income tax on any taxable portion of the distribution. In such cases, the named beneficiary could deduct the amount of taxes that would be owed on the amount, and give the balance to his siblings.
The Bottom line…
Ultimately, retirement account owners will be responsible for paying any income tax due on distributions that they take from their retirement accounts, whether or not those distributions are shared with others. This can come as a surprise to clients who are not knowledgeable about how retirement accounts work.
For clients who request distributions, helping to ensure that they understand any possible tax consequences can help to prevent such surprises. For those who want to share inherited accounts with others, strategies can be implemented to ensure that any tax burden is also shared.
In some cases, putting measures in place before the death of the retirement account owner is optimum. For instance, if the intent is to have three siblings share an inherited IRA, it might be more practical to name all three as primary beneficiaries of the IRA, instead of naming one and expecting him (or her) to share distributions with the other siblings.