Estate Planning for a Marital Property Interest in IRAs
This online article is a companion to the
author's print article (of the same title) published in the July 2000
Wisconsin Lawyer. This article provides broader discussion, including
legal analysis, of estate planning for a marital property interest in
IRAs than space allowed in the print article. You may
reach Mr. Willms online.
by Andrew J. Willms
Wisconsin's Marital Property Act presents tough questions to estate
planning attorneys. These questions include whether a married person has
a marital property interest in a spouse's IRA. If so, can the marital
property interest be used to fund the spouse's unified credit if the
spouse dies first? Is there a way to preserve the pre-tax growth of the
spouse's marital property interest in the IRA after his or her
death?
Greater attention needs to be focused on the marital property issues
created by IRAs because:
- the tremendous growth in the amounts held inside IRAs;
- the increase in the applicable unified credit amount available to
each taxpayer; 1 and
- the U.S. Supreme Court's 1997 decision in Boggs v.
Boggs.
This author has recently been sparring with the IRS over these
issues. This article reports the author's understanding of the current
state of the law.
Round 1: No Decision
The Scenario. Suppose your client is a married
Wisconsin resident and has funded an IRA by a rollover of his account
balance with an employer-sponsored qualified plan (the "rollover
IRA").Your client (for simplicity, called the "account owner" even
though both spouses may own a marital property interest in the account)
and his spouse are both age 70. The account owner's spouse has also
established her own IRA (the "spousal IRA"). However, the rollover IRA
represents the vast majority of the parties' total assets. The account
owner's IRA is worth more than $2,000,000, while the spousal IRA is
worth about $50,000. The couple's assets outside the IRA total
approximately $400,000.
The Estate Plan. The couple would like to be in a
position to fund the spouse's unified credit with part of the rollover
IRA if the spouse dies first, and also would like to allow their
children to continue the tax-free growth inside the rollover IRA for as
long as the minimum distribution rules allow regardless of who dies
first. In an effort to accomplish this objective, the couple executes an
estate plan that provides:
- The parties enter into a marital property agreement that classifies
the rollover IRA as marital property. The spousal IRA is classified as
the spouse's individual property by the marital property agreement.
- The marital property agreement provides that Wisconsin's terminable
interest rule2 does not apply to the
rollover IRA and, therefore, the spouse's interest will not be
terminated at her death by application of state law.
- Spouse's will and the marital property agreement provides that when
the spouse dies, the spouse's one-half interest in the rollover IRA
should be transferred to the account owner if he is alive.3 If the account owner disclaims this interest, the
will and marital property agreement provide the spouse's interest to the
rollover IRA should be distributed directly to the spousal IRA.
- The spouse files a beneficiary designation with the custodian of the
rollover IRA that is consistent with her will and the martial property
agreement.
- The beneficiary designation for the spousal IRA names a trust for
the benefit of the couple's children (the "children's trust") as the
beneficiary. The children's trust will be a qualified beneficiary, as
defined by Prop. Treas. Reg. 1.401(a)(9)-1 (as modified).4
- On or before her Required Beginning Date (RBD), the spouse will
direct the custodian of the spousal IRA to make annual distributions to
her during her lifetime based on her and the oldest trust beneficiaries'
joint life expectancies, subject to the minimum distribution incidental
death benefit rule.5 For this purpose,
neither life expectancy will be recalculated.
The Estate Plan's Effect
In the author's opinion, the effect of such an estate plan should
be:
- A spouse may have a marital property interest in an IRA
notwithstanding I.R.C. §
408(g).6
- The anti-alienation rules of the Internal Revenue Code and the
corresponding provisions of the Employee Retirement Income Security Act,
do not prevent the spouse from having a marital property interest in an
IRA.7
- Classification of the rollover IRA of the taxpayer as marital
property should not be considered a taxable distribution for purposes of
I.R.C. §
408(d)(1).8
- State law does not prevent the transfer of spouse's interest in the
rollover IRA to the spousal IRA.9
- If the spouse dies first and the account owner makes a qualified
disclaimer of her interest in the spousal IRA, amounts passing to the
children's trust as a result of the disclaimer can be protected from
transfer tax by the spouse's unified credit.10
- If the spouse dies first, and the account owner makes a qualified
disclaimer, it should be possible to make a tax-free transfer of the
spouse's one-half interest in rollover IRAs to the spousal IRA.11
- So long as the children's trust meets the requirements of proposed
Treasury Regulations § 1.401(a)(9)-1 (as modified), then after the
death of the spouse, minimum distributions from the spousal IRA can be
taken on the remaining joint life expectancy of the spouse and the
oldest trust beneficiary.12
Legal Analysis
State law does not prevent the transfer of the deceased
spouse's interest in the rollover IRA to the spousal IRA.
The Marital Property Act provides that a nonemployee spouse owns a
marital property interest in deferred employment benefits that accrue
after the effective date of the Marital Property Act.13 IRAs whose assets are traceable to a rollover
from a qualified plan are considered to be a deferred employment benefit
under Wisconsin law.14
Deferred employment benefits are subject to a terminable interest
rule which states that a nonemployee spouse's interest in a deferred
employment benefit plan terminates at the death of the nonemployee
spouse.15 However, spouses may negate the
application of the terminable interest rule with regard to deferred
employment benefits and rollover IRAs by so providing in a marital
property agreement.16
In the above hypothetical, the parties' marital property agreement
classifies the rollover IRAs as marital property and directs that the
terminable interest rule will not apply. The account owner has consented
to the transfer of his spouse's interest in the rollover IRAs to her own
IRA. Accordingly, a transfer of the spouse's one-half interest in the
rollover IRAs to the spousal IRA would be consistent with state law.
I.R.C. § 408(g)
does not defeat a spouse's marital property interest in an IRA to the
extent the existence of that interest is consistent with state law.
I.R.C. § 408(g)
states that section 408 "shall be applied without regard to any marital
property laws." Private Letter Ruling (PLR) 8040101 stated that the
House Committee Report for Code Section 408(g)
made clear that I.R.C. § 408(g)
was intended to limit deductions taken by a nonwage earning spouse from
marital property income received by the wage-earning spouse.
That PLR further stated:
"Because there is no specific language on what effect Congress
intended Code section 408(g)
to have, and because of the general rule of statutory construction which
provides the federal statutes are construed as to not preempt state law
unless that was the clear and manifest intent of Congress, we conclude
that section
408(g) does not abrogate any substantive rights under state
law."17
Thus, where a couple resides in a marital property jurisdiction, the
spouse of an IRA participant may have a marital property interest in the
IRA to the extent the existence of that interest is consistent with
state law.18 In addition, in PLR 9419036
the IRS acknowledged that the classification of an IRA as marital
property under state law is not a taxable event under section
408(d)(1), provided no actual distributions are made from the IRA
pursuant to the agreement.19
The anti-alienation rules of I.R.C. §
401(a)(13) and ERISA § 1055 do not defeat a nonparticipant
spouse's marital property interest in an IRA.
The anti-alienation rules of I.R.C. §
401(a)(13) and ERISA § 206(d) are intended to ensure that the
economic security of a surviving spouse is not undermined by allowing a
predeceasing spouse's interest to be distributed to other beneficiaries.
Therefore, under the anti-alienation rules, if the nonparticipant spouse
dies first, her interest in qualified retirement plans of the
participant spouse terminate. The anti-alienation rules of I.R.C. §
401(a)(13) and ERISA § 206(d) govern qualified retirement
plans, but do not apply to IRAs.20
In the hypothetical under consideration, although the IRA is also
traceable to an ERISA governed plan, the retirement funds have been
rolled over to an IRA during the spouse's lifetime. This rollover
terminates the application of the anti-alienation.
The transfer of the spouse's one-half interest in rollover
IRAs to the spousal IRA should not be regarded as a taxable
distribution.
I.R.C. §
408(d)(3)(A) provides that amounts paid or distributed out of an IRA
are not currently taxable to the distributee if the entire amount
received is paid into an IRA for the benefit of the distributee within
60 days. Furthermore, Rev. Rul. 78-406, 1978-2 C.B. 157, provides that
the direct transfer of funds from one IRA trustee to another IRA trustee
does not result in such funds being currently taxable.
As explained above, under state law the participant's spouse is the
owner of a one-half interest in an IRA that is classified as marital
property. Likewise, the spouse is the owner of the spousal IRA. Thus, in
the author's opinion, the transfer of the spouse's interest in the
rollover IRA to the spousal IRA should be nontaxable since the 60-day
requirement of §
408(d)(3)(A) and the direct transfer requirement of Rev. Rul. 78-406
will both be satisfied.21
If the spouse's interest in the rollover IRA can be
transferred to the spousal IRA, then the life payout method should be
available when determining the amount of required minimum distributions
from the spousal IRA after death of the spouse.
I.R.C. §
401(a)(9) provides for minimum distribution rules governing when
qualified plan distributions must begin, the minimum amount that must be
distributed to the participant during his or her lifetime, and the
payment of plan benefits upon the participant's death.22 I.R.C. §
401(a)(9)(A) provides that distributions cannot extend for a period
longer than the life of the participant, the lives of the participant
and the designated beneficiary, a period (which may be a term certain)
not extending beyond the life expectancy of the participant, and a
period (which may be a term certain) not extending beyond the life
expectancies of the participant and the designated beneficiary. The
amount of the minimum distribution is to be determined by dividing the
account balance as of Dec. 31st of the preceding calendar year by the
applicable life expectancy.23
If there are multiple designated beneficiaries, the designated
beneficiary with the shortest life expectancy must be used for
determining the distribution period.24 If
the designated beneficiary is not the participant's spouse, the joint
life expectancy of the participant and the designated beneficiary must
be calculated as if the beneficiary was no more than 10 years younger
than the participant.25
Applying the foregoing to the facts at hand, if the transfer of the
spouse's interest in the rollover IRA to the spousal IRA is permissible,
it should be permissible for distributions to be taken from the spousal
IRA based on the joint life expectancy of the spouse and her oldest
child, subject to the minimum distribution incidental benefit
rule.26
The IRS's View
In 1999 the author submitted a private letter ruling request to the
IRS in an effort to confirm the opinions expressed above. Unfortunately,
the IRS declined to respond to that ruling request, asserting the
request involved a "hypothetical situation" until the death of either
the account owner or the spouse.
Round 2: A Split Decision
In light of the IRS's position, a new ruling request was submitted.
The new ruling request asked whether a married person residing in
Wisconsin could transfer her marital property interest in the rollover
IRA by a direct trustee-to-trustee transfer to the spousal IRA,
prior to the death of either the account owner or the spouse.
The new ruling request indicated that actual distribution of IRA funds
would not be made at the time of the transfer to either the account
owner or to the spouse. The new ruling request also asked whether
minimum distributions from the spousal IRA could be taken based on the
joint life expectancy of the spouse and her oldest designated
beneficiary, subject to the minimum distribution incidental benefit
rule.
The IRS's Response
The IRS responded to the new ruling request by issuing PLR 199937055
(June 24, 1999). The ruling confirmed that I.R.C. § 408(g)
does not abrogate any substantive rights under state law. Furthermore,
the IRS ruled that the reclassification of an IRA as marital property
pursuant to a property agreement is not considered a taxable
distribution for purposes of §
408(d)(1). However, the IRS also ruled that the transfer of a
spouse's marital property interest in the rollover IRA to the spousal
IRA would constitute a taxable distribution for purposes of §
408(d)(1). In reaching that decision, the IRS stated:
"The owner of an IRA account is deemed to be the individual in whose
name the account was established. This conclusion is not affected by
state law."
The IRS then went on to state that even if a spouse is the owner of
one-half of an IRA account under state law, distributions from the IRA
are to be taxed as if the account owner is the sole owner of the
IRA. The IRS cited absolutely no authority in either of its
positions, however.
Legal Analysis
Notwithstanding its admission that § 408(g)
was not intended to preempt state law in this respect, the IRS
stated in its ruling that property rights established by state law could
be ignored when determining how IRA distributions are to be taxed. The
critical question then becomes whether the IRS can in fact ignore the
existence of property rights created by state law when applying the
Internal Revenue Code.
In U.S. v. Mitchell,27 the U.S.
Supreme Court considered whether a married woman domiciled in the
community property state of Louisiana was personally liable for federal
income tax on half of the marital income realized during the existence
of the marriage despite the exercise of her statutory right of
exoneration. The Court held that the spouse was liable for the federal
income tax on one-half of the marital income. In doing so, the Court
stated:
"[T]hus, with respect to marital income, as with respect to other
income, federal income tax liability follows ownership. Blair v.
Commissioner, 300 U.S. 5, 11-14 (1937). See Hoeper v. Tax
Comm'n, 284 U.S. 206 (1931). In the determination of ownership,
state law controls. 'The state law creates legal interests but the
federal statute determines when and how they shall be taxed.' Burnet
v. Harmel, 287 U.S. 103,110 (1932); Morgan v.
Commissioner, 309 U.S. 78, 80-81 (1940); Helvering v.
Stuart, 317 U.S. 154, 162 (1942); Commissioner v. Harmon,
323 U.S. 44, 50-51 (1944); See Commissioner v. Estate of Bosch,
387 U.S. 456 (1967)."28
Where, as here, both spouses have identical ownership interests in an
IRA under state law, it would seem the IRS should be obligated to treat
those property interests in the same manner when applying the Internal
Revenue Code. "It was the object of Congress to provide a uniform basis
of taxation in order to secure uniformity in the burdens imposed.
'Equality is equity.'"29 However, the U.S.
Tax Court's recent decision in Bunney v. Commissioner30 can be read to support a different
conclusion.
Andrew J. Willms , University
of Miami 1984 cum laude, LL.M.-Estate Planning 1985, is a shareholder
with the Thiensville firm of Willms Anderson S.C. He is a frequent
author and speaker on estate planning and related topics.
Bunney concerned a community property IRA that was
distributed to the person who had established the account and then
transferred from that person to his former spouse pursuant to their
divorce. The Tax Court held that the entire amount distributed was
taxable to the account owner. In so doing, the court indicated (in
dicta) that recognition of a spouse's community property interest in an
IRA for income tax purposes would conflict with the application of § 408(g).
In the author's view, the court's reasoning in this regard is
questionable. Moreover, the Tax Court did not address the more
fundamental issue mentioned above; namely, can state created property
rights be ignored when applying the tax code where there is no
preexemption? And if so, what is to be made of the Private Letter
Rulings cited above?
Conclusion
A spouse may have a marital property interest in an IRA to the extent
that his interest is consistent with state law. If the application of
Wisconsin's terminable interest rule is negated by a marital property
agreement, the spouse's marital property interest in the IRA can be used
to fund the spouse's unified credit. It also may be possible to transfer
the spouse's interest in a marital IRA to an IRA established in the
spouse's name. If so, the minimum distribution rule should be applied
based on the life expectancy of the spouse and her designated
beneficiary.
Endnotes
1 For a discussion on using IRA
assets to fund the Unified Credit, see Herbers, John A., Funding
the Credit Shelter Trust with IRA
Benefits, 73 Wis. Law. 14 (July 2000).
2 Wis. Stat. §§
766.62(5); 766.31(3).
3 Wis. Stat. §
766.58(3)(f).
4 See Campbell, Terry L.,
The
IRA Maze: Finding A Way Out, 73 Wis.
Law. 10 (July 2000).
5 I.R.C. §
401(a)(9)(A).
6 PLR 1999 37055; PLR 8040101.
7 I.R.C. §
401(a)(13); ERISA § 206(d); PLR 1999 37055.
8 PLR 1999 37055; PLR 8007024; PLR
8929046; PLR 94190396; PLR 9439020.
9 Wis. Stat. §§
766.01(4)(a); 766.17(1); 766.31(3)0; 766.62(1)(a); 766.62(5)(b).
10 See I.R.C.
§§ 2518, 2011. See
also Herbers,
supra note 1.
11 See PLR 8040101; PLR
9439020.
12 See Campbell,
supra note 4.
13 Wis. Stat. §
766.62(1)(a).
14 Wis. Stat. §§
766.01(4)(a); 766.62(5)(b).
15 Wis. Stat. §§
766.62(5); 766.31(3).
16 Wis. Stat. §
766.17(1).
17 See also PLR 9630034;
PLR 9623063; PLR 9439020; PLR 9427035; PLR 9419036; PLR 8929046; PLR
8007024.
18 But see, Bunny v.
Commissioner, 114 T.C. No. 17, Docket No. 20713-97 (filed April 10,
2000).
19 In accord, see, PLR
8007024, 8929046, 9439020.
20 While the recent U.S. Supreme
Court case of Boggs v.
Boggs contains dicta that could be considered to apply ERISA's
anti-alienation and state preemption provisions to an IRA of the
decedent, the facts of Boggs make clear that the decision in
that case does not result in the anti-alienation rules of ERISA applying
to IRAs.
21 PLR 9630034 considered the
transfer of a surviving spouse's marital property interest in a
custodial IRA that had been established by her deceased husband to an
IRA that was established by the surviving spouse. In that ruling, the
IRS concluded that the custodian-to-custodian transfer of a spouse's
marital property interest in the IRA established by her deceased spouse
constituted an election to treat such transferred portions as the
spouse's own account and, therefore, qualified as a tax-free transfer
pursuant to §
408(d)(3)(A), and furthermore was not subject to the limitation
found in §
408(d)(3)(B).
Similarly, in PLR 9439020, the IRS ruled that a division of a marital
property IRA into two individual IRAs (one for each spouse) was not a
taxable event. The IRS further ruled that each spouse could direct the
testamentary disposition of their respective interests in the IRA since
applicable state law so allowed.
In PLR 8040101, the IRS recognized the one-half ownership interest of
the spouse under the marital property laws of the state in which the
couple were domiciled and approved distribution of the spouse's share of
the IRA to her heirs while the spouse in whose name the IRA was
established was still living. The IRS further ruled that a
distribution of the deceased spouse's interest in the IRA was not
taxable to the surviving spouse because he was not the payee or the
distributee under I.R.C. §
408(d)(1).
22 See, Campbell,
supra note 4.
23 Prop. Regs. §
1.401(a)(9)-1, Q&A F-1 and F-5.
24 Prop. Regs. §
1.401(a)(9)(E), Q&A E-5.
25 Prop. Regs. §
1.401(a)(9)-2, Q-4.
26 In accord, see, PLR
9630034. See also Herbers,
supra note 1.
27 U.S. v. Mitchell, 403
U.S. 190 (1971).
28 Id. at 197.
29 Pacific Ins. Co. v.
Soule, 74 U.S. 433 (1868) at 433.
30 Bunny v.
Commissioner, 114 T.C. No. 17, Docket No. 20713-97 (filed April 10,
2000).
Wisconsin
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