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Tuesday September 22, 2020

Washington News

Washington Hotline

SECURE Act Creates Potential IRA Beneficiary Problems

The SECURE Act was passed by Congress and signed by the President in late December. It reduces future taxes for IRA owners by increasing the age for required minimum distributions from 70½ to 72. However, to pay for the cost of this tax reduction, the taxes paid by future IRA beneficiaries (typically children) will increase.

After the owner's death, IRAs, 401(k)s and other retirement accounts are generally transferred to designated beneficiaries. Custodians of IRAs and other retirement accounts offer a form, either printed or online, to select primary and secondary beneficiaries.

Most married IRA owners select their spouse as the primary beneficiary and children as the secondary beneficiary. When the first spouse passes away, the surviving spouse usually rolls over the IRA into his or her own IRA account. Under the SECURE Act, this is permitted and the surviving spouse must start required minimum distributions (RMDs) after reaching age 72.

When a surviving spouse passes away, children are typically the IRA designated beneficiaries. For individuals without children, the designated beneficiaries are often nephews and nieces. If the IRA owner designates children, nephews, nieces or other family as beneficiaries and also allocates part of the account to a charitable beneficiary, the portion for the nonprofit is normally distributed in a lump sum. However, distributions to children, nephews, nieces and other family members must now be made within 10 years.

For IRA owners who passed away in 2019, a child was able to "stretch" the IRA payout over his or her life expectancy. Assume mother Mary owned a traditional IRA and passed away in 2019. She designated daughter Susan (age 50) as her IRA beneficiary. While the IRA payouts are taxable income, Susan could reduce taxes by taking RMDs over her life expectancy. For a child age 50, the potential distribution period was approximately 34 years. By "stretching" the traditional IRA payout over 34 years, Susan reduced her income tax and benefitted from tax-free growth within the IRA.

If Mary passes away in 2020, the SECURE Act makes Susan take all distributions within ten years. She can wait and take the full payout in the tenth year, but that will greatly increase the tax rate paid on the IRA. Most children will choose to take partial payouts each year for the ten years. With a ten-year payout, the income taxes paid by Susan will be substantially higher than the prior "stretch" plan.

Some surviving spouses have three, four or more children. If one of the children is a "creative spender," a parent may choose to set up a trust. Without the protection of a trust, this creative spender may take the full IRA payout, send a huge tax payment to the IRS and quickly exhaust the balance in creative and unexpected ways. To protect these children, many parents have created "conduit" trusts to restrict the payout to only the RMDs due to the child.

Unfortunately, the SECURE Act eliminates RMDs for most children (there are exceptions for a disabled or chronically ill child). Under the SECURE Act there is no RMD and thus, with a conduit trust, no payout to the child until the tenth year. At that time, the full payout is made and the child will face a huge income tax bill.

Jamie Hopkins is a financial expert with Carson Wealth, headquartered in Omaha, Nebraska. He explains the conduit IRA trust problem and notes, "That is a complete disaster from a planning perspective," Hopkins said. "We just subjected most of that IRA money to the highest tax margin possible and locked up access to it."

Many concerned IRA owners want to update their estate plans to attempt to replace the "stretch" IRA distribution schedule. Could a plan combine the tax-saving benefits of a stretch IRA with a term-of-years or life payout to children or other heirs? Could this plan also have the tax-free growth benefit of a stretch IRA?

While it sounds too good to be true, an IRA to a testamentary unitrust plan includes all of these benefits. An IRA owner may create a testamentary unitrust to create a replacement stretch distribution. When the IRA owner passes away, the unitrust is funded with the traditional IRA. Because the unitrust is tax-exempt, there is a bypass of the income tax on the traditional IRA and any future growth within the trust.

In the unitrust, the full IRA proceeds are invested and earn taxable income for the unitrust recipients. After all payments are completed, the remaining unitrust principal is transferred to qualified charities. The children or other heirs benefit from substantial income (with no reduction in trust corpus earning power due to taxes). After all payments are completed, there is a generous gift to the donor's favorite charities.

Conservation Easement Deduction Denied

In TOT Property Holdings LLC et al. v. Commissioner; No. 5600-17 (13 Dec 2019), the Tax Court denied a conservation easement deduction and held a syndicated partnership liable for gross misstatement of value and negligence penalties.

In 2005, George R. Dixon acquired 652 acres of rural Tennessee property for $486,000. In 2013 he transferred a 99% interest in the real estate to TOT Land Manager, LLC ("TOT").

PES Fund VI, LLC ("PES") owned 99% of TOT. PES paid approximately $1.04 million in cash and improvements for the 99% interest in TOT and the underlying real estate. In 2013, TOT donated a conservation easement to Foothills Land Conservancy in 637 of the 652 acres.

Appraiser David R. Roberts valued the TOT conservation easement at $6.9 million. His valuation was based on the assumption that the property could be developed into a residential property. The IRS denied the deduction.

At trial, IRS appraiser Gerald Barker valued the property at $1.28 million and the easement at $486,000. Barker noted there were no mountains, lakes or other topographic features on the property that would encourage individuals to build a residential development. In addition, the property was remote and not adjacent to any other development property. Barber valued the property based upon timber and agricultural use.

Because Roberts had passed away, at trial the new TOT appraiser Thomas Wingard valued the property as a residential development. The Wingard valuation of the easement was $2.7 million.

The IRS claimed the easement deed provisions for judicial extinguishment failed the "granted in perpetuity" test, impermissibly permitted a state law merger extinguishment and contained commercial forestry and other improper retained rights. See Sec. 170(h)(2)(C).

The Tax Court determined the judicial extinguishment provisions did not create an absolute right to proceeds because the formula was not based on fair market value. Reg. 1.170A-14(g)(6). As a result, the conservation easement charitable deduction was denied.

Because the Tax Court determined the easement value was $496,000, both the gross misstatement of value and negligence penalties were applicable.

Editor's Note: This was major victory for the IRS. The charitable deduction was denied, the value of the property set by the IRS appraiser was accepted and the tax and penalties were imposed on the 19 PES investors.

Rettig Highlights IRS Conservation Easement Campaign

In IR-2019-213, the Service highlighted its success in the first conservation easement partnership case. The letter states, "On December 13, 2019, the U.S. Tax Court entered its first decision on a syndicated conservation easement transaction. In TOT Property Holdings, LLC v. Commissioner, Docket No. 005600-17, the Tax Court sustained the IRS's determination that all tax benefits from a syndicated conservation easement transaction should be denied and that the 40% gross valuation misstatement and negligence penalties applied."

IRS Commissioner Chuck Rettig had previously indicated the IRS will oppose inflated conservation easement valuations by syndicated partnerships. Regarding the judgment, Rettig stated, "In denying the deductions and upholding the 40% gross valuation misstatement penalty, the Tax Court confirmed that aggressive syndicated easement transactions simply will not survive scrutiny. We will not stop in our coordinated pursuit of these abusive transactions while seeking the imposition of all available civil penalties and, when appropriate, various criminal options for those involved."

The IRS reports that over 50 conservation easement cases are pending. These cases involve other syndicated partnerships that have reported substantial charitable deductions as a result of conservation easements.

IRS Chief Counsel Mike Desmond noted, "We are prepared to take each of these and all other cases being developed by the IRS to trial, although the substance of most cases can be resolved without trial because the transactions do not meet the basic requirements to claim the charitable contribution deduction."

Editor's Note: The Service is clearly on the offensive against inflated valuations of conservation easements. The TOT conservation easement valuation was 14 times the value accepted by the Tax Court. Pending legislation in Congress may limit deductions for future conservation easement syndicated partnerships to 2.5 times the amount invested by the limited partners. See The Charitable Conservation Easement Program Integrity Act (CCEPIA) of 2019 (S. 170; H.R. 1992).

Applicable Federal Rate of 2.0% for January -- Rev. Rul. 2020-1; 2020-3 IRB 1 (17 Dec 2019)

The IRS has announced the Applicable Federal Rate (AFR) for January of 2020. The AFR under Section 7520 for the month of January is 2.0%. The rates for December of 2.0% or November of 2.0% also may be used. The highest AFR is beneficial for charitable deductions of remainder interests. The lowest AFR is best for lead trusts and life estate reserved agreements. With a gift annuity, if the annuitant desires greater tax-free payments the lowest AFR is preferable. During 2020, pooled income funds in existence less than three tax years must use a 2.2% deemed rate of return.

Published December 27, 2019

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