Current Tax Issues In Estate Planning

 Presented to the Arizona Chapter of the National Academy of Elder Law Attorneys
September 11, 2009
Presented by
Thomas J. Murphy
Murphy Law Firm, Inc.



The number of estates subject to the federal estate tax has plummeted. According to the Statistics of Income Division of the IRS, the figures are as follows:

Year                 # of FET returns         # of FET returns From AZ

2007                38,031                          579
2006                49,050                          713
2005                45,070                          615
2004                65,039                          1,262
2003                73,128                          1,014
2002                99,603                         1,417
2001                108,071                        1,706
2000               108,322                        1,660
1999                103,979                        1,965
1998                97,856                          1,628
1997                90,006                         1,309
1996                79,321                          1,252
1995                69,755                          1,180

Each year, around 45% of the returns have no tax owed, so that for 2007, only 17,416 returns actually owed estate taxes.

These numbers must be viewed in the context of 2.4 million deaths each year in the United States so that well under one percent of all decedents will owe estate taxes, or 1 out of every 137 decedents.

For 2008, the amount of estate and gift tax was $29.8 billion, as compared to the largest source of tax revenue, individual income taxes, that amounted to $1.425 trillion and is 47 times larger than the amount of estate and gift taxes. As a percentage of total tax revenue, the estate and gift tax only amounts to 1.1%.


According to Tax Analysts and ACTEC, 23 states now have some form of state estate and/or gift tax. They are: Connecticut, Delaware, Illinois, Indiana, Kansas, Kentucky, Maine, Maryland, Massachusetts, Minnesota, New Jersey, New York, North Carolina, Ohio, Oklahoma, Oregon, Pennsylvania, Rhode Island, Tennessee, Vermont, Washington and Wisconsin plus the District of Columbia. For most of these states, the estate tax exemption is $1M. However, Indiana’s exemption is only $100,000, Ohio’s exemption is only $338,000 and New Jersey, Rhode Island and Wisconsin have a $675,000 exemption. Nebraska and Virginia recently eliminated its estate tax and Oklahoma is phasing it out with its elimination effective January 1, 2010.


Most everything that I have read indicates that Congress and the Obama administration will maintain the status quo – a $3.5M exemption with a 45% rate. The release in March 2009 of the White House’s “Green Book” says this with two added features – the elimination of discounts for family limited partnerships and a ten-year minimum period for a Grantor Retained Annuity Trusts. The conventional wisdom is that neither feature will pass.

There are two other proposals that have gained attention but it is difficult to determine if they will be enacted. One is called “portability”. The concept is that a surviving spouse can use the unused amount of the deceased spouse’s estate tax exemption. For example, if the first spouse to die only used $1M of the $3.5M exemption, then the unused $2.5M could be used by the surviving spouse in addition to the $3.5M that spouse already has.

The other proposal is from Senator Blanch Lincoln (D-Arkansas) that would raise the exemption to $5M and cut the tax rate to a 35% rate. Ten Democratic senators have already endorsed the bill against the wishes of the White House, so it will be interesting to see where this ends up.

It looks like Congress will wait until the very end of the year before passing legislation. It is certain that the one-year elimination of the estate tax in 2010 will not be allowed to happen.


Beginning on January 1, 2010, the Tax Increase Prevention and Reconciliation Act of 2005 will eliminate the income limitations that prevented many people from converting a traditional IRA to a Roth IRA. Until then, high income taxpayers – defined as those with adjusted gross incomes of more than $100,000, whether single or married — are not eligible to make such a conversion.

Please note that there is an additional requirement for Roths that does not end. If a taxpayer earns $110,000 or more ($160,000 for married joint filers) then you cannot contribute to a Roth. These two requirements have effectively precluded upper income taxpayers from enjoying the benefits of a Roth IRA.  They couldn’t convert their traditional IRA to a Roth, and they could fund one either.

That will now change and practitioners will be hearing a great deal about it if they have not already. But remember that this applies only to conversions and not contributions.

The painful aspect of a conversion to a Roth is that it is treated as a taxable distribution from the existing IRA. This means that all of the tax must be paid in the year of the conversion. The new law changes this in that, for conversions done in 2010, the payments of taxes attributable to the conversion can be spread over the following two years, 2011 and 2012. Note that is only applies to conversions done in 2010 and not to subsequent years. The commentators that I have seen are of the opinion that the tax must be evenly spread over the two years unless an election is made to pay it all in 2011. In other words, payment of the tax is either 50% in 2011 and 50% in 2012 or 100% in 2011.

For those TPs who have not yet reached 59 ½ years of age, the funds in a Roth cannot be withdrawn for five years without incurring a 10% early withdrawal penalty. However, it usually will not make economic sense to withdraw that quickly from a Roth since the primary benefit of a Roth is the long-term tax-free appreciation.

Another factor to be considered is whether the client fears future legislation that creates a large income tax increase.

The consensus among commentators is that this conversion can be done from a 401k or other qualified plan as long as the plan allows for a rollover to an IRA.

A TP can do a partial conversion and can do conversions from multiple IRAs.

Many websites have conversion calculators to assist with this.



From a tax standpoint, an area that has been and will continue to receive attention concerns early (ie, pre-59 ½ ) withdrawals from 401k’s and IRA without incurring the 10% penalty. Penalty-free withdrawals from a 401k or IRA are allowed if the account owner:

  • Becomes totally disabled.
  • has medical expenses that exceed 7.5 percent of adjusted gross income.
  • is required by court order to give money to your divorced spouse (ie, a QDRO)
  • is separated from service (through permanent layoff, termination, quitting or taking early retirement) in the year the account owner turned 55 or later, or.
  • withdrawals in substantially equal amounts over the owner’s life expectancy that 1) must be paid at least once each year, 2) must be based on the life expectancy of the plan participant or the joint life expectancy of the participant and a designated beneficiary; and (3) must not be modified before the later of five years after the first distribution or the date on which the plan participant reaches age 59½.


In addition, for an IRA (but not a 401k), there are three additional possible means of withdrawing funds pre- 591/2 years of age:

  1. to pay health insurance premiums during a period of unemployment lasting at least 12 consecutive weeks;
  2. to pay for higher-education expenses applies to either the account owneror the account owner’s spouse, child, or grandchild, but only if the distribution is used to pay for tuition, fees, books, supplies, equipment, or room and board and is net of any scholarships; or
  3. to pay up to $10,000 of the cost of purchasing (and NOT refinancing) a first home as defined as someone who did not own (and whose spouse did not own) a principal residence in the two years preceding the distribution from the account.

Hardship withdrawals

An additional means of withdrawal from a 401k are for hardship distributions. A 401(k) plan may allow employees to receive a hardship distribution because of an “immediate and heavy financial need” and the distribution is “necessary to satisfy that financial need “. Hardship distributions from a 401(k) plan are limited to the amount of the employee’s contributions and generally do not include any income earned on the deferred amounts. If the plan permits, certain employer matching contributions and employer discretionary contributions may also be included in hardship distributions. Hardship distributions cannot be rolled over to another plan or IRA.

A distribution is deemed to be on account of an immediate and heavy financial need of the employee if the distribution is for:

  • Expenses for medical care previously incurred by the employee, the employee’s spouse, or any dependents of the employee or necessary for these persons to obtain medical care
  • Costs directly related to the purchase (and NOT the refinancing) of a principal residence for the employee, not to exceed $10,000 and only if no home has been owned in the previous two years;
  • Payment of tuition, related educational fees, and room and board expenses, for the next 12 months of postsecondary education for the employee, or the employee’s spouse, children, or dependents;
  • Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence;
  • Funeral expenses; or
  • Certain expenses relating to the repair of damage to the employee’s principal residence.

Distribution necessary to satisfy financial need.  This determination generally is to be made on the basis of all relevant facts and circumstances. The employee’s resources are deemed to include those assets of the employee’s spouse and minor children that are reasonably available to the employee. Thus, for example, a vacation home owned by the employee and the employee’s spouse, whether as community property, joint tenants, tenants by the entirety, or tenants in common, generally will be deemed a resource of the employee. The amount of an immediate and heavy financial need may include any amounts necessary to pay any federal, state, or local income taxes or penalties reasonably anticipated to result from the distribution.

An immediate and heavy financial need generally may be treated as not capable of being relieved from other resources reasonably available to the employee if the employer relies upon the employee’s written representation, unless the employer has actual knowledge to the contrary, that the need cannot reasonably be relieved:

  • Through reimbursement or compensation by insurance or otherwise;
  • By liquidation of the employee’s assets;
  • By cessation of elective contributions or employee contributions under the plan; or
  • By other distributions or nontaxable (at the time of the loan) loans from plans maintained by the employer or by any other employer, or by borrowing from commercial sources on reasonable commercial terms in an amount sufficient to satisfy the need.

Loans from 401k’s

Background: §72(p) of the Internal Revenue Code generally provides that an amount received as a loan from a qualified employer plan by a participant (or beneficiary) is treated as a taxable “deemed distribution”, except if certain conditions are satisfied as set forth in §72(p)(2)(A). The statutory conditions that must be satisfied to avoid a deemed distribution are:

1) Loan can’t exceed the lesser of $50,000 or half the participant’s nonforfeitable account balance. (The $50,000 limit is reduced if there were outstanding loans during the 1-year prior to issuing the new loan.)

2) Loan must be repayable within 5 years, except that this restriction does not apply to loans to acquire a principle residence.

3) Repayment must be required in substantially level payments, not less frequently than quarterly.

4) Loan be evidenced by a written, enforceable agreement.

Advantages of a loan from a qualified plan:

  1. Quick and convenient. There is no credit check or long credit application form. Some plans only require you to make a phone call, while others require a short loan form.
  2. There is a low interest rate. You pay the rate set by the plan, usually one or two percentage points above the prime rate.
  3. There usually are no restrictions. Most plans allow you to borrow for any reason.
  4. You are paying the interest to yourself, not to the bank or credit card company.
  5. The interest is tax-sheltered. The plan does not pay taxes on the interest until retirement, when the money is taken out of the plan.
  6. You choose where the money comes from. The advantage of being able to choose which investment option you will sell in order to obtain the funds for your loan is that you can leave untouched those investments with the best performance.
  7. The existence of these loans or loan defaults are not reported to credit rating agencies


Disadvantages of a loan from a qualified plan:

  1. The interest rate paid on a plan loan is often less than the rate the plan funds would have otherwise earned.
  2. Smaller contributions. Because you now have a loan payment, you may be tempted to reduce the amount you are contributing to the plan and thus reduce your long-term retirement account balance.
  3. Job loss. If you lose your job or change employers, the loan must be immediately paid back. Most plans require full repayment of a loan within 60 days of termination of employment. If you can’t repay the loan, it is considered defaulted, and you will be taxed on the outstanding balance, including an early withdrawal penalty if you are not at least age 59 ½.
  4. There may be fees involved although this is usually a low-cost loan.
  5. Interest on the loan is not tax deductible, even if you borrow to purchase your primary home.
  6. The term of the loan cannot be longer than 5 years.
  7. Difficult to obtain if your 401k is with a former employer – plans usually prohibit them.

Watch out for loans balances that exceed loan limits:

Billips v. Commissioner, TC Summ Op 2009-86. TP had taken out 11 loans from his 401K plan during a 12 year span. It was #11 that got TP into trouble when he took out a $12,630 loan. At the time, TP already had loans in the amount of $27, 012, making a total of $39,748.06. The problem was that TP’s account balance was $52,863.30, meaning that outstanding loans could not exceed $26,431.69.   The excess over the $26,431.69 was taxable and subject to the 10% early withdrawal penalty.


Marquez v. Commissioner, TC Summ Op 2009-80. Almost identical facts to Billups with same result.



Rollovers. Another means of withdrawing funds is to do a rollover. It is best to do these trustee-to-trustee but the account owner has 60 days from the date of the withdrawal to deposit the funds in another IRA or qualified account.



2009 saw a continuation of the long line of private letter rulings (PLRs) that have waived penalties where IRA rollovers were wrongly done but not due to any fault of the TP. For a summary of these rulings from prior years, see my article in the April 2005 edition of Estate Planning

Under IRC section 408(d)(3), any funds withdrawn from an IRA are taxable unless they are rolled over into another IRA within 60 days of the distribution. That same IRC section grants authority to the IRS to waive the 60 day rule if the failure to do so would be “against equity and good conscience”. See Rev Proc 2003-16 for further guidance on this. The following is a list of PLRs from 2009.


200930051 – TP retires from the Air Force with an outstanding loan from his Thrift Savings Plan account. TP is told he must repay the loan with 60 days of his separation from the Air Force but TP did not realize that the failure to repay would be treated as a taxable distribution. TP is hospitalized twice during the 60 day period. Waiver granted to deposit the amount of the loan into an IRA


200930052 – TP attempted to rollover funds within 60 day period but day 60 fell on Sunday and transaction was not completed until the next day, Day 61. Waiver granted.


200925043 – Attempted spousal rollover on spouse’s death. TP is not aware of problem until form 1099R was issued. Bank made mistake by putting funds into non-qualified account and submitted affidavit admitting mistake. TP had not otherwise used the funds. Waiver granted


200925046 – Attempted 60 day rollover. TP was incapacitated as evidenced by doctor’s report. Son was told – incorrectly – by bank personnel that IRA distributions would be non-taxable because of TP’s incapacity. All funds were placed in non-qualified CDs and were not otherwise used. TP learns of problem the following spring when meeting with tax preparer. Waiver granted.


200927044 – TP was diagnosed with terminal cancer that “impaired (his) decision making ability” during the 60 day period. TP had doctors’ statements to this effect. Waiver granted.


200926042 – H&W had health problems. H underwent quadruple bypass surgery and undergoes dialysis treatment three days week. W had two broken vertebrae. Both on medications. This “impaired their abilities to monitor their financial affairs”. Ruling does not state what documentation or other proof was supplied by TPs but waiver is granted.


200924056 – During the 60 day period, TP had several hospitalizations for a “severe and life threatening medical condition” and “suffered from memory and hearing loss as a result of his medical condition”. Waiver granted.


200924057 – W is full-time caregiver of H who had, apparently over a number of years, suffered a heart attack, a series of seizures and strokes and a painful hip relocation that “caused severe pain, disorientation and spasms”. H was paralyzed on his right side. During the 60 day period, their daughter died unexpectedly. Waiver granted.


200925047 – TP has her spouse, father and uncle all die within a short time span. TP experiences serious depression and is under doctor’s care for it. Dr submits letter to this effect. TP hires probate attorney who tells her all inheritance proceeds are non-taxable. TP then transfers funds into nonqualified account. Later, her financial planner alerts her to mistake. Waiver granted.


200929020, 200927043, 200926039, 200926040, 200926041, 200924061 – Bank admits its error by depositing rollover funds into non-qualified account. Waiver granted.


200929022 – TP’s wife rolls over TP’s qualified funds into a non-qualified account without his knowledge. TP’s wife had completed the forms without informing TP. Wife “is impaired and cannot make sound financial decisions and has a past history of making irrational decisions”. Ruling does not state what proof was provided by TP but a waiver is granted.


But sympathy has its limits and the IRS will refuse to waive in certain cases:


200925048 – TP changes accounts due to market losses. After withdrawing funds from his IRA, he injures his foot in a roofing accident. TP was able to travel to his bank and doctor. TP also asserts that he needed time to determine which financial advisor he could trust. IRS had asked for additional medical information that was not provided. Waiver denied.


200919061 – TP alleges bank error but bank refused to acknowledge any mistake. Ruling notes that the IRA was deposited into a joint account and that an IRA cannot be jointly titled. The documentation of the initial deposit did not indicate that the source of the funds was an IRA. Waiver denied.


200914071 – TP claims bank error. Bank refuses to admit error and says that TP was told in both English and Spanish of the taxability of the transaction. Waiver denied.


200919071 – TP mistakenly thought he had 90 days to do a rollover and did not realize his mistake until the 60 days had run. Waiver denied.


Series of substantially equal periodic payments (SOSEPP)

Another means of withdrawing funds from qualified plans – one that has received quite a bit of attention in the professional journals, is the SOSEPP. It is the most universally available since it does not require the existence of certain situations, such as medical expenses or college expenses. Section 408(d)(1) and 72(t)(2)(A)(4) allow for withdrawals from qualified plans for those pre-59 ½ without incurring the 10% early withdrawal penalty set forth in section 72(t)(1) if done over the life expectancy of the participant/owner. The payments must be made for at least five years. See also Rev Rul 2002-62. For an excellent discussion of SOSEPPs, see “Substantially Equal Periodic Payments From IRAs” by Linda Burilovich and Andrew Burilovich in the October 2008 edition of The Tax Advisor.

Where TPs run into trouble is when they change aspects of the SOSEPPs. The downside to SOSEPPs is the irrevocable nature of the election – once made, it cannot be changed or, as stated in the tax code, “modified”. Many of the PLRs in this area deal with transactions that, inadvertently or not, may have modified to SOSEPPs. Once modified, there is a retroactive penalty so that taxes on all payments are triggered. So a TP wants to avoid the label of “modification” at all costs.


Benz v. Commissioner, 132 TC No. 15. TP had huge IRA, taking SOSEPPs of $102,000 per year after leaving her employer. TP also took out $22,500 to pay her son’s college tuition. Normally, college expenses are penalty-free withdrawals IAW section 72(t)(2)(E) but the payment was made after the SOSEPPs had begun. Tax Court holds that a TP can qualify for more than one exception to the 10% penalty and the withdrawals for college expenses are made penalty-free.


200925044 – TP had two IRAs, one of which he was taking SOSEPPs. TP wanted to get out of equities and into cash CDs but his brokerage house did not offer this so TP moved both IRAs to another institution that combined both IRAs. While this constituted a valid trustee-to-trustee rollover, TP later realized that it created a problem with the IRA that was distributing SOSEPPs. TP sought the PLR seeking permission to undo the transaction. IRS rules against him by not allowing the reversal of transactions and thereby finding a modification, meaning taxes are owed.


200930053 – IRA custodian omitted to withhold state tax payments that were supposed to be made by custodian. TP initially planned to pay the taxes from his own, non-qualified funds but now sought a ruling from the IRS that would allow the custodian to make up to omitted amount by increasing the amount paid in the current year. TP sought a ruling that this increased amount would not constitute a modification of the SOSEPP so that there would be no 10% penalty. IRS rules there is no modification and the increased amount can be made without penalty.


200929021 – Bank accidentally rolled over funds into an IRA from which TP was taking SOSEPPs. IRA ruled that the mistaken funds could be withdraw and that the added funds would not be counted as part of the base on which the SOSEPPs were calculated. The SOSEPPs were not modified.



Warren v. Commissioner, TC Memo 2009-148. TP filed for bankruptcy in 2005. After his bankruptcy petition filing, TP then files his income tax returns for 2002, 2003 and 2004. Bankruptcy court denies discharge of the taxes for those years. Tax Court agrees and assesses additional penalties for negligence and failure to timely file.



Rev Proc 2009-9 & 2009-20 — On March 17, 2009, the IRS issued Rev Proc 2009-20 that provided guidance on investment losses due to criminally fraudulent conduct. Losses incurred in the year 2008 are given special treatment but much of the ruling applies to any year in which a loss due to fraud occurs. The Rev Proc was meant to address the difficulty that a TP faces in determining the precise amount of loss since, in a fraud situation, there is always a possibility of a subsequent recovery that will lessen the loss. It attempts to remedy this by creating a safe harbor by allowing a deduction for 95% of their net investment. If a lawsuit is planned or undertaken against financial advisors who directed TP into the fraudulent funds, a 75% deduction will be allowed. By doing so, the TP would not be able to amend prior year returns for the phantom income reported in those years.

The promoter of the scheme must be indicted or convicted. The IRS, through public comments, have stated that it has not yet decided how to address these losses occurring inside a 401K or other qualified plan. The main benefit for losses occurring in 2008 is a five-year loss carryback rather than the customary three years.

Rev Proc 2009-9 is a summary of the loss recognition rules of IRC section 165. This is a concept that can get complicated, such as determining losses when the TP used a feeder hedge fund or other intermediary rather than directly investing in the fraudulent product. Another example is determining the adjusted basis of the investment (ie, contributions made over the years less the distributive share of investment income). For a good discussion of these issues, see “Federal Treatment of Ponzi Scheme Losses” in the May 14, 2009.edition of Estates, Gifts and Trust Journal and “Deducting Losses For Defrauded Investors” by John C. Zimmerman in the June 2009 edition of Journal of Accountancy.


PLR 200921039 – Discusses the implementation of Rev Rul 2002-45 regarding “restorative payments”. This ruling was issued before Rev Proc 2009-20. Here, financial institution enters into settlement agreement regarding unauthorized transactions with funds inside TP’s IRA. The settlement calls for funds to be replenished in the account. TP seeks ruling that these funds will be considered a restorative payment rather than a contribution that would be in excess of the annual limitations. Ruling points out that IRA losses due to breach of fiduciary duty, fraud or violation of securities laws will be considered restorative.



Estate of Miller, TC Memo 2009-119. TP, an 86 year old widow, created and funds an FLP in April 2002 with $3.8M in marketable securities. Mr Miller, who had died in 2000, had a unique investment philosophy that he had taught his son who carried out this philosophy as general partner of the FLP. TP dies in May 2003 of complications from a fall. In that same month, TP transfers another $1M. Tax Court approves the April 2002 transfer, emphasizing that the FLP accounts were actively managed by the son. Court finds that the desire to maintain Mr Miller’s trading philosophy was a valid nontax reason to uphold and recognize the transaction. IRS emphasized that the FLP was not a business but court, in what will likely be a widely cited comment, notes that a nontax purpose does not have to equate to a business. TP does not fare as well on the May 2003 transactions. The court includes these transfers in TP’s estate, since they were done knowing that TP’s death was imminent. Court also notes that the transfers left TP with very little in other assets.


Estate of Jorgensen, TC Memo 2009-66. H & W form FLP in 1995 with $900,000 of marketable securities. H, a knowledgeable investor, dies in 1996. W, who had no financial expertise, forms second FLP in 1997 with $1.8M in marketable securities with a son and two nephews as general partners. W dies in 2002. Court uses section 2036 to include all assets in the second FLP to be included in W’s gross estate. Many bad facts. No books were kept. A$125,000 loan was made to the son who only made two payments on the note. $48,000 was withdrawn from FLP funds to buy a car and then another $48,000 was given to another child to equalize the gifting. The administrative fees of H’s estate were paid by the FLP. Court notes that there was no active management by H&W’s children and that there was no evidence that H had shared his knowledge with his children. Court also notes that H&W had a trust that could have managed the funds just as effectively and in accordance with H’s investing philosophy. Estate had also proffered spendthrift concerns with the children but the court notes that the spendthrift child was a general partner who had received the $125,000 loan.


PLR 200928043 – Another in a long line of PLRs involving a spousal trust that is named as beneficiary of the deceased spouse’s IRA where the IRS allowed the surviving spouse to be treated as the beneficiary of the deceased spouse’s IRA when the surviving spouse is the sole trustee and sole income beneficiary and the IRA is community property. Surviving spouse is treated as the beneficiary who can in turn do a spousal rollover.



Worker, Retiree, and Employer Recovery Act of 2008 (“WRERA”) passed in December 2008. Section 201 of WRERA creates a new subparagraph H to section 401(a)(9) that suspends the minimum distribution requirements, both initial and annual required distributions, for defined contribution arrangements, including IRAs, for calendar year 2009. Plan participants and beneficiaries are allowed, but are not required, to take required minimum distributions for 2009. However, it should be noted that the required distributions for 2008, or for years after 2009, are not waived by the new law.



After the passage of the Pension Protection Act of 2006, the IRS had taken the position that the new section 402(c)(11) permitted, but did not require, plans to provide nonspousal rollovers. See Notice 200707. WRERA amended section 402(c)(4) so that distributions to a nonspouse beneficiary’s inherited IRA are to be considered “eligible rollover distributions,” and plans are thus required to allow these beneficiaries to make these direct rollovers. § 402(c)(11)(A). This provision is effective for plan years beginning on January 1, 2010.