By: Thomas J. Murphy
Murphy Law Firm, Inc.
Rev Rul 2002-62 — Modifying Substantially Equal Periodic Payments For Sudden Decreases In Account Balance
This ruling addresses the situation where a taxpayer began receiving pre-59-1/2 distributions from a retirement plan under the fixed “substantially equal periodic payment” provisions of IRC 72(t). With the drop in the stock market, these fixed payments, based on stock valuations in much better times, will deplete the retirement account within a matter of years. The revenue ruling tries to provide some relief.
OVERVIEW OF APPLICABLE LAW
Section 72(t)(1) provides for a 10% penalty if a plan participant or IRA owner begins receiving distributions before attaining age 59-1/2. However, section 72(t)(2)(A)(iv) creates a safe harbor exception to this rule if the payments are part of a “series of substantially equal periodic payments” based on the life expectancy of the owner/participant. This series of payments cannot be modified for five years after the first payment is received or until attaining age 59-1/2, whichever is longer.
Notice 89-25 provides for three methods in computing the amount of these payments. The first one is the similar to the minimum distribution method used for post-59-1/2 distributions. Each year, the account balance is divided by the owner/participant’s life expectancy, using the IRS life expectancy tables.
The other two methods, the fixed amortization and fixed annuitization methods, allowed for fixed payments that are determined using the account balance when the first distribution was received. The owner/participant was then locked into this distribution amount for the remaining life expectancy.
With the drastic drop in the stock market, these fixed payments, computed in much better times with much higher account balances, now threaten to exhaust the account balance unless the owner/participants are allowed to lower the distribution amounts. If a change is made, section 72(t)(4) requires the imposition of the 10% penalty on all funds received up to that point, thereby compounding the problem. The IRS was under some pressure to address this.
THE SOLUTION — SORT OF
The revenue ruling tries to solve this problem by creating two special rules. The main rule says that anyone using the fixed methods can switch to the minimum distribution method without incurring the 10% penalty. This is an irrevocable, one-time election. The other, almost comical, rule is that there will be no 10% penalty assessed if the periodic payments cannot be made due to the depletion of the account.
These two rules apply to any distributions made after January 1, 2003.
STILL, PROBLEMS REMAIN
While the IRS deserves credit for trying to resolve the situation, many owner/participants will still face difficulties. The new revenue ruling gives the owner/participant two options. One is for the owner/participant to continue taking the fixed amount that is more than the plan can accommodate. The other option is to switch to a lower amount to preserve the account balance but this may be less than what they need to live on. They cannot later increase this amount without incurring the 10% penalty on everything they have withdrawn up to that point.
The ruling touched on several other aspects of substantially equal payments that have not received much attention. First, there are some important issues regarding choice of beneficiary and life expectancy. Under the final regs, it no longer matters who the beneficiary is in determining the minimum required distribution (unless the beneficiary is a much younger spouse). This ruling provides an exception to this. The ruling confirms that an owner/participant can use joint life expectancies, to include the beneficiaries, in determining the minimum required distribution. And it is the actual joint life expectancy. There is no MDIB requirement that effectively limits the age of the beneficiary to within ten years of the owner/participant. And the rulings seem to allow for a change in beneficiaries, so that the age of the new beneficiary will be used from that point on.
Another important aspect is the interest rate cap. If an owner/participant wants to use a fixed amortized or annuitized amount, the interest rate used cannot exceed 120% of the federal mid-term rate. This will be almost identical to the section 7520 rate.
The interest rate cap should eliminate any differences between the two fixed methods. Prior to the issuance of this ruling, the fixed amortization method used the IRS tables for life expectancy. The fixed annuitization method, however, could use any “reasonable mortality table”. Typically, this allowed for a shorter life expectancy resulting in higher annual distributions. This will no longer be the case.
Finally, the ruling did not change any of the reporting requirements. Owner/participants will still be required to file a form 4329 with their income tax returns, indicating that the substantially equal periodic payments method is being used.
TAM 200247001 — No discount for taxes payable by beneficiary of retirement plan.
A really creative tax planner at work, here. A personal representative sought a discount on the form 706 for monies held in a retirement plan. The PR reasoned that the valuation of the retirement plan for estate tax purposes should factor in the taxes that will be subsequently paid on the account. The PR analogized the case to Eisenberg v. Commissioner, 155 F3d 50 (2nd Cir, 1998), which allowed for a discount of built-in gains in the valuation of a closely-held corporation.
The writer of the TAM disagreed and would not allow a discount, citing Robinson v. Commissioner, 69 TC 222 (1977), in which no discount was allowed for the possible income taxes payable on a promissory note.
The PR also sought a discount for lack of marketability, emphasizing that an IRA cannot be transferred or assigned. Again, and not surprisingly, the IRS disagreed, pointing out that this problem can be alleviated by withdrawing funds from the IRA and then transferring or assigning those funds.
PLRs 200235038 — 200235041 — Problems with naming trusts as beneficiaries of retirement plans.
These four PLRs, which deal with four beneficiaries of the same IRA, exemplify the problems with naming trusts as beneficiaries of retirement plans.
A trust was the beneficiary of an IRA. The trust provided 25% would pass to decedent’s brother with the residue passing to the decedent’s three children in equal shares. The trust provided that the brother’s shares would be distributed outright with the children’s shares to be further held in trust. The question submitted to the IRS regarded what life expectancy could be used for computing minimum distributions to the children.
Under the final regs, this is a problem since the life expectancy of the oldest trust beneficiary must be used. The beneficiaries took some steps to avoid having to use the life expectancy of the oldest trust beneficiary (resulting in using the shortest life expectancy and increasing the amount of the required minimum distribution). They created four sub-accounts, one for each beneficiary and each with separate accountings and TINs.
Without given its reasoning, the IRS ruled that the children had to use the life expectancy of the oldest child, which will increase and accelerate the minimum distributions that the beneficiaries were trying to avoid.
But it could have been worse. It is not clear why the life expectancy of the decedent’s brother was not considered. Also, the trust gave each beneficiary a limited power of appointment that was limited the appointment to individuals younger than that particular beneficiary. The concern was that, if the power was not exercised, then the default takers would be the surviving children of the beneficiary who cannot be determined until the beneficiary’s death. This uncertainty as to the identity of all trust beneficiaries threatened the trust’s special status as a “designated beneficiary”. However, the IRS apparently did not have a problem with this although it is not specifically addressed in the rulings.
PLRs 200248030 & 200248031 — Separate accounts within IRAs
These rulings, dealing with two beneficiaries of the same IRA, confirmed the provisions in the final regs regarding separate accounts in and IRA that are timely established post-mortem.
The final regs are unclear as to whether separate accountings are sufficient or whether the IRA must be divided into separate accounts for each beneficiary. These rulings do not address this specific issue since, in these rulings, separate accounts had already been established.
Notice 2003-3 — Reporting MRDs from IRAs
This notice largely confirms the new reporting requirements for IRA custodians regarding minimum required distributions. There are two alternatives. One alternative is to provide a statement to the IRA owner stating that a distribution is required and the date by which the distribution must be taken. The custodian must also make an offer to compute that amount if asked to do so by the IRA owner. The second alternative is to compute the amount without first being asked. These notices will be sent on form 5498, entitled “IRA Contribution Information”.
The only real news here is that the custodian does not have to use the same method for all IRA owners and that the notices can be sent electronically.