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Roundup of DOMA Guidance re: Benefit Plans

The Internal Revenue Service and Department of Labor have in recent months issued initial guidance to employers on the benefit plan consequences of the U.S. Supreme Court’s June 2013 decision in U.S. v. Windsor, 133 S.Ct. 2675 (2013), which ruled Section 3 of the federal Defense of Marriage Act (“DOMA”) to be unconstitutional on equal protection grounds.  That now defunct DOMA provision limited the federal law definitions of “marriage” and “spouse” to refer only to unions between members of the opposite sex.

The recent guidance, which I summarize below (and have separately addressed in earlier posts), represents early stages in the process of fully implementing the US v. Windsor holding within ERISA’s extensive compliance regime.  Please note that this post focuses on the federal tax consequences of same-sex benefits; state taxation of such benefits, and those provided to domestic partners, depends upon the revenue and taxation laws of each state.

IRS and DOL Adopt “State of Celebration” Rule

In U.S. v. Windsor the Supreme Court held that federal law will recognize all “lawful marriages” between members of the same sex, but left open the question of which state’s law will determine whether a same-sex marriage is lawful:  the state of domicile (where the married couple lives), or the state of “celebration” (where the marriage took place).

This is an important question because the Supreme Court decision left intact Section 2 of DOMA, under which a state, territory or Indian tribe need not give effect to another state’s laws regarding same-sex marriage.  The “state of domicile” rule, if it determined whether or not a same-sex couple was legally married, could cause benefits chaos.  For instance, an employer with operations in multiple states would be required to track where each employee in a same-sex relationship lived, and possibly modify their benefit offerings if they moved from a state that recognizes same-sex marriage, to a “non-recognition” state.

Note:  As of the date of this post, the District of Columbia and 14 states recognize same-sex marriage: California (since June 28, 2013, also prior to November 5, 2008); Connecticut; Delaware (eff. 7/1/2013); Iowa; Maine; Maryland; Massachusetts; Minnesota (eff. Aug. 1, 2013); New Hampshire; New Jersey (eff. October 21, 2013); New York; Rhode Island (eff. Aug. 1, 2013); Vermont; and Washington.  (Follow updates to this list here.)

The U.S. v. Windsor ruling also gave rise to some confusion over the status, under federal law, of domestic partnerships, civil unions, and other formalized same-sex relationships that fall short of marriage.

Fortunately, both the IRS and the DOL have resolved these issues in separate guidance released in September 2013.

Specifically, in Revenue Ruling 2013-17, the IRS announced that:

  • The IRS will recognize, as a legal marriage for all federal tax purposes, a marriage of same-sex individuals that was validly entered into in a domestic or foreign jurisdiction that recognizes same sex marriage, regardless of where the couple lives.
  • Under federal tax law, the terms “husband,” “wife,” “husband and wife,” “marriage” and “spouse” includes lawful same-sex marriages and individuals in such marriages.
  • “Marriage” for federal tax purposes does NOT include domestic partnerships, civil unions, or other formal relationships falling short of marriage.

To reach these conclusions the IRS invoked a prior Revenue Ruling from 1958 (Rev. Rul. 58-66) that held that individuals who became common-law spouses under state law were entitled to be treated as legally married spouses for federal income tax purposes regardless of where they later resided.

The DOL also adopted the “state of celebration” rule for purposes of defining same-sex marriage under ERISA benefit plans, including retirement plans, in Technical Release 2013-14.  In this guidance, published September 18, 2013, the DOL also specifies that the terms “spouse” and “marriage,” for ERISA purposes, do not include domestic partnerships or civil unions, whether between members of the same sex or opposite sex, regardless of the standing such relationships have under state law.

The IRS ruling takes effect September 16, 2013 on a prospective basis.  The DOL Technical Release should be treated as effective immediately on a prospective basis.  The DOL will issue further guidance explaining any retroactive application of the U.S. v. Windsor ruling under ERISA, for instance with regard to previously executed beneficiary designations, plan distribution elections, plan loans and hardship distributions.

Other Tax Guidance from Revenue Ruling 2013-17 and FAQs

Revenue Ruling 2013-17 also contains guidance on prospective and retroactive tax filing aissues resulting from the U.S. v. Windsor decision, including refund/credit opportunities.  More specific guidance for taxpayers is set forth in separate IRS FAQs for same-sex married couples, and for couples in registered domestic partnerships.

In order to understand  the tax refund/credit procedures it is helpful first to review the federal tax consequences of providing employment benefits to same-sex spouses while Section 3 of DOMA remained in effect.

Through Internal Revenue Code (“Code”) Section 105(b), Federal law has long allowed employers to provide health and other benefits on a tax-free basis to employees, their opposite-sex spouses and dependents.  However, under DOMA § 3, the same benefits provided to same-sex spouses and other partners generally resulted in “imputed incometo the employee for federal tax purposes, in an amount generally equal to the value of the benefits provided.  Similarly, employees could not use Sec. 125 cafeteria plans to pay premiums for same-sex spouses/partners on a pre-tax basis.  Only in rare instances where the same-sex spouse was a dependent of the employee spouse as a result of disability, did same-sex spousal coverage not result in an additional federal tax burden to the employee spouse.

Note that benefits provided to domestic partners and partner in civil unions are still treated this way for Federal tax purposes.  For benefits provided to employees who are lawfully married to same-sex spouses, however, the new rules effective September 16, 2013 and prospectively are as follows:

  • Individuals in lawful same-sex marriages must file their federal income tax returns for 2013 and subsequent years as either married filing jointly, or married filing separately.
  • Employer-provided benefits provided to an employee’s lawfully-married same-sex spouse are excludable from the employee’s income for federal tax purposes.
  • As a consequence, employers must stop imputing income to employees, for federal tax purposes, based on same-sex spousal benefits, and must adjust affected employees’ Form W-2 income for 2013 to remove imputed income amounts.
  • The tax-qualified benefit plans that are affected are:
    • health, dental and vision coverage;
    • qualified tuition reduction plans maintained by educational organizations;
    • meals and lodging provided to employees on business premises (other specific conditions apply);
    • fringe benefit including qualified transportation fringe benefits, moving expenses, employee discounts, and work-related expenses; and
    • pre-tax participation in Section 125 cafeteria/flex plans, including health flexible spending accounts and dependent care flexible spending accounts.
  • Employees in lawful same-sex marriages can file amended personal income tax returns for “open” tax years (generally 2010, 2011, 2012) to recoup over-withheld federal income taxes resulting from imputed income and after-tax cafeteria plan participation.
  • However, if they re-file, they must re-file as married for all tax purposes, not just to obtain the refund or credit.  In many cases, the income tax adjustment will not warrant the loss of other deductions.  Employees must consult their individual CPAs and other tax advisors for answers; employers must refrain from offering any specific advice or guidance in this regard.

Corrective Payroll/Withholding Steps for 2013 and Prior “Open” Tax Years

IRS Notice 2013-61, published September 23, 2013, sets forth optional, streamlined ways for employers to claim refunds of over-withheld “employment taxes” (FICA and federal income taxes) applied to imputed income/same sex spouse benefits in 2013, and prior “open” tax years.

The “normal” over-withholding correction process – which remains available to employers in this instance – varies slightly depending on whether or not the employer is seeking an adjustment of withholding taxes, or a refund of withholding taxes, but generally includes the following steps:

  • identify the amount of over-withholding;
  • repay the employee’s portion to the employee in cash (or “reimburse” them by applying the overpayment to FICA taxes for current year);
  • obtain written statements from affected employees that they will not also claim a refund of over-withheld FICA taxes, and if an employer is seeking a refund of over-withheld taxes, obtain affected employees’ written consent to the refund; and
  • file IRS Form 941-X for each quarter affected, to recoup the employer portion of the tax.

Notice 2013-61 sets forth two streamlined correction methods permitting use of one single Form 941 or Form 941-X for all of 2013.  Under the first method, the employer takes the following steps before the end of the current year:

  • identify and repay/reimburse employees’ share of excess income tax, FICA tax withholdings resulting from same-sex spousal benefits on or before December 31, 2013; and
  • make corresponding reductions in affected employees’ wage and income-tax withholding amounts on the 4th quarter 2013 Form 941.

The second method is available if the employer does not identify and repay/reimburse employees’ share of excess income tax, FICA tax withholdings until after December 31, 2013.  In that case the employer:

  • Files one single Form 941-X in 2014 seeking reimbursement of employer’s share of tax with regard to imputed income for same-sex spouse benefits reported in all quarters of 2013.
  • In addition to the regular Form 941-X filing requirements, including obtaining written statements and/or consents from employees, employers must write “WINDSOR” at the top of the Form 941-X and must file amended Form W-2s (IRS Form W-2c) for affected employees, reporting the reduced amount of wages subject to FICA withholding.

Note:  This second correction method can apply only to FICA taxes.  Employers cannot make adjustments for overpayments of income tax withholding for a prior tax year unless an administrative error (e.g., wrong entry on Form 941) has occurred.

Employers may also recoup their share of FICA taxes for earlier open tax years (generally, 2010, 2011 and 2012) using one Form 941-X for all four calendar quarters that is filed for the fourth quarter of each affected year.  In addition to marking the Form “WINDSOR” the employer must also file amended Form W-2s for affected employees, reporting the reduced amount of wages subject to FICA withholding.

Employers making use of the correction methods set forth in IRS Notice 2013-61 for 2013 or earlier open years must take account of the Social Security Wage Base in effect for applicable years.  For employees whose 2013 compensation exceeds the taxable wage base ($113,700) even after imputed income is eliminated, no corrections for the Social Security component of FICA taxes can be made.  If retroactive corrections are made, you must observe the SS wage base limitations in effect in prior years:  $106,800 for 2010 & 2011, and $110,100 for 2012.

One final note:  many employers that provide benefits to employees’ domestic partners and/or same sex spouses have followed a practice of grossing up the employees’ taxable compensation to account for the additional federal taxes they must pay on imputed income.  The IRS guidance on recouping over-withheld taxes apply only to imputed income amounts, not to the gross-up amounts.  “Normal” over-withholding correction procedures using Forms 941 and 941-X should apply to 2013 gross-up amounts but employers should consult their payroll and tax advisors for specific advice.  Note also that California recently adopted a law that will exclude gross-up amounts from employees’ taxable compensation for state personal income tax purposes.  AB 362 takes immediate effect and is slated to expire January 1, 2019.  You can find a fuller discussion of the measure here.

IRS Provides Federal Tax Parity to Same Sex Spouses

On August 29, 2013, the Internal Revenue Service (“Service” or “IRS”) issued guidance on how same-sex spouses will be treated for Federal tax purposes, in the wake of the Supreme Court’s ruling, in US. v. Windsor, that Section 3 of the Federal Defense of Marriage Act was unconstitutional.  The guidance, announced here, takes the form of Revenue Ruling 2013-17 and two FAQs – one for legally married same sex spouses, and one for persons in domestic partnerships, civil unions, and other formal relationships other than marriage.  This post discusses the Revenue Ruling; a future post will cover the FAQs which describe tax refund procedures related to same sex spousal coverage, and begin to address the impact of US v. Windsor on retirement plans.

Section 3 of DOMA – the part struck down in US v. Windsor – provided that, for all federal law purposes, the word “marriage” meant only a legal union between one man and one woman as husband and wife, and the word “spouse” referred only to a person of the opposite sex who is a husband or wife.   In US v. Windsor the Supreme Court determined that, with respect to individuals in same sex marriages, that provision violated the principles of due process and equal protection under the law guaranteed by the 5th Amendment to the US Constitution.

The question that the new IRS guidance answers is whether, in determining whether a same sex marriage is valid for Federal tax purposes, the IRS will look to the laws of the state where the marriage was performed or “celebrated” (the “celebration” rule), or the laws of the state where the couple resides (the “domicile rule”).

Traditionally, ERISA case law has determined married status based on the domicile rule.  However it quickly became clear, after the Supreme Court decision, that employers with employees in multiple states would face significant administrative hardship –particularly with regard to health and retirement benefit plan coverage – if they needed to look to each employee’s state of residence in order to determine whether spousal benefits applied.  Thus, it was hoped that a same sex marriage legally performed in any state or other jurisdiction would constitute a valid marriage for Federal tax purposes in all states, including those that do not recognize same sex marriage.

Under Revenue Ruling 2013-17, that is indeed the case.  In it the Service concludes that, for Federal tax purposes (including income and estate tax purposes), the following is true:

  • The terms “spouse,” “husband and wife,” “husband” and “wife” include an individual married to  a person of the same sex if the individuals are lawfully married under  state law, and the term “marriage” includes a same sex marriage.  “State” for these purposes means a U.S. state or the District of Columbia, as well as any foreign jurisdiction.
  • The gender-specific terms “husband” and “wife” apply, for Federal tax purposes, to members of a same-sex couple regardless of their actual gender.
  • This is the case even if the state where the same sex couple resides does not recognize the validity of same-sex marriages.
  • The terms “marriage,” “spouses” and “husband and wife” for federal tax purposes will not, however, include domestic partnerships, civil unions or other formal relationships – short of marriage – between same-sex or opposite sex individuals.

Revenue Ruling 2013-17 is effective as of September 16, 2013 and subsequent, however the accompanying FAQ for same sex spouses describes how individuals who included same sex spouses in their employers’ benefit plans, and who received “imputed income” as a result, may seek tax refunds and credits back to 2010.  As mentioned, I will cover those points in a separate post in the very near future.

The IRS describes Revenue Ruling 2013-17 as an “amplification and clarification” of 1958 Revenue Ruling (Rev. Rul. 58-66, 1958-1 C.B. 60) which concluded that persons who enter into a common law marriage in a state that recognizes common law marriage could file a joint Federal tax return even after they moved to a state that did not recognize common law marriage.   And, in fact, following the laws of the state of domicile for purposes of common law marriage would present the same difficulties in the context of same sex marriage:

“A rule under which a couple’s marital status could change simply by moving from one state to another state would be prohibitively difficult and costly for the Service to administer, and for many taxpayers to apply.”

The IRS notes that it may provide future additional guidance on this rule and on the application of US v. Windsor with respect to Federal tax administration, and that other agencies may discuss its impact on other federal programs that are affected by the Internal Revenue Code.   It will also be interesting to see how the new rule is squared with the traditional “domicile” rule used to determine marital status in ERISA case law.  (Interestingly, the first post-Windsor (but pre-Rev. Rul. 2013-17) decision on same-sex benefits under ERISA, Cozen O’Connor, P.C. v. Tobits, 2013 WL 3878688 (E.D. Pa., July 29, 2013), followed the domicile rule in order to award survivor benefits to a same sex spouse.  A good discussion of the case is found here.)

Revenue Ruling 2017-13 also stands in contrast with still-in-effect Section 2 of DOMA, which permits each state to ignore, for state law purposes, same sex marriages officiated in other states:

“No State, territory, or possession of the United States, or Indian tribe, shall be required to give effect to any public act, record, or judicial proceeding of any other State, territory, possession, or tribe respecting a relationship between persons of the same sex that is treated as a marriage under the laws of such other State, territory, possession, or tribe, or a right or claim arising from such relationship.”

As a consequence, imputed income will continue to apply to same sex spouses for state tax purposes in states that do not recognize same sex marriages, despite its abolition at the federal level.  Additionally, state law will continue to govern group health insurance and HMO contracts, and states that do not recognize same sex marriage generally do not require that policies sold in the state cover same sex spouses.

Clearly, further guidance from the IRS and other federal agencies will be needed to address the complicated benefit compliance issues raised by US v. Windsor.

A final note – this post is my 100th at EforERISA, a bit of a milestone, and I want to thank my readers and subscribers for their support and helpful comments and suggestions along the way.

COLA Increases Raise 2013 Contribution Limits

An almost 3.3% cost of living increase in the Social Security wage base for 2013 has triggered increases in annual contribution and other dollar limits affecting 401(k) and other retirement plans, the Internal Revenue Service announced on October 18, 2012.  Here are some of the key changes for 2013 (citations are to the Internal Revenue Code):

–Salary Deferral Limit for 401(k), 403(b), and 457 plans increased from $17,000 to $17,500. (The age 50 and up catch-up limit remains unchanged at $5,500, however.)

–Maximum total contribution to a 401(k) or other “defined contribution” plans under 415(c) increased from $50,000 to 51,000 ($56,500 for employees aged 50 and older).

–Maximum amount of compensation on which contributions may be based under 401(1)(17) increased from $250,000 to $255,000.

–Maximum annual benefit under a defined benefit plan increased from $200,000 to $205,000.

–Social Security Taxable Wage Base increased almost 3.3% from $110,100 to $113,700.

–The IRA contribution limit increased from $5,000 to $5,500.  The catch-up limit remains at $1,000, however.

–Note also that the annual exclusion from gift taxes will increase in 2013 from $13,000 to $14,000.

Some limits that did not change for 2013 are as follows:

–The compensation threshold for “highly compensated employee” remained at $115,000.

–The dollar limit defining “key employee” in a top-heavy plan remained at $165,000.

Reality Check on IRA Investments in Real Estate

Multiple times each year I am asked by prospective clients whether, and how, they can invest traditional IRA assets in real estate.  In this time of distressed real estate and very low interest rates, many investors have maxed out on their after-tax investments in real estate, and their IRA account balances beckon as a new source of investment capital.  If these folks look online, they will find many sources of purported “advice” on how to get rich through IRA investments in real estate.  Unfortunately, the information available online usually obscures or overlooks altogether some significant practical and tax hurdles to making IRA investments in real estate work from both the technical/legal and “return on investment” perspectives.

Below I summarize those obstacles.  They are not barriers, per se, but prospective investors should assess them carefully, preferably in consultation with their attorneys, CPAs, or other tax advisors, before committing IRA assets to an investment in real property.    Failure to steer clear of them could result in immediate taxation of the entire IRA account – including conventional investments.

  1. Understand How the IRS Views Your IRA

A very important concept that much of the online marketing around IRAs overlooks is that, from the perspective of the IRS:

  • the IRA is solely meant to provide a source of retirement income and is not a ready source of capital for an investment opportunity; and
  • You are a fiduciary with regard to your IRA account.

The IRS applies a term – prohibited transaction or “PT” – to any use of IRA assets for personal gain other than preservation of a retirement income stream.  The prohibited transaction rules disallow a number of specific transactions, such as selling real estate to or buying it from your IRA, or personal or immediate family member use of real estate owned by an IRA, but they also generally prohibit “self-dealing” which is defined to include any act of a fiduciary (i.e., you) by which IRA income or assets are used for the fiduciary’s own interest.   Examples of self-dealing could include purchase of real estate built on speculation by a son in law, purchase of real estate adjoining your own property or that of a family member in order to control how the property is used and who lives there, or , outside the real estate context, use of IRA assets alongside personal assets in order to meet a minimum investment account threshold.

If your IRA investment in real estate constitutes a prohibited transaction of any stripe, the total account balance of the IRA will be treated as if it were distributed to you on the first of the year in which the investment is made, and thus included in your taxable income for that year.  If you are under age 59 ½, you also may have to pay an early distribution penalty equal to 10% of the prohibited investment.

Even if the purchase transaction satisfies PT rules, management of the IRA-owned real estate can also trigger violations, as is discussed in section 4, below.

  1. Analyze the Tax Consequences:  Income Tax Rates, versus Capital Gains (plus deductions)

Investing IRA assets in real estate means that gains on your investment  –  when realized through sale of the real estate and distributed from the IRA – will be taxed at regular income tax rates, rather than the lower capital gains rates that apply to after-tax real estate investments.  Also, during the time that your IRA holds the real estate, depreciation and the many deductions for property expenses claimed on Schedules C or E will not apply as they would to after-tax real property investments.

  1. Pay Cash – Avoid Unrelated Debt Financed Income

Your IRA must pay cash for the real estate, otherwise tax will be owed on “unrelated debt financed income” under Internal Revenue Code Section 514 if the leveraged property generates income (such as rents) or if it is sold for a profit while the mortgage is still outstanding (or within 12 months of paying it off).   The IRA trustee or custodian must pay the tax.

In determining how much your IRA can afford to pay for a parcel of real estate, you must arrange ahead of time, preferably with the help of a CPA or other tax advisor, to maintain liquid investments in the IRA to pay off certain recurrent costs and expenses, and for other reasons outlined in 5 – 7, below.

  1. Follow Correct Procedures (the Natalie Choate 4-Step Test)

As mentioned, the IRS views you as a fiduciary with regard to your own IRA.  Because the PT rules prohibit an IRA fiduciary from engaging in business transactions with the IRA itself, you will need to use third parties both to purchase the real estate, and to manage the real estate.  Natalie Choate, a nationally recognized authority on the estate planning aspects of IRAs and qualified retirement plans, specifically recommends the following four steps:

  • Find a specialized IRA  custodian.  Not all IRA custodians are well versed in the intricacies of the prohibited transaction rules, and how real estate investments may trigger violations.  You will want to find a bank custodian who has experience in this area.  Work through trusted contacts such as your CPA or other tax advisor until you have found the right match.
  • Custodian engages in purchase transaction, not you.  The PT rules require that the IRA custodian, not you as IRA fiduciary, uses your IRA assets to purchase the real estate.  You cannot buy the real estate and transfer it to your IRA, or sell it to your IRA.  The latter transaction would be a PT; the transfer would not work because generally only cash may be contributed to an IRA.
  • The Custodian engages a third party property manager. This step is recommended if your real estate has residential tenants or commercial tenants in anything other than a “triple net” lease requiring that they assume costs the landlord otherwise would pay.  The property manager, not you, should run the property (e.g., make repairs, collect rent, pay expenses and property taxes, etc.) and send the IRA custodian a check each month that is net of all such costs.  This arrangement makes it unlikely that you will intermingle your personal assets with the IRA assets, for instance by directly hiring a painter or gardener, or by paying a bill associated with the IRA owned property.
  •  No family use or sweat equity.  For the same reasons that a third party property manager is recommended, you must avoid any personal use of the IRA-owned real estate, or use by direct family members.  Even use by extended family members or family friends could comprise a “self-dealing” type of PT as described above.  You must also resist the urge to work on the property yourself, show apartments, or have family members fill any of these roles.  Ideally, your property manager will anticipate and take care of such needs on an arms-length basis, without involving you.
  1. Set Aside Liquid IRA Investments for Required Minimum Distributions

When you reach age 72, the IRS requires that you begin taking annual minimum required distributions from your traditional (i.e., non-Roth) IRA.  If you have multiple traditional IRAs, you can choose one from which to take distributions, but you must pool all IRA account balances together to determine the minimum required amount you must withdraw each year.  Failure to timely take out a sufficient amount could result in a 50% tax, based on what you should have withdrawn.  Needless to say, minimum required distributions are most easily made from liquid IRA investments – stock that can be sold, money market accounts, etc.  Before investing IRA assets in real estate, make sure that you preserve sufficient liquid IRA investments from which to take required minimum distributions.  You CPA or other tax advisor can help you do some advance planning in this regard, to determine the principal amount you should set aside for this purpose, and income you can expect it to generate.

Failure to preserve liquid investments for this purpose will make it very hard to take minimum required distributions.  You might have to distribute fractional interests in the IRA-owned real estate, which would be an expensive process (both in determining the value of the fractional interests, and in documenting the interest transfer).

  1. Set Aside Liquid IRA Investments for Annual Valuations of the RE Investment

Most reputable IRA custodians will require annual valuations of real estate investments or other non-traditional investments (privately held stock, etc.)  The valuation may cost several thousand dollars, possibly more.  The IRA must pay for this expense; you cannot use personal funds.  Before committing IRA assets to the real estate purchase, you need to determine how much in liquid IRA investments you need to aside in order to pay this recurrent expense from either the liquid investments themselves and/or anticipated investment income they generate.

  1. Set Aside Liquid IRA Investments for Property Taxes, Expenses, Insurance Improvements, Management Fees

As mentioned, your third party property manager will be using IRA funds to pay property taxes, maintenance and other expenses, insurance, improvements, and will also draw on the IRA to pay its own management fees.  Before committing IRA assets to the real estate purchase, you will need to determine how much in liquid IRA investments you need to set aside in order to pay these expenses from the investments themselves and/or anticipated investment income they generate.  Some amounts will be predictable and recurring; others, such as large repairs (roof replacement, etc.) are not predictable and you will have to use good judgment in estimating a set-aside.

Bottom line, IRA investments in real estate can be done, but there are many rules that must be followed to avoid disqualification of the IRA and immediate taxation of the entire IRA account. The availability of required minimum distribution amounts, the loss of capital gains treatment, and the self-dealing restrictions, generally make an IRA investment in real property unsuitable and problematical at best.  For investors who are still “game,” some advance financial and tax planning strongly is advised both before the transaction occurs, during the life of the real estate investment, and well in advance of any minimum required distribution start date.

Finally, you will note that this post does not discuss strategies using business entities within an IRA, such as IRA-owned single member limited liability companies (“LLCs”).   Often marketed as “checkbook control” IRAs, these arrangements raise a host of compliance issues over and above the ones discussed below.  The Groom Law Group has an excellent article debunking this and a number of other questionable IRA strategies that you can read here.

Photo by Rowan Heuvel on Unsplash

Treasury Department Issues Guidance Easing Access to Lifetime Payout Options

On February 2, 2012 the Treasury Department issued guidance aimed at easing employee access to lifetime payout options from 401(k) and other defined contribution plans (IRAs and IRA-based arrangements are exempt) A link to the related fact sheet is here, and proposed regulations and a Treasury/IRS ruling will follow with more details. (An advance copy of the proposed regulation is available here.)

The Department’s fact sheet outlines the reason for the initiative – the “longevity risk” that results from increased life spans and the prevalence of lump-sum retirement plan distributions in the post-defined benefit plan era. Through a request for public comments, the Department gathered data and studied ways in which current provisions of the Internal Revenue Code discourage plan participants from choosing life annuity and other incremental payout options. The guidance package outlines both the regulatory barriers that they identified, and their proposals to make lifetime income options more accessible and popular among plan participants. The proposed changes are as follows:

1) To correct the “all or nothing” choice between a lump sum or an annuity payout, proposed regulations will simplify the manner of calculating a distribution that is part lump sum, part annuity, so that plans are more likely to offer this blended form of distribution;
2) To address retirees’ fears of outliving required minimum distribution payments that generally must begin at age 70 ½, proposed regulations would allow use of up to 25% of an IRA or 401(k) account balance (or $100,000, if less) to purchase a “longevity annuity” that will begin payment by age 85.
3) To expand access to cost-effective annuity forms of payout under the relatively few remaining defined benefit pension plan, a Treasury/IRS ruling will explain permit full or partial rollovers from a 401(k) plan, to a defined benefit pension plan sponsored by the same employer, in exchange for an immediate annuity from that plan.
4) To aid employers and third party administrators who are unsure of how spousal consent rules work in relation to deferred annuities, including longevity annuities, a Treasury/IRS ruling will identify plan and annuity terms that will automatically protect spousal rights without requiring spousal consent before the annuity begins, shifting the spousal consent compliance to the insurer issuing the annuity. (Many if not most 401(k) plans have opted out of rules requiring spousal consent under ERISA, however many investment providers in community property states require spousal consent to any loans or distributions.)

COLA Increases Raise 2012 Contribution Limits

A 3.6% Social Security cost of living increase for 2012 has triggered increases in annual contribution and other dollar limits affecting 401(k) and other retirement plans, the Internal Revenue Service announced on October 20, 2011. These dollar limits were static from 2009 through 2011 due to the floundering economy. Here are some of the key changes (citations are to the Internal Revenue Code):

–Salary Deferral Limit for 401(k), 403(b), and 457 plans increases from $16,500 to $17,000. (The age 50 and up catch-up limit remains unchanged at $5,500, however.)

–Maximum total contribution to a 401(k) or other “defined contribution” plans under 415(c) increased from $49,000 to $50,000 ($55,500 for employees aged 50 and older).

–Maximum amount of compensation on which contributions may be based under 401(1)(17) increased from $245,000 to $250,000.

–Compensation threshold for “highly compensated employee” increased from $110,000 to $115,000.

–Dollar limit defining “key employee” in a top-heavy plan increased from $160,000 to $165,000.

–Maximum annual benefit under a defined benefit plan increased from $195,000 to $200,000.

–Social Security Taxable Wage Base increased from $106,800 to $110,100.

–IRA contribution and catch-up limits remain $5,000 and $1,000, respectively.

DOJ Deems DOMA Unconstitutional

The Deparment of Justice officially has taken the position that the federal Defense of Marriage Act (DOMA) violates equal protection guarantees under the Fifth Amendment. As set forth in a letter to Congress from Attorney General Eric Holder, which reportedly reflects the President’s own thinking on the subject, the Administration no longer supports the reasoning and arguments formerly used to uphold DOMA. The DOMA was enacted under President Clinton in 1996 (before “L’Affaire Lewinsky,” for those who are counting.) The DOMA defines a legal spouse, for federal law purposes, only as a lawfully married member of the opposite sex.

As a result of DOMA, registered domestic partners do not have the same status and rights as opposite sex spouses under ERISA retirement and health plans, under federal estate tax laws, and in a variety of other legal settings. As a simple example, a surviving registered domestic partner does not have the same ability as an opposite sex surviving spouse to treat an IRA inherited from a decedent spouse as the surviving partner’s own account, which greatly increases the stretch-out distribution capability of the account. This “spousal election” right remains limited to opposite sex spouses. Although the tax laws recently changed to allow non-spouse beneficiaries (including domestic partners) the ability to roll over amounts from an inherited IRA, the rollover right simply does not permit the same stretchout options as does the spousal election.

In California, registered domestic partners (as defined by Section 297 et seq. of the California Family Code) do have the same legal status and rights as opposite sex spouses for all purposes under California law. This means that benefits such as group health insurance that an employee provides to his or her registered domestic partner are treated at the state tax level just as are any other benefits provided to a dependent, and do not result in imputed California income to the employee. However unless the domestic partner meets the federal definition of a dependent (as set forth in IRC Section 152), provision of benefits to him or her will cause the employee to experience imputed income at the federal level. It is rare for a domestic partner to meet the dependency test under Section 152 as it requires they receive more than half of their financial support from the employee partner, and with regard to non-health benefit plans also imposes a cap on compensation that is extremely low.

Employers in states like California have long been burdened with the process of tracking and assigning a value to benefits provided to domestic partners, for federal tax compliance. Now, in a whipsaw effect, they are required to do just the opposite (track imputed state income) with regard to group health benefits provided to dependent children up to age 26, as a result of expanded coverage to this group under PPACA. Fortunately California likely will bring its tax laws into conformity with PPACA in the near future, as AB 36 wends its way through Sacramento.

The path to repeal of DOMA likely will be longer and more fraught with controversy because of the “hot button” nature of the issue at the national level. However, there have been less direct attempts to address the problem nationally in the past. The “Tax Equity for Domestic Partners and Health Plan Beneficiaries Act” was introduced in Congress by Republican Senator Gordon Smith of Oregon, but never moved past the committee level. It is possible that as DOMA is reexamined in coming months, even factions that disagree on the moral/religious issues can reach agreement that parity in tax treatment between spouses and domestic partners is warranted at the federal level. I will continue to track this issue as it develops.

DOL Disallows IRA Promissory Note Investment

Last week, the Department of Labor issued Advisory Opinion 2011-04A finding that it would be a “prohibited transaction” (“PT”) for an IRA to purchase a promissory note and deed of trust from a bank where the IRA owner and his spouse were indebted under the note, and where the IRA owner’s family trust held title to the real property at issue.

This ruling is important because the Department of Labor concluded that the proposed arrangement would be an impermissible extension of credit from the IRA to the IRA owners, even though the owners simply intended to move the existing loan over from a bank to the IRA without thereafter refinancing or otherwise taking any action that would constitute a new loan from the IRA. Also significant is that the Department of Labor classified the proposed transaction as prohibited self dealing, for reasons explained below.

The Advisory Opinion involved an IRA that the owner opened over twenty years ago. The owner was the sole account holder and his wife was the sole beneficiary. In 1993 the owners bought an eight-unit apartment building in San Diego for $200,000, financed with a loan from Chase Bank that was secured by a first deed of trust on the property, and evidenced in the form of a promissory note. Title to the property was held in the name of the owners’ family trust. The owners were the trustees and sole beneficiaries of the family trust.

What the owners proposed to do was to have the IRA purchase the promissory note and deed of trust from Chase Bank. Chase Bank would assign the note and deed over to the IRA, or more precisely to another bank serving as IRA custodian, and the owners would make all subsequent payments on the note to the IRA custodian, which in addition to receiving payments would otherwise enforce the promissory note.

The owners’ request for an advisory opinion specifically pointed out that “the transaction [was] structured to avoid any new loan or other extension of credit between the IRA and the [owners], as would occur if they refinanced the loan under different terms using the IRA as a new lender.”

This language refers to one type of prohibited “party in interest” transaction – the direct or indirect lending of money or other extension of credit between a plan (here, the IRA) and a disqualified person or persons (here, the IRA owners). ERISA and the Internal Revenue Code (“Code”) describe four other types of specific prohibited transactions as well as several general categories of prohibited “self dealing” with IRA/plan assets by a fiduciary. Of relevance here are (a) the transfer of plan assets or income to, or use of them by or for the benefit of, a disqualified person; and (b) dealing with plan assets or income for the fiduciary’s own personal account. These are set forth in Code Section 4975(c)(1)(D) and (E), respectively.

The Department of Labor analysis first identified the IRA owner as a fiduciary with regard to the IRA due to his sole discretion over IRA investments. As a fiduciary he was a “disqualified person” as that term is defined in Code Section 4975(e)(2), as were his family members (including his wife) and his family trust, as he and his wife (now both fiduciaries and disqualified persons) together owned more than 50% of the trust. (The DOL has express authority to interpret Section 4975 of the Code and also interprets parallel provisions of ERISA governing prohibited transactions.)

Then, the Department of Labor rejected the notion that simply “moving” the loan over from Chase Bank to the IRA was not a prohibited extension of credit from the IRA to the IRA owners. First, it cited Department policy that a loan is a transaction that “continued from the time it is made until all amounts due are paid,” and that the parties must be examined throughout that time for indicia of a prohibited relationship. On that basis the Department found that a prohibited extension of credit would occur as soon as the IRA acquired the note from Chase Bank, and that the IRA’s holding of the note would constitute another prohibited extension of credit so long as the IRA owners or any other disqualified persons made payments on the note.

The Department of Labor went on to determine that the transfer to and holding of the loan by the IRA would also constitute prohibited self dealing if the transaction was part of an agreement, arrangement or understanding by the IRA owner, as the IRA’s fiduciary, “to benefit himself or persons in which he has an interest that affects his best judgment as a fiduciary (e.g., the Family Trust.)” Noting that this was “generally an inherently factual question,” the Department observed that the proposed purchase of the note by the IRA from Chase Bank would be one in which the IRA owner “would have an understanding, as a fiduciary, that the assets of the IRA are being used to create a prohibited transaction (i.e., an ongoing debtor-creditor relationship between the IRA and disqualified persons) once the IRA acquires the Note.” It therefore concluded that, under those circumstances, the IRA’s purchase of the note would be a separate, self-dealing prohibited transaction under Code Section 4975(c)(1)(D) and (E).

This Advisory Opinion is a good example of how a proposed IRA investment that had been structured with an attorney’s advice and approved by a very reputable bank custodian could still be found to be three different types of prohibited transaction, once under the scrutiny of a government agency. Simply put, this is an area of the law where even the cautious can come to grief. Seeking a tax advisor’s opinion, if not agency approval, is advised before proceeding with any unorthodox IRA investment.

Benefits Provisions of the Tax Relief Act of 2010

On December 17, 2010, President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the “Tax Relief Act” or “Act”). The Act was the result of painful compromise between fiscally conservative and liberal factions in Washington, D.C. Basically the Obama administration agreed to a two-year continuation of certain income and other tax cuts dating back to 2001, in exchange for an additional 13 months of continued unemployment benefits.

You can read the 74-page text of the Act here, and the 177-page Congressional explanation of the Act here.

The Act significantly changes the estate planning landscape through 2012. For more information on the specific opportunities that exist during this brief window of time, contact an attorney in Mullen & Henzell LLP’s Estate Planning Group.

The Act also makes a 2% reduction in employees’ share of FICA taxes for 2011 (the Old Age, Survivors and Disability component, not the Medicare component), from 6.2% down to 4.2%. The employer’s portion is unchanged, at 6.2%. A comparable change is made to self-employment taxes. Even before the Act became law, the IRS issued new income tax withholding tables reflecting the 2% reduction.

The Act also affects a number of employer-provided, tax-qualified benefits, as listed below, by lifting the December 31, 2010 expiration date that otherwise would have applied under 2001 and subsequent tax laws. Unless otherwise stated all changes expire on December 31, 2012:

• Educational assistance plans under Internal Revenue Code (“Code”) Section 127 are given another two-year lease on life. The maximum dollar amount that employers can provide (whether as direct payment for education or in the form of an employee reimbursement) remains $5,250 per calendar year. Unlike education reimbursements provided as “working condition fringe benefits” under Code Section 132(d), benefits provided under Section 127 may cover study that is not necessarily limited to improving the employee’s existing skill set.
• The Act extends certain adoption benefits through 2012. The maximum adoption tax credit, and the maximum tax-exempt employer reimbursement for adoption expenses under Code Section 137, will remain at indexed rates (subject to phase-out for adjusted gross income starting at $182,500). The 2010 dollar limit was $13,170. For 2011, the maximum dollar amount of the credit or exclusion from income will be $13,360 however this will drop to $12,170 in 2012 because the Act did not extend a $1,000 increase in the limit made under the health care reform bill. For this same reason, the adoption tax credit is not refundable after 2011.
• Qualified transportation benefits under Code Section 132(f) are also continued at current levels, through December 31, 2011. Employees may exclude up to $230 from income each month in employer-provided mass transit and/or vanpool benefits; this combined dollar limit was linked to the separate $230 dollar limit that applies to employer-provided parking benefits under the 2009 recovery act. Thus, up to $460 is available per employee, per month for transportation and parking expenses. The $230 dollar limit that applies to mass transit and vanpool benefits only (not parking) was slated to drop to $120 per month on January 1, 2011.
• Tax-free IRA distributions to charitable organizations are extended through 2011. Although the Act permits 2010 IRA distributions to be made to a charitable organization through January 31, 2011, the IRS recently announced that there is no “re-do” available for individuals who took 2010 distributions prior to passage of the Act on December 17, 2010. The Wall Street Journal discusses the IRS announcement, and predicament to taxpayers, here.