IRA Errors

James Theissen and his wife worked for Kroger or its subsidiaries for 30 years. They lived in Colorado, and in 2002 Kroger informed Mr. Theissen that his job would be moved to Ohio.  As the Theissens did not wish to move, they retired and rolled their 401(k) money into “his and hers” IRAs, totaling some $432,076.41.

 Because Mr. Theissen was interested in metal fabrication, he began shopping for a company to buy.  He planned to use the IRA money to fund the purchase and let the IRA own the new company.  A corporation was formed, Elsara, and the couple’s IRAs purchased all the Elsara stock.  A suitable metal-fabricating firm was found.  The price was $601,000.  The couple contributed $60,000 from their savings; Elsara paid $341,000; and Elsara also provided a promissory note for $200,000, to be paid over five years at 7% interest.

Unfortunately, the Theissens also personally guaranteed repayment of the note.

 Apparently, the note was properly repaid according to its terms.  However, in 2010, six years after the transaction, the IRS challenged the financial structure used for the acquisition of the business.  According to the IRS, the personal guarantee of the note was a prohibited transaction. It amounted to an extension of credit to the IRAs by the beneficiaries of the accounts.

Federal law has some very strict rules concerning transactions between qualified retirement plans, which includes IRAs, and those who are the beneficiaries of such plans. The public policy being served is the preservation of the money in the plan for retirement.  

 Before adopting this structure for their business purchase, the Theissens consulted with a CPA firm and an attorney. They didn’t come up with this idea on their own.  Nevertheless, the Tax Court ruled that they had, in fact, committed a prohibited transaction when they personally guaranteed the loan.  That caused two unfortunate consequences.  First, the IRAs stopped being tax qualified in 2003.  That meant the entire amount in them was deemed distributed to the Theissens in that year and subject to ordinary income tax, which came to nearly $190,000.  Second, because neither was yet 59½ at the time of the distribution, they owed an additional 10% penalty tax!  Plus interest since 2003.

 It’s not entirely clear how this will enhance the Theissens’ retirement income security, but perhaps that was not the point.

Another Problem

Dr. Mark Vandenbosch decided to loan $125,000 to a radiology technician whom he had befriended, John Carver. Carver needed the money for an investment opportunity.  The source of funds was Dr. Vandenbosch’s Simplified Employee Pension (SEP).  However, the SEP did not distribute funds to Carver, nor did it execute a promissory note for the loan.  Rather, the money went into Vandenbosch’s personal checking account, and the loan document showed the doctor and his wife as the lenders.

 The couple argued that they were acting as conduit, and that the loan to Carver was essentially a tax-free IRA rollover.  The Tax Court held that it was not.  The $125,000 was a taxable early distribution to the doctor, subject to income taxes and the 10% penalty for early distribution.  Fortunately, the balance in the doctor’s SEP was not tainted by the transaction, so it continued to be tax deferred.  

Jeopardy for Family Limited Partnerships

Valuing a publicly traded company is a fairly easy proposition. Every day, shares trade hands between willing buyers and willing sellers. The price of that trade, times the number of shares outstanding, provides the capitalized value of the company. For any shareholder’s stake, the value of that interest is the number of shares held multiplied by the price.

Valuing privately held companies is far more difficult. The standard is, fundamentally, the same: What would a willing buyer pay, and what would a willing seller accept, if neither were under any requirement to buy or sell? Putting that standard into practice is very different, because there is no public market for the shares. In particular, with closely held firms the issue of control becomes paramount. If one stakeholder controls the enterprise, his or her share may command a premium, while the minority shareholders’ interest will be discounted. The minority interest may get an additional discount if there are restrictions on selling it, as is usually the case. 

These principles of tax law are nothing new. The new twist came in utilizing them in the context of a family limited partnership or, alternatively, a family-run limited liability company. These are legal entities used to manage family wealth, and also to move wealth to younger generations in a planned, controlled fashion. By employing discounts for illiquidity and lack of control, the transfer tax costs (gift taxes or estate taxes) could be significantly reduced. The IRS gets particularly unhappy when the new legal entity is essentially a repository for a portfolio of marketable securities. There are many sound non-tax reasons for employing a family limited partnership to manage any kind of wealth, but the IRS believes that no one would go to the trouble for a portfolio of securities except to secure additional tax benefits. 

Accordingly, the IRS has effectively declared war on family limited partnerships, by proposing a new set of regulations under Internal Revenue Code 2704 last year, which deals with intra-family transfers. The proposal is detailed and abstruse, and it is not limited to securities portfolios. There has been much resistance to the proposal from business owners.

Speaking to estate planners at the Heckerling Institute on Estate Planning, Catherine Hughes from the Treasury Office of Tax Legislative Counsel reported that the IRS will be moving ahead on finalizing the controversial proposed Regs. She reported that more than 10,000 comments were received, and no doubt the vast majority were in opposition. The December hearing on the proposal lasted more than six hours, which Ms. Hughes thought to be a record for recent times.

Contrary to the reactions of many commentators, the proposed Regs. were not intended to eliminate all minority discounts, Ms. Hughes asserted. The final Regs. will make that point very clear, as well as addressing other misunderstandings identified during the comments period.

Elimination of the federal estate tax might not render the §2704 Regs. moot. They could come into play if the federal gift tax is retained, or if there will be a capital gains tax imposed at death.

New Perspectives on Revocable Living Trusts

One of the most useful and flexible wealth management tools is the revocable living trust. Traditionally, we like to point to three basic benefits that these trusts offer. 

Professional asset management. After studying your goals and circumstances we will map out a diversified investment program appropriate to your requirements. Our objective is not only to add to your financial security, but also to give you more opportunity to enjoy it. 

Uninterrupted family financial protection. A living trust agreement can instruct us to perform a wide variety of special tasks when the need arises. With proper planning, living trusts can do much to avoid the financial management problems that arise during a prolonged period of incapacity—problems that might otherwise have to be dealt with by a court-appointed conservator. 

Probate avoidance. Assets placed in a living trust are said to avoid probate because these assets are removed from your “probate estate”—the estate controlled by your will. Trust assets are distributed to beneficiaries, or held in continuing trust, as you direct in the trust agreement. Thus, using a living trust as the core of an estate plan usually leads to reduced settlement costs. More importantly, delays are avoided. 

More Benefits

But living trusts can do more. Noted estate planner Martin Shenkman explored new perspectives on trust benefits in an article in a professional journal last year [“How to Avoid Complicated Trust Issues,” Bank Investment Consultant]. Among the emerging benefits he pointed out:

Minimizing identity theft. The problem of identity theft has exploded in recent years. A funded revocable trust may have its own tax ID number, rather than using the settlor’s own Social Security number. In the event that the settlor’s Social Security Number is compromised, the trust assets still will be protected.           

Protecting aging retirees. More and more retirements are lasting longer than 20 years, and more and more elderly are developing some level of cognitive impairment. A living trust can provide for successor trustees as the beneficiary’s abilities decline. Checks and balances can be built into the plan, in the form of co-trustees or trust protectors. A care manager plan also might be included, to provide annual or quarterly assessments of how the beneficiary is doing.

Serving disabled loved ones. A revocable trust may contain special-needs language to provide for an ill relative or incapacitated adult child. The trust also may provide for successor trustees should the caregiver become incapacitated. 

Asset protection in divorce. If gifted or inherited assets are segregated into a trust, they won’t be commingled with other marital assets. As such, those assets won’t be vulnerable in a subsequent divorce proceeding.               

Notwithstanding the decline in estate planning attributable to the increase in the federal exemption from estate taxes, attorney Shenkman predicted that the traditional and emerging benefits associated with revocable living trusts will make them an essential part of late-stage life planning for years to come.

Get Started 

To set up a living trust with us, you give us your instructions in a trust agreement, prepared by your attorney, and transfer the stocks, bonds, investable cash or other assets that you with to place in your trust. Because the trust agreement is revocable, you can cancel the arrangement if ever you find it unsatisfactory. You also remain free to add assets, withdraw assets, or modify the terms of the trust.

Can resourceful management and responsive financial services eliminate all threats to financial security? Not quite. Always there remains an element of luck. But as a wise person has said, you can’t hope to be lucky. You have to prepare to be lucky.

 We look forward to assisting you in your preparations.

DJIA 20000

Dear Garden State Trust Company: 

How should the fact that the Dow Jones Industrial Average crossed the 20000 barrier affect my investment strategy? —Numbers Maven

Dear Numbers: 

Passing a stock index milestone is not a signal to buy or sell.  However, it does focus attention on the market, and it may cause some investors to evaluate their portfolio.  There can be a strong temptation to “take some money off the table.”

How close are you to retirement?  How much risk are you willing to assume?  Those answers are better clues to making an investment decision that allows you to sleep well at night.

This could be a time for portfolio rebalancing, if you haven’t made this assessment recently.  If your asset allocation target was 60% stocks, 40% bonds, you may find that the stock portion has now grown to 70%.  That means your portfolio is now riskier than it used to be.  If that makes you uncomfortable, you need to sell some stocks and invest in bonds, to keep your allocation steady.

On the other hand, bonds have risks of their own, as interest rates are likely to rise in the coming years, to return to more normal levels.  That will push down the value of previously issued bonds.  What’s more, if you share in the optimism about the economy this might not be the right time to reduce your exposure to growth.

If you might benefit from a second opinion on your investment strategies or the composition of your portfolio, we would be pleased to meet with you to discuss your situation.  Investment management throughout market cycles is a core element of our daily business. We will be pleased to share our expertise with you.

Do you have a question concerning wealth management or trusts? Send your inquiry to

(February 2017)

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