Estate Planning for a Marital Property Interest in IRAs

This online article is a companion to the author's print article (of the same title) published in the July 2000 Wisconsin Lawyer. This article provides broader discussion, including legal analysis, of estate planning for a marital property interest in IRAs than space allowed in the print article. You may reach Mr. Willms online.

by Andrew J. Willms

Wisconsin's Marital Property Act presents tough questions to estate planning attorneys. These questions include whether a married person has a marital property interest in a spouse's IRA. If so, can the marital property interest be used to fund the spouse's unified credit if the spouse dies first? Is there a way to preserve the pre-tax growth of the spouse's marital property interest in the IRA after his or her death?

Greater attention needs to be focused on the marital property issues created by IRAs because:

• the tremendous growth in the amounts held inside IRAs;

• the increase in the applicable unified credit amount available to each taxpayer; ¹ and

• the U.S. Supreme Court's 1997 decision in Boggs v. Boggs.

This author has recently been sparring with the IRS over these issues. This article reports the author's understanding of the current state of the law.

Round 1: No Decision

The Scenario. Suppose your client is a married Wisconsin resident and has funded an IRA by a rollover of his account balance with an employer-sponsored qualified plan (the "rollover IRA").Your client (for simplicity, called the "account owner" even though both spouses may own a marital property interest in the account) and his spouse are both age 70. The account owner's spouse has also established her own IRA (the "spousal IRA"). However, the rollover IRA represents the vast majority of the parties' total assets. The account owner's IRA is worth more than $2,000,000, while the spousal IRA is worth about $50,000. The couple's assets outside the IRA total approximately $400,000.

The Estate Plan. The couple would like to be in a position to fund the spouse's unified credit with part of the rollover IRA if the spouse dies first, and also would like to allow their children to continue the tax-free growth inside the rollover IRA for as long as the minimum distribution rules allow regardless of who dies first. In an effort to accomplish this objective, the couple executes an estate plan that provides:

• The parties enter into a marital property agreement that classifies the rollover IRA as marital property. The spousal IRA is classified as the spouse's individual property by the marital property agreement.

• The marital property agreement provides that Wisconsin's terminable interest rule² does not apply to the rollover IRA and, therefore, the spouse's interest will not be terminated at her death by application of state law.

• Spouse's will and the marital property agreement provides that when the spouse dies, the spouse's one-half interest in the rollover IRA should be transferred to the account owner if he is alive.³ If the account owner disclaims this interest, the will and marital property agreement provide the spouse's interest to the rollover IRA should be distributed directly to the spousal IRA.

• The spouse files a beneficiary designation with the custodian of the rollover IRA that is consistent with her will and the martial property agreement.

• The beneficiary designation for the spousal IRA names a trust for the benefit of the couple's children (the "children's trust") as the beneficiary. The children's trust will be a qualified beneficiary, as defined by Prop. Treas. Reg. 1.401(a)(9)-1 (as modified).⁴

• On or before her Required Beginning Date (RBD), the spouse will direct the custodian of the spousal IRA to make annual distributions to her during her lifetime based on her and the oldest trust beneficiaries' joint life expectancies, subject to the minimum distribution incidental death benefit rule.⁵ For this purpose, neither life expectancy will be recalculated.

The Estate Plan's Effect

In the author's opinion, the effect of such an estate plan should be:

• A spouse may have a marital property interest in an IRA notwithstanding I.R.C. § 408(g).⁶

• The anti-alienation rules of the Internal Revenue Code and the corresponding provisions of the Employee Retirement Income Security Act, do not prevent the spouse from having a marital property interest in an IRA.⁷

• Classification of the rollover IRA of the taxpayer as marital property should not be considered a taxable distribution for purposes of I.R.C. § 408(d)(1).⁸

• State law does not prevent the transfer of spouse's interest in the rollover IRA to the spousal IRA.⁹

• If the spouse dies first and the account owner makes a qualified disclaimer of her interest in the spousal IRA, amounts passing to the children's trust as a result of the disclaimer can be protected from transfer tax by the spouse's unified credit.¹⁰

• If the spouse dies first, and the account owner makes a qualified disclaimer, it should be possible to make a tax-free transfer of the spouse's one-half interest in rollover IRAs to the spousal IRA.¹¹

• So long as the children's trust meets the requirements of proposed Treasury Regulations § 1.401(a)(9)-1 (as modified), then after the death of the spouse, minimum distributions from the spousal IRA can be taken on the remaining joint life expectancy of the spouse and the oldest trust beneficiary.¹²

Legal Analysis

State law does not prevent the transfer of the deceased spouse's interest in the rollover IRA to the spousal IRA.

The Marital Property Act provides that a nonemployee spouse owns a marital property interest in deferred employment benefits that accrue after the effective date of the Marital Property Act.¹³ IRAs whose assets are traceable to a rollover from a qualified plan are considered to be a deferred employment benefit under Wisconsin law.¹⁴

Deferred employment benefits are subject to a terminable interest rule which states that a nonemployee spouse's interest in a deferred employment benefit plan terminates at the death of the nonemployee spouse.¹⁵ However, spouses may negate the application of the terminable interest rule with regard to deferred employment benefits and rollover IRAs by so providing in a marital property agreement.¹⁶

In the above hypothetical, the parties' marital property agreement classifies the rollover IRAs as marital property and directs that the terminable interest rule will not apply. The account owner has consented to the transfer of his spouse's interest in the rollover IRAs to her own IRA. Accordingly, a transfer of the spouse's one-half interest in the rollover IRAs to the spousal IRA would be consistent with state law.

I.R.C. § 408(g) does not defeat a spouse's marital property interest in an IRA to the extent the existence of that interest is consistent with state law.

I.R.C. § 408(g) states that section 408 "shall be applied without regard to any marital property laws." Private Letter Ruling (PLR) 8040101 stated that the House Committee Report for Code Section 408(g) made clear that I.R.C. § 408(g) was intended to limit deductions taken by a nonwage earning spouse from marital property income received by the wage-earning spouse.

That PLR further stated:

"Because there is no specific language on what effect Congress intended Code section 408(g) to have, and because of the general rule of statutory construction which provides the federal statutes are construed as to not preempt state law unless that was the clear and manifest intent of Congress, we conclude that section 408(g) does not abrogate any substantive rights under state law."¹⁷

Thus, where a couple resides in a marital property jurisdiction, the spouse of an IRA participant may have a marital property interest in the IRA to the extent the existence of that interest is consistent with state law.¹⁸ In addition, in PLR 9419036 the IRS acknowledged that the classification of an IRA as marital property under state law is not a taxable event under section 408(d)(1), provided no actual distributions are made from the IRA pursuant to the agreement.¹⁹

The anti-alienation rules of I.R.C. § 401(a)(13) and ERISA § 1055 do not defeat a nonparticipant spouse's marital property interest in an IRA.

The anti-alienation rules of I.R.C. § 401(a)(13) and ERISA § 206(d) are intended to ensure that the economic security of a surviving spouse is not undermined by allowing a predeceasing spouse's interest to be distributed to other beneficiaries. Therefore, under the anti-alienation rules, if the nonparticipant spouse dies first, her interest in qualified retirement plans of the participant spouse terminate. The anti-alienation rules of I.R.C. § 401(a)(13) and ERISA § 206(d) govern qualified retirement plans, but do not apply to IRAs.²⁰

In the hypothetical under consideration, although the IRA is also traceable to an ERISA governed plan, the retirement funds have been rolled over to an IRA during the spouse's lifetime. This rollover terminates the application of the anti-alienation.

The transfer of the spouse's one-half interest in rollover IRAs to the spousal IRA should not be regarded as a taxable distribution.

I.R.C. § 408(d)(3)(A) provides that amounts paid or distributed out of an IRA are not currently taxable to the distributee if the entire amount received is paid into an IRA for the benefit of the distributee within 60 days. Furthermore, Rev. Rul. 78-406, 1978-2 C.B. 157, provides that the direct transfer of funds from one IRA trustee to another IRA trustee does not result in such funds being currently taxable.

As explained above, under state law the participant's spouse is the owner of a one-half interest in an IRA that is classified as marital property. Likewise, the spouse is the owner of the spousal IRA. Thus, in the author's opinion, the transfer of the spouse's interest in the rollover IRA to the spousal IRA should be nontaxable since the 60-day requirement of § 408(d)(3)(A) and the direct transfer requirement of Rev. Rul. 78-406 will both be satisfied.²¹

If the spouse's interest in the rollover IRA can be transferred to the spousal IRA, then the life payout method should be available when determining the amount of required minimum distributions from the spousal IRA after death of the spouse.

I.R.C. § 401(a)(9) provides for minimum distribution rules governing when qualified plan distributions must begin, the minimum amount that must be distributed to the participant during his or her lifetime, and the payment of plan benefits upon the participant's death.²² I.R.C. § 401(a)(9)(A) provides that distributions cannot extend for a period longer than the life of the participant, the lives of the participant and the designated beneficiary, a period (which may be a term certain) not extending beyond the life expectancy of the participant, and a period (which may be a term certain) not extending beyond the life expectancies of the participant and the designated beneficiary. The amount of the minimum distribution is to be determined by dividing the account balance as of Dec. 31st of the preceding calendar year by the applicable life expectancy.²³

If there are multiple designated beneficiaries, the designated beneficiary with the shortest life expectancy must be used for determining the distribution period.²⁴ If the designated beneficiary is not the participant's spouse, the joint life expectancy of the participant and the designated beneficiary must be calculated as if the beneficiary was no more than 10 years younger than the participant.²⁵

Applying the foregoing to the facts at hand, if the transfer of the spouse's interest in the rollover IRA to the spousal IRA is permissible, it should be permissible for distributions to be taken from the spousal IRA based on the joint life expectancy of the spouse and her oldest child, subject to the minimum distribution incidental benefit rule.²⁶

The IRS's View

In 1999 the author submitted a private letter ruling request to the IRS in an effort to confirm the opinions expressed above. Unfortunately, the IRS declined to respond to that ruling request, asserting the request involved a "hypothetical situation" until the death of either the account owner or the spouse.

Round 2: A Split Decision

In light of the IRS's position, a new ruling request was submitted. The new ruling request asked whether a married person residing in Wisconsin could transfer her marital property interest in the rollover IRA by a direct trustee-to-trustee transfer to the spousal IRA, prior to the death of either the account owner or the spouse. The new ruling request indicated that actual distribution of IRA funds would not be made at the time of the transfer to either the account owner or to the spouse. The new ruling request also asked whether minimum distributions from the spousal IRA could be taken based on the joint life expectancy of the spouse and her oldest designated beneficiary, subject to the minimum distribution incidental benefit rule.

The IRS's Response

The IRS responded to the new ruling request by issuing PLR 199937055 (June 24, 1999). The ruling confirmed that I.R.C. § 408(g) does not abrogate any substantive rights under state law. Furthermore, the IRS ruled that the reclassification of an IRA as marital property pursuant to a property agreement is not considered a taxable distribution for purposes of § 408(d)(1). However, the IRS also ruled that the transfer of a spouse's marital property interest in the rollover IRA to the spousal IRA would constitute a taxable distribution for purposes of § 408(d)(1). In reaching that decision, the IRS stated:

"The owner of an IRA account is deemed to be the individual in whose name the account was established. This conclusion is not affected by state law."

The IRS then went on to state that even if a spouse is the owner of one-half of an IRA account under state law, distributions from the IRA are to be taxed as if the account owner is the sole owner of the IRA. The IRS cited absolutely no authority in either of its positions, however.

Legal Analysis

Notwithstanding its admission that § 408(g) was not intended to preempt state law in this respect, the IRS stated in its ruling that property rights established by state law could be ignored when determining how IRA distributions are to be taxed. The critical question then becomes whether the IRS can in fact ignore the existence of property rights created by state law when applying the Internal Revenue Code.

In U.S. v. Mitchell,²⁷ the U.S. Supreme Court considered whether a married woman domiciled in the community property state of Louisiana was personally liable for federal income tax on half of the marital income realized during the existence of the marriage despite the exercise of her statutory right of exoneration. The Court held that the spouse was liable for the federal income tax on one-half of the marital income. In doing so, the Court stated:

"[T]hus, with respect to marital income, as with respect to other income, federal income tax liability follows ownership. Blair v. Commissioner, 300 U.S. 5, 11-14 (1937). See Hoeper v. Tax Comm'n, 284 U.S. 206 (1931). In the determination of ownership, state law controls. 'The state law creates legal interests but the federal statute determines when and how they shall be taxed.' Burnet v. Harmel, 287 U.S. 103,110 (1932); Morgan v. Commissioner, 309 U.S. 78, 80-81 (1940); Helvering v. Stuart, 317 U.S. 154, 162 (1942); Commissioner v. Harmon, 323 U.S. 44, 50-51 (1944); See Commissioner v. Estate of Bosch, 387 U.S. 456 (1967)."²⁸

Where, as here, both spouses have identical ownership interests in an IRA under state law, it would seem the IRS should be obligated to treat those property interests in the same manner when applying the Internal Revenue Code. "It was the object of Congress to provide a uniform basis of taxation in order to secure uniformity in the burdens imposed. 'Equality is equity.'"²⁹ However, the U.S. Tax Court's recent decision in Bunney v. Commissioner³⁰ can be read to support a different conclusion.

Andrew J. Willms, University of Miami 1984 cum laude, LL.M.-Estate Planning 1985, is a shareholder with the Thiensville firm of Willms Anderson S.C. He is a frequent author and speaker on estate planning and related topics.

Bunney concerned a community property IRA that was distributed to the person who had established the account and then transferred from that person to his former spouse pursuant to their divorce. The Tax Court held that the entire amount distributed was taxable to the account owner. In so doing, the court indicated (in dicta) that recognition of a spouse's community property interest in an IRA for income tax purposes would conflict with the application of § 408(g). In the author's view, the court's reasoning in this regard is questionable. Moreover, the Tax Court did not address the more fundamental issue mentioned above; namely, can state created property rights be ignored when applying the tax code where there is no preexemption? And if so, what is to be made of the Private Letter Rulings cited above?

Conclusion

A spouse may have a marital property interest in an IRA to the extent that his interest is consistent with state law. If the application of Wisconsin's terminable interest rule is negated by a marital property agreement, the spouse's marital property interest in the IRA can be used to fund the spouse's unified credit. It also may be possible to transfer the spouse's interest in a marital IRA to an IRA established in the spouse's name. If so, the minimum distribution rule should be applied based on the life expectancy of the spouse and her designated beneficiary.

Endnotes

¹ For a discussion on using IRA assets to fund the Unified Credit, see Herbers, John A., Funding the Credit Shelter Trust with IRA Benefits, 73 Wis. Law. 14 (July 2000).

² Wis. Stat. §§ 766.62(5); 766.31(3).

³ Wis. Stat. § 766.58(3)(f).

⁴ See Campbell, Terry L., The IRA Maze: Finding A Way Out, 73 Wis. Law. 10 (July 2000).

⁵ I.R.C. § 401(a)(9)(A).

⁶ PLR 1999 37055; PLR 8040101.

⁷ I.R.C. § 401(a)(13); ERISA § 206(d); PLR 1999 37055.

⁸ PLR 1999 37055; PLR 8007024; PLR 8929046; PLR 94190396; PLR 9439020.

⁹ Wis. Stat. §§ 766.01(4)(a); 766.17(1); 766.31(3)0; 766.62(1)(a); 766.62(5)(b).

¹⁰ See I.R.C. §§ 2518, 2011. See also Herbers, supra note 1.

¹¹ See PLR 8040101; PLR 9439020.

¹² See Campbell, supra note 4.

¹³ Wis. Stat. § 766.62(1)(a).

¹⁴ Wis. Stat. §§ 766.01(4)(a); 766.62(5)(b).

¹⁵ Wis. Stat. §§ 766.62(5); 766.31(3).

¹⁶ Wis. Stat. § 766.17(1).

¹⁷ See also PLR 9630034; PLR 9623063; PLR 9439020; PLR 9427035; PLR 9419036; PLR 8929046; PLR 8007024.

¹⁸ But see, Bunny v. Commissioner, 114 T.C. No. 17, Docket No. 20713-97 (filed April 10, 2000).

¹⁹ In accord, see, PLR 8007024, 8929046, 9439020.

²⁰ While the recent U.S. Supreme Court case of Boggs v. Boggs contains dicta that could be considered to apply ERISA's anti-alienation and state preemption provisions to an IRA of the decedent, the facts of Boggs make clear that the decision in that case does not result in the anti-alienation rules of ERISA applying to IRAs.

²¹ PLR 9630034 considered the transfer of a surviving spouse's marital property interest in a custodial IRA that had been established by her deceased husband to an IRA that was established by the surviving spouse. In that ruling, the IRS concluded that the custodian-to-custodian transfer of a spouse's marital property interest in the IRA established by her deceased spouse constituted an election to treat such transferred portions as the spouse's own account and, therefore, qualified as a tax-free transfer pursuant to § 408(d)(3)(A), and furthermore was not subject to the limitation found in § 408(d)(3)(B).

Similarly, in PLR 9439020, the IRS ruled that a division of a marital property IRA into two individual IRAs (one for each spouse) was not a taxable event. The IRS further ruled that each spouse could direct the testamentary disposition of their respective interests in the IRA since applicable state law so allowed.

In PLR 8040101, the IRS recognized the one-half ownership interest of the spouse under the marital property laws of the state in which the couple were domiciled and approved distribution of the spouse's share of the IRA to her heirs while the spouse in whose name the IRA was established was still living. The IRS further ruled that a distribution of the deceased spouse's interest in the IRA was not taxable to the surviving spouse because he was not the payee or the distributee under I.R.C. § 408(d)(1).

²² See, Campbell, supra note 4.

²³ Prop. Regs. § 1.401(a)(9)-1, Q&A F-1 and F-5.

²⁴ Prop. Regs. § 1.401(a)(9)(E), Q&A E-5.

²⁵ Prop. Regs. § 1.401(a)(9)-2, Q-4.

²⁶ In accord, see, PLR 9630034. See also Herbers, supra note 1.

²⁷ U.S. v. Mitchell, 403 U.S. 190 (1971).

²⁸ Id. at 197.

²⁹ Pacific Ins. Co. v. Soule, 74 U.S. 433 (1868) at 433.

³⁰ Bunny v. Commissioner, 114 T.C. No. 17, Docket No. 20713-97 (filed April 10, 2000).

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