MORE DETAILS ON NONSPOUSAL ROLLOVER OF INHERITED QUALIFIED PLANS

An important new provision in the Pension Protection Act of 2006 relates to rollovers of inherited qualified plan assets, such as assets from a 401(k) plan.

GENERAL BENEFITS OF DEFERRAL

When an individual dies owning assets in a qualified retirement plan, and a designated beneficiary is provided for under the plan, that beneficiary becomes the new owner of the decedent's plan assets. Such plan assets must be eventually distributed out of the plan to the beneficiary. When this happens, the recipient is generally taxable in the year of distribution.

Plan beneficiaries can benefit in two key ways by deferring such distributions as long as possible. First, since such distributions are taxable, from an economic perspective the longer one can defer paying such taxes the better off one usually is. Second, while such plan assets are still in the plan, any current earnings from those assets are not subject to immediate tax and are likewise deferred until ultimate distribution.

To avoid extensive deferral of taxes, the Internal Revenue Code contains provisions that require that distributions be made out of the plans within certain time periods.

MANDATORY TIME PERIODS FOR DISTRIBUTION

Prior to the Pension Protection Act of 2006, deferral opportunities existed for the recipients of inherited qualified plan assets. These provisions can be summarized as:

• If the decedent/employee dies before he or she was obligated to start taking his or her own pension distributions, then distribution of the plan assets to the beneficiaries after death must be completed either (a) within five years of death, or (b) over the life expectancy of the beneficiary, beginning within one year of the employee's death.

• If the decedent/employee was obligated to start taking his own pension distributions or had started taking them before he or she died, then his remaining interest must be distributed at least as rapidly as under the distribution method used by the decedent/employee as of the date of death.

Note, however, that beneficiaries who are spouses have additional deferral opportunities, since they can rollover the plan assets of their deceased spouse into THEIR OWN IRA. Once that is done, the surviving spouse must distribute the IRA assets in accordance with the rules that apply to his or her own IRA. Depending on the age of the surviving spouse, this will usually provide superior deferral opportunities than the above nonspousal rules.

WHY WERE CHANGES NEEDED?

If nonspousal beneficiaries already had the above deferral opportunities, why was a change in the law needed? Because while the law allows the above deferral opportunities, they apply only if the particular pension plan documents allow for one or more of them. Out in the real world, most company plans do not allow for them and require rapid payment of account balances to beneficiaries after the employee dies. Thus, most company plan beneficiaries cannot avail themselves of the deferral opportunities allowed under the law.

WHAT CHANGES WERE MADE?

The new law now allows for the plan assets to be rolled into an "inherited IRA." Once rolled into an "inherited IRA" the beneficiary can take advantage of all of the nonspousal deferral opportunities described above, even if the qualified plan mandated earlier distribution.

STILL NOT AS GOOD AS A SPOUSAL ROLLOVER

Some people now believe that a nonspouse beneficiary is treated the same as a spouse. However, this is not correct.

The new IRA is treated as an "inherited IRA" and gets to use the general deferral provisions listed above. This is not the same as the spousal option to transfer plan assets to his or her own IRA - that type of transfer allows for more enhanced deferral oportunities to the spouse.

MISC. OBSERVATIONS

• A trust for designated beneficiaries can elect the same rollover as an individual beneficiary

• The rules apply to distributions made AFTER December 31, 2006.

• The new IRA must be titled in a manner that identifies it as an inherited IRA.

• A direct trustee-to-trustee transfer is required.

• The rollover can be made only by a beneficiary that qualifies as a "designated beneficiary" under the Internal Revenue Code rules. Thus, for example, a probate estate that is the beneficiary cannot do a rollover.

ACTION TO CONSIDER

Nonspousal beneficiaries who have inherited an interest in a plan should try to defer distributions from the plan until 2007 to take advantage of the rollover provision.

APPLICABLE FEDERAL RATES - SEPTEMBER 2006

SEPTEMBER 2006 Applicable Federal Rates Summary:

-Short Term AFR - Semi-annual Compounding - 5.07% (5.19%/August -- 4.99%/July -- 4.93%/June)

-Mid Term AFR - Semi-annual Compounding - 4.95 (5.14%/August -- 4.99%/July -- 5.00%/June)

-Long Term AFR - Semi-annual Compounding - 5.14 (5.29%/August -- 5.22%/July -- 5.25%/June)

DIRECTION OF RATES: Down

DEFINED VALUE GIFT CLAUSE UPHELD BY APPELLATE COURT

Federal transfer tax law has various exemptions that may apply to otherwise taxable estate or gift transfers- unified credit amounts, annual exclusion gifts, generation skipping tax exemptions, etc. Taxpayers often desire to make transfers of property that come within these exemptions. Since the value of property is always open to challenge, a taxpayer that transfers a fixed fraction or percentage of property based on the taxpayer's valuation so as to come within a specific exemption amount may be subject to a nasty surprise if the IRS or a court determines a higher value for the property. In that case, the taxpayer will have given more than the targeted exemption amount, and thus will likely suffer unfavorable tax results (usually by exceeding the available exemption amount).

One way to avoid this problem is to provide in the transfer instrument that only so much of the subject property is being transferred that equals the available exemption amount (instead of transferring a fixed percentage or value of the property). Such a clause is often referred to as a "defined value gift clause." If the value of the property is higher than anticipated, the effect will be to reduce the fraction of the property that is transferred - the total gift value remains at the stated gift amount so the applicable exemption will not be exceeded.

The IRS is generally hostile to such clauses on public policy grounds since it effectually frustrates their audit of value of gifted property - if the property value is increased on audit the IRS will not collect any additional taxes on the gift itself since the amount of property gifted is automatically reduced to remain within the total dollar amount stated for the gift.

In 2003, the Tax Court in the McCord case voided the effect of a defined value gift clause. The Tax Court hung its hat on the fact that the formula used in that case defined the gift based on its "fair market value" and not its "fair market value as finally determined for federal gift tax purposes."

You would think that this was a slender thread on which to base its decision - and you would be right! The 5th Circuit Court of Appeals has now reversed the Tax Court, and gave full effect ot the defined value gift clause provided for by the taxpayers.

Does this mean defined value gift clauses will now be accepted as valid by the IRS and courts? Not necessarily. Interestingly, the IRS did not argue the public policy enforcement issues discussed above and often raised in these circumstances (based on the old case of Procter and its progeny). Therefore, a court faced with such a public policy argument might still invalidate a defined value gift clause on those grounds. Further, since this case was in the 5th Circuit, courts in other Circuits are not bound by it.

Nonetheless, the decision is helpful both in structuring defined value gifts that will be more likely to withstand IRS scrutiny and as precedent that may eventually lead to some final acceptance by the IRS or more courts as to their effectiveness.