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Thursday, June 01, 2017

Purchasing A Financial Institution Having Inherited IRAs- Caution Is Warranted

Most everyone tends to believe what the IRS says is correct and must be followed. That is not always the case. The IRS must follow the statutory law and its regulations, and the U.S. Tax Court has no problem ruling that the IRS is wrong in its tax position. Courts give some deference to the IRS, but it is not absolute. For example, in the Bobrow rollover case the tax court ruled the IRS did not have the authority to expand the once per year rollover rule to permit a person to make rollovers on a per plan agreement basis.

Sometimes a taxpayer should be more conservative and adopt a position more conservative than the IRS' position. This is the case with inherited IRAs. In IRS Notice 2002-27 and the instructions for Forms 1099-R and 5498 the IRS had stated an IRA beneficiary is responsible to calculate and withdraw the applicable required distribution. The IRA custodian is not required to send a beneficiary a required distribution notice as it must for someone age 70½ or older.

An IRA custodian must remember that its relationship with its IRA clients is primarily governed by the IRA plan agreement and not by what IRS guidance provides. The IRA plan agreement requires that certain distributions be made to IRA owners who are age 70½ and older and to an IRA beneficiary after the IRA owner dies. A strong argument exists that the IRA custodian has a duty to make sure such distributions are taken.

The law imposes a 50% excise tax when a person fails to take their RMD by the applicable deadline. This 50% tax is an annual tax. For example, if a beneficiary had an RMD of $400 for 2013 and fails to withdraw it for 2013-2016 but withdraws it in 2017, the beneficiary owes $800 plus interest and applicable penalties (i.e. $200 for 2013, 2014, 2015 and 2016).

A financial institution wants to protect itself against the following situation. Bank A had purchased Bank B in 2013. Bank B had a long time IRA client, Jane Smith, who had died in February of 2012 at age 73. She had designated her daughter Mary (age 48) to be her IRA beneficiary. It is now May of 2017. Mary's IRA CD has just matured and she is in the process of deciding if she will reinvest it with Bank A or have it transferred to another IRA custodian. Mary understands her IRA is an inherited IRA. The problem is - Mary's IRA is not listed on the computer system at Bank A as an inherited IRA. It is listed only as her own IRA. She has not taken any required distributions for 2012-2016.

What's to be done? What are the possible adverse tax consequences and the possible adverse non-tax consequences? Jane is required to pay the 50% on her missed RMDs unless she can convince the IRS she should not have to pay the tax on account of the IRA custodian's failure to perform its duty of distributing the RMD for each year. The IRS may well rule she owes the taxes on account of Notice 2002-47. Jane may well commence legal action to include the IRA custodian (Bank A) in her tax dispute with the IRS. Litigation is expensive and it is to be avoided.

When a financial institution buys another financial institution (and its IRAs) the buyer wants to determine that there are no inherited IRA problems within the seller's IRA portfolio. There should be a thorough review conducted before the closing and possibly the inclusion of a contract provision where the seller remains liable if any unknown problems arise after the sale/purchase.

Posted by James M. Carlson at 10:12.45
Edited on: Thursday, September 28, 2017 10:38.01