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A retirement plan is not unemployment insurance

Licensed attorney Molly Woll was laid off by her employer in 2017. That meant her 401(k) account was terminated, and some $86,000 was distributed to her.  Molly did not roll the money over into an IRA.  Instead, she and her husband used the funds to pay off a $39,000 plan loan from the 401(k), over $9,000 in medical expenses that year, student loans, and various other ordinary bills during a year when the family income was sharply curtailed. 

Molly reported the entire distribution as income on the couple’s Form 1040 for 2017, and they paid full ordinary income tax on it.  However, they did not pay the 10% penalty tax for the premature distribution.  The IRS computers caught the oversight, and they added a penalty for understatement of tax to the penalty for taking retirement money before reaching age 59½.

The Wolls filed an appeal with the Tax Court, stating that an exception should apply to the penalty taxes because the unemployment caused a financial hardship.  Unfortunately, the Tax Code does not include any such relief for taxpayers in this situation.

The Wolls also objected to the fact that the penalty was imposed automatically by the IRS computer, without human supervision as is required by IRS procedures.  Curiously, the Tax Court held that 10% payment required upon an early distribution from a retirement plan isn’t a penalty at all, or even a penalty tax.  Rather, it is a tax increase. As such, written supervisory approval of the imposition of the “not a penalty” is not required.

Although the Court acknowledged the financial distress the Wolls found themselves in, both tax penalties were confirmed.


Article ©2021 M.A. Co. All rights reserved. Used with permission. 

How far does “absolute discretion” go?

Sonja’s estate consisted of farm real estate and equipment and an oil lease.  She bequeathed the farm property to her two sons, Brad and Mark, and created a trust for all five of her children to hold the oil lease. Brad was the trustee of the trust, and in that capacity he had “absolute discretion” over the trust property. Mark later assigned his interest in the land to Brad.

Brad managed the farm and used all of the trust income to pay down debt on the property and fund the agricultural operations.  He effectively treated the trust as his own, never distributing anything, not even an accounting, to the other trust beneficiaries, his siblings. The trust income came to $1.3 million over the years. In 2013 and 2014 Brad conveyed the mineral rights in the trust to himself personally, leaving nothing in the trust. 

The other beneficiaries filed suit in 2015. They lost. The trial court held that the trust instrument was clear and unambiguous. Brad’s “absolute discretion” over the uses of trust principal and income barred any second guessing of actions. Viewing Sonja’s will and trust documents together, the trial court concluded that Brad was only doing what she would have wanted.

The appellate court now reverses, holding that the trial court failed to take into account settled trust law.  “Absolute discretion” does not trump a trustee’s fiduciary duties of loyalty to all the beneficiaries, the duty to act in good faith and with impartiality. The interests of the other beneficiaries may not be simply ignored, as Brad did.

The case was remanded for further consideration, including possible remedies.


Article ©2021 M.A. Co. All rights reserved. Used with permission. 

The “American Families Plan”

In April President Biden announced a program of major tax increases aimed at affluent families.  Key elements of his program include:

• Restoration of the 39.6% top tax rate on ordinary income in 2022 instead of 2026, as under current law.

• Elimination of preferential taxation of capital gains and qualified dividends for those with taxable income in excess of $1 million. The top tax rate on capital gains would go to 43.4%.

• Ending the step-up in tax basis for inherited assets at death.  This would be subject to a $1 million exemption ($2 million for married couples).

• Eliminate the “carried interest” provision that allows hedge fund managers to enjoy capital gain treatment of a portion of their compensation.

• Limit the tax benefit of like-kind exchanges to $500,000.

Notably absent from the list of tax reforms was the repeal of the $10,000 limit on the deduction for state and local taxes, a change advocated by many Democratic legislators.  Failure to include that element might cast doubt on Democratic support for the proposal, though there is no doubt of strong Republican opposition.  Legislative prospects of the proposal are uncertain.

Elimination of the basis step-up at death was tried during the Carter administration and later abandoned as too complicated to administer.  Still, Canada adopted that rule some years ago, and it seems to be working for them.  The compromise was the trade of eliminating basis step-up for dropping the Canadian estate tax, a roughly revenue-neutral move.  President Biden did not propose changing the estate tax. 


Article ©2021 M.A. Co. All rights reserved. Used with permission. 

The top income tax rate

Dear Trust Officer: I see that President Biden has proposed bringing back the 39.6% income tax rate early, before its already scheduled return in 2026.  Why is that tax rate a fraction, instead of a whole percentage rate as all the other tax rates are?  Where did that extra 0.6% come from? Wouldn’t it be simpler to just round up to a 40% top tax rate?—Trivia Buff

Dear Trivia: It’s a political story.  When he ran for President in 1992, Bill Clinton campaigned for a 10% “millionaire’s surtax” to be applied to everyone with taxable income over $1 million.  The top tax rate was then 36%, and 10% of that is 3.6%.  Add them up and you get the 39.6% top tax rate.

When the millionaire’s surtax was enacted, there was a new definition of “millionaire,” as the new top rate applied to anyone with taxable income over $250,000.  This rather stark departure from the campaign rhetoric was justified at the time with the observation that those with incomes over $250,000 likely had more than $1 million in assets, so they were still millionaires.  However, the fact that so many more taxpayers ended up affected by the increase has led to some skepticism of political statements on taxes ever since.

Although a round 40% top tax rate might look simpler, the computers that handle all the tax calculations these days are not bothered by extra digits in the tax rate.


Article ©2021 M.A. Co. All rights reserved. Used with permission. 

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