ASSET PROTECTION PLANNING FOR THE IRA R. Glen Woods
Woods Erickson Whitaker Miles & Maurice LLP 1349 Galleria Drive
Henderson, NV 89014 (702) 433-9696
Many business owners, professionals and investors are familiar with the benefits that can be obtained from the use of limited partnerships. Indeed, limited partnerships have proven to be effective estate planning tools for almost every kind of asset, except S corporation stock1. The estate planning benefits of limited partnerships include (i) asset protection; (ii) estate tax reduction; (iii) simplification in administration of estates; (iv) the ability to shift assets outside one’s estate while maintaining investment control of assets; and (v) efficiency in the management of assets. The advantages of Nevada’s limited partnership laws—particularly after some recent legislative changes2—are becoming widely known.
For many people the IRA is becoming an increasingly large portion of available investment assets. Many investors have rolled over or transferred qualified plan assets into their IRAs. Others have successfully invested through IRAs. Still others have inherited substantial IRA balances. Most investors are aware that the federal pension law does not protect IRAs from claims of creditors.3 The laws of some states, such as Nevada,4 exempt limited amounts of IRA assets from claims of creditors. Other states contain only small exemptions or no exemptions for IRA assets. This has prompted investors, professionals and others to ask if they can use family limited partnerships to protect their IRA assets. In the past, the answer has often been negative. Now, however, many investors will be in a position to use limited partnerships to gain a measure of asset protection for their IRA assets. Investors who use limited partnerships will also achieve other benefits, including reduction in income taxes upon distributions are made from the IRA.
How the Limited Partnership is Used with the IRA. To use the limited partnership with the IRA, the IRA owner forms a limited partnership. The IRA owner is the general partner, and contributes a nominal amount of assets to the partnership in order to obtain a one percent general partnership interest. The IRA contributes its assets to the limited partnership in exchange for a limited partnership interest. The limited partnership will most likely be an investment partnership, and will buy, hold and sell investment securities for a profit. As the general partner, the IRA owner has management control over the partnership and its assets.
Subsequently, the IRA distributes limited partnership interests to the IRA owner, at retirement or otherwise. The IRA owner takes advantage of available discounts for lack of
1 The author often recommends that estate planning clients contribute all of their investment assets to limited
partnerships, other than (i) S corporation stock; (ii) tax-deferred annuities; (iii) the personal residence; and (iv) so-called “dangerous assets,” such as automobiles, trucks, aircraft, boats, snowmobiles, motorcycles and recreational vehicles. When active businesses and real estate are transferred to limited partnerships, they should usually be held indirectly by the limited partnership, through single-member limited liability companies.
2 Reference to charging order provision added in 2001. 3 ERISA Section 106(d)(1).
control, minority interest and lack of marketability, thereby reducing income taxes on the distribution. The IRA owner recognizes taxable income in the amount of the discounted fair market value of the partnership interests distributed. The taxable income is less than the amount that would have been recognized if the assets of the partnership had themselves been distributed to the IRA owner.
The IRA owner receives all of the asset protection advantages associated with limited partnerships. The IRA owner also achieves all of the other benefits of limited partnerships, including reduction of estate taxes due to discounting, and simplification in estate administration. Legal Issues. In the past, several legal issues have affected the willingness of some estate planners to recommend limited partnerships for use in combination with IRA assets.
Definition of Partnership. Some have questioned whether a passive investment
partnership will be respected for tax purposes. Fortunately for investors, inside and outside IRAs, this question has been answered in the affirmative. For income and estate tax purposes, a partnership is defined as a syndicate, group, pool, joint venture or other unincorporated organization, through which any business, financial operation or venture is carried on.5 Most investment activities qualify as financial operations for this purpose. The IRS has now ruled that passive investment partnerships have a business purpose, and that they are valid for tax purposes.6
IRA Owners Can Use Limited Partnerships to Achieve Asset Protection Advantages.
Unlike qualified retirement plan assets, IRA assets are not protected from creditor claims by the federal pension law. Therefore, unless state law provides for an exemption, IRA assets are available to satisfy claims of creditors. However, depending upon state law, assets of limited partnerships may not be reached by a partner’s creditors. The partner’s creditor must instead obtain a “charging order,” which entitles the creditor to receive the distributions from the partnership that would otherwise be made to the partner. This is the case in Nevada, where the law now provides that the charging order is the exclusive remedy available to a partner’s creditor who wishes to satisfy a debt from the assets of the partnership.7 In practice, many creditors do not seek charging orders, because the creditor who holds a charging order is taxable on all of the partner’s distributive shares, whether or not distributions are actually made.8
In practice, this deters many creditors from attempting to obtain charging orders.
A limited partnership that is drafted for asset protection purposes will contain a number of provisions. Such a partnership will give to the general partners wide latitude and discretion in determining whether and when to make distributions to partners of partnership income or assets. Such a partnership will also provide that the general partners will remain in office for as long as they so choose, and will limit or foreclose entirely the ability of anyone other than the general partners to dissolve or liquidate the partnership. A limited partnership that is drafted for
5 I.R.C. (Internal Revenue Code) Section 7701(a)(2). 6
IRS Revenue Ruling (Rev. Rul.) 75-523, 1975-1 C.B. 257, Rev. Rul. 75-525, 1975-1 C.B. 350, IRS Pvt. Ltr. Rul. 9547004 (date).
7 Insert statutory reference to exclusive charging order provision. 8 Rev. Rul. 77-137, 1977-1 C.B. 178.
investment purposes will confer upon the general partners wide latitude to invest partnership assets and to determine the investments that are appropriate for partnership assets.
IRA Owners Can Use Limited Partnerships to Simplify Estate Administration. Another
reason for IRAs to invest in limited partnerships has to do with simplification in the administration and management of investment assets. Even where asset protection is unnecessary, this can be another reason for owners of substantial IRAs to invest in limited partnerships. Consider the situation faced by the surviving spouse and trustee in a community property state such as Nevada. The revocable living trust prepared for many married couples who reside in community property states commonly divides into three parts at the death of the first spouse. The first trust is often referred to as the survivor’s trust, and often consists of the surviving spouse’s half of the community property and all of the surviving spouse’s separate property. The second trust is a so-called “bypass” or “credit shelter” trust, and contains the amount of property that may be passed on without payment of estate taxes ($1,000,000 in 2002). The third trust often consists of the remaining portion of the deceased spouse’s separate property and the deceased spouse’s half of the community property. Some of these trusts may contain IRA assets. Depending upon the trust provisions, the surviving spouse may or may not be the trustee of one or more of these trusts.9
If there is no limited partnership, the surviving spouse and the trustee must divide the assets among the three trusts, and maintain separate accounting records for each trust. On the other hand, if there is a limited partnership, all that is necessary is that the limited partnership interests be divided among the three trusts. Consequently, instead of dealing with three trusts and an IRA, the surviving spouse need deal directly with only one partnership. Where the surviving spouse is not the trustee of one or more of the trusts, the surviving spouse who is a general partner can effectively manage all of the assets, without actually being trustee of one or more of the trusts.
Prohibited Transaction Issues. This is often cited as a reason for IRA assets not to be
invested in limited partnerships. However, upon further reflection, as long as the IRA owner avoids engaging in prohibited transactions, this need not prevent the IRA owner from enjoying the tax and nontax advantages of limited partnerships.
The tax law considers certain transactions to be “prohibited transactions.” The consequences of engaging in a prohibited transaction can be serious. An IRA that engages in a prohibited transaction with its owner loses its status as an IRA, resulting in immediate taxation.10 For this purpose, the owner of the IRA and the owner’s spouse, ancestors, lineal descendants and spouses of lineal descendants are considered to be “disqualified persons.” A partnership or other entity that is 50 percent or more owned by other disqualified persons is also a disqualified person.
Common prohibited transactions include direct or indirect (A) sales or exchanges, or leasing, of property between the IRA and a disqualified person; (B) lending of money or other
9 The author does not usually recommend that the surviving spouse be named the trustee of the so-called “bypass”
trust or “credit shelter” trust. A detailed discussion of the reasons for this opinion is beyond the scope of this article.
extension of credit between the IRA and a disqualified person; (C) furnishing of goods, services or facilities between the IRA and a disqualified person; (D) transfer to, or use by or fore the benefit of, a disqualified person of the IRA’s assets or income; (E) an act by a disqualified person who is a fiduciary that constitutes dealing with the IRA assets in his own interest or for his own account; and (F) receipt by a disqualified person of consideration for his own account by a person who is dealing with the IRA in a transaction involving the IRA’s assets or income.
The formation of the IRA has been held not to constitute a prohibited transaction. When the partnership is formed, the IRA technically contributes its assets to the partnership, and receives a 99 percent limited partnership interest. The courts, and now the IRS, have ruled that the initial capitalization of the partnership does not constitute a “sale or exchange” for purposes of the prohibited transaction rules. Only after the partnership has been formed will the partnership be a disqualified person, who is prevented from dealing with the IRA.11
The courts have also ruled that the IRA owner who acts as general partner does not enter into a prohibited transaction by managing the assets of the partnership.12 Therefore, ongoing management of the partnership’s assets by its owner, as general partner, does not result in a prohibited transaction. However, the IRA owner, as general partner of the partnership, must not be paid a salary for the owner’s services as general partner. The receipt of compensation by the IRA owner may well amount to a prohibited transaction.13
When the time comes for the IRA owner to take withdrawals from the IRA, whether at the “required beginning date” after reaching age 70½ or otherwise, the IRA owner and general partner may make distributions in kind without running afoul of the prohibited transaction rules. Since the IRA will own limited partnership interests, the IRA owner may withdraw limited partnership interests from the IRA. The partnership remains in place; the IRA owner makes the distribution by transferring limited partnership interests from the IRA to the owner. Such a distribution constitutes a receipt by the disqualified person from the IRA of benefits to which he would otherwise be entitled. The tax law permits this.14
Unrelated Business Taxable Income. The unrelated business taxable income rules are
also frequently cited as a reason for IRA owners not to benefit from establishing limited partnerships. IRAs are usually tax-exempt entities.15 However, like qualified pension plans, when IRAs have “unrelated business taxable income,” they are subject to income tax (at corporate rates) on their unrelated business taxable income in excess of a $1,000 exemption. Unrelated business taxable income is generally the income from a trade or business that is regularly carried on. Dividends and interest are specifically exempted, unless they are debt-financed.16 A partner’s share of partnership income retains its character when it passes through to the partner.17 Therefore, if the partnership has unrelated business taxable income, the IRA’s share of this income will be unrelated business taxable income. To avoid possible income
Swanson v. Commissioner, 106 T.C. 76 (1996).
12 Etter v. J. Pease Construction Co., 963 F.2d 1005 (7th Cir. 1992). 13 I.R.C. § 4975(c)(1)(F). 14 I.R.C. § 4975(d)(9). 15 I.R.C. § 501(a). 16 I.R.C. §514(a). 17 Treas. Reg. § 1.512(c)-1.
taxation, a limited partnership that includes an IRA should operate solely as a passive investment entity, and should avoid debt financing.
Conclusion. IRA owners may achieve significant benefits, in asset protection and trust administration if they use limited partnerships to hold their investments. In addition, IRA owners who plan to make withdrawals from their IRAs, or who are required to do so by the prohibited transaction rules, may well achieve significant income tax benefits by using limited partnerships with their IRAs. The greatest benefits from this strategy will be achieved by IRA owners who have substantial IRA assets, and who live in states that do not exempt IRA assets from creditors, or that have only partial exemptions for IRA assets.