Trustee's 1041 for the bankruptcy estate

[Vandervecken]

Good evening! This topic requires a bit of setup. I doubt many people ever see this, but it may be one of the rare ways to get a "win-win" for both me as debtor and for the trustee. I just want to ask and see if any of our legal gurus can poke a hole in my research.

Background: when a chapter 7 case is an asset case, the trustee has to file a form 1041 to the IRS for any income to the estate. According to IRS website, any items transferred from the debtor to the estate does not cause the debtor to owe the taxes. The estate pays the taxes, and pays on the "married filing separately" rate table.

In the past, I've posted some threads about a rental house I own next door to my own. I knew there was equity in it, and I was planning to use a small IRA to redeem the equity. I have a lot of reasons to keep the house, so giving up this IRA is in my best long-term interest.

I've been projecting my taxes for 2017. If I cash out the IRA and write a check to the trustee, then I have to pay taxes on the IRA, including the 10% penalty (I'm under 59 years old.) And worse, the added IRA income jumps the tax bracket on my regular earnings by 3%. So I have to withhold more all year. (By coincidence, the IRA balance less taxes comes very close to the equity I have to redeem.)

For round numbers: assume the IRA has $50,000. If I cash it in:
Balance: $50,000
Taxes (28%): 14,000
Penalty: 5,000

Total to trustee: $31,000

On the other hand... what if I simply surrender the IRA to the trustee directly? The estate pays taxes on it, and at a lower rate, meaning there's more for the unsecured creditors. And in my case, my regular earnings stay at the lower 25% tax bracket as well.

Balance: $50,000
Taxes (25%): 12,500
Penalty: 5,000

Total to trustee: $32,500

Either way, the IRA is lost to me. If this works, both the trustee and I will both be able to come out ahead.

Is there a flaw in my assumptions or research? Trying to google this has been a nightmare, since 99% of the websites talk about how to avoid giving IRA money to a trustee!

Thanks, everybody!

[leonel9]

Maybe I'm missing something here ... how would an IRA distribution NOT be considered income to you personally?

Wouldn't the sequence of events be:
1) Distribution counted as income, and a taxable event to you
2) Funds transferred from you to the trustee/bankruptcy estate
3) Estate files its own return (i.e. 1041)

Since your IRA isn't already a part of the bankruptcy estate, wouldn't an IRA distribution flow to you first? I have zero experience with this, and am not an attorney or CPA, but that is the hole I would punch. Stated differently, how would your personal taxes on the distribution be calculated if the income received was not also your personal income?

[leonel9]

I'm wondering if the IRS guidelines you read refer to the transfer from you to the estate, versus the initial distribution (e.g. no gift tax on transfers to the estate).

[Vandervecken]

Leonel9, your steps above are the first way I thought of it. I would cash out the IRA, pay the tax then write a check to the trustee.

But my understanding is that all my assets are in the estate but retirement accounts may be exempted. Remember that on Schedule B, we have to quote the law that allows the exemption. So my thought was: what if I propose to the trustee that I trade assets with him? Yes, the asset I'm trading happens to be a retirement account, but is it forbidden? I have no clue if this is even legal.

Just a wild thought maybe.

[Vandervecken]

Along those lines, the exemption for a traditional IRA is $1.2 million (approximately.) There has to be rules and procedures for IRAs that exceed this amount.

[despritfreya]

Trustee's job is to maximize the recovery to the creditors. It is unlikely that a Trustee will agree to such an exchange if that exchange will needlessly increase the cost of the administration of the estate thus dilute the funds available to the creditors to which he holds a fiduciary duty to.

You are settling with the Trustee. The Trustee does not care how you get the funds - he just cares that you pay him the settlement amount.

Des.

[leonel9]

The more I think about this, it seems like this would be only feasible one of two ways:

1. The entire IRA account is re-titled to be owned by the estate vs. you. Distribution is made to the estate and the estate files taxes on its own behalf. I find this unlikely, as it is already exempt, and seems like a ton of paperwork (if at all possible).
2. If you truly can avoid an increase of reported income for a distribution transferred to the trustee, the more likely scenario would be that you process a distribution and handle the tax implications when you file your taxes. In that case it's a question for an accountant, I believe.

By the way, could you link/quote the section of the tax code that you believe applies to this situation?

[Vandervecken]

Des and Leonel9, thanks for your replies! I think you're both right, easiest is for me to just cash it myself and pay the taxes. I was having an "attack of the clevers" and causing more work for myself to save a few hundred bucks .