ED SLOTT’S IRA ADVISOR © 2016 Ed Slott's IRA Advisor, Inc.

August 2016

Tax & Estate Planning For Your Retirement Savings

Community Property and Retirement Plans My IRA is Not Always Your IRA What do you get when the They will contribute to bank accounts, community property rules mix with make investments and buy real estate, the retirement plan rules? Well, as one cars, etc. And in many situations, widow discovered, the two sets of rules contributions will be made to retirement don’t always play nicely together. In a plans. When the marriage ends either by surprising recent private letter ruling death or divorce, it must be determined (PLR 201623001), the IRS said no to a who gets the property, including the surviving spouse who wanted to roll over retirement accounts. State property laws her deceased spouse’s IRA, even though provide much of the guidance in this a state court awarded her a community area. property interest in the IRA. This PLR Community Property States is a reminder that understanding the key concepts about how state community property and retirement plan rules Generally, there are two systems interact is essential for advisors to ensure of state property law. Most states use the common law system. the best outcome for clients ...understanding This system has been facing these complicated adopted by 41 states. The issues. the key concepts community property system about how state Retirement Plans and community property has been adopted by nine Other “Stuff” states: Arizona, California, and retirement plan Idaho, Louisiana, New rules interact is A wedding is the beginning Mexico, Nevada, Texas, essential... of the story for understanding Washington and Wisconsin. community property. When Alaska has adopted an a couple says “I do,” they often receive optional community property system. wedding gifts to celebrate the occasion The U.S. Territory of Puerto Rico is and so begins an accumulation of “stuff,” also a community property jurisdiction. or to use a more formal term “property.” Approximately 30% of Americans live in This will continue during their marriage. community property states. Are advisors

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Community Property and Retirement Plans My IRA is Not Always Your IRA

• Retirement Plans and Other “Stuff” • Community Property States • Determining Whether Community Property Rules Apply • How Community Property Works • When Do the Rules Collide? • Naming IRA Beneficiaries Proceed with Caution! • ERISA Trumps Community Property • QDROs and Community Property Interests in Plans • IRAs and Community Property • State Court Order Cannot be Accomplished Under Federal Tax Law • Advisor Action Plan - Pages 1-5

Dude, Where’s My IRA? Late 60-Day Rollover Allowed After IRA Escheatment

• Facts of the PLR • Understanding Escheatment • Advisor Action Plan - Pages 5-6

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in other states off the hook when it comes to community property? Not so fast! Clients are increasingly mobile and move to and from community property states. Some common law states, such as Florida, have a statute that addresses community property for residents who have moved there from a community property state. As such, nearly all advisors must have at least a basic understanding of the community property rules.

Determining Whether Community Property Rules Apply For community property rules to apply, a client must have two things; a valid marriage and a domicile in a community property state. The words "residence" and "domicile" do not mean the same thing. A person may have several places of residence, but only one domicile. Domicile is based on where the person intends their permanent home to be. For example, a client who is on a temporary work assignment that takes him from New Jersey to Arizona for a few months would most likely not be considered domiciled in Arizona. However, the same would generally not be true for clients who retire and move to Arizona with the intention of living out their golden years.

How Community Property Works

value before marriage. If the couple divorces, his wife could only receive the difference in value that occurred during the marriage. Chances are this wedding date was not an accident! It’s important to keep in mind that community property is like ice cream. It comes in many different flavors and each state will have its own unique flavor. California community property law is not the same as Arizona community property law. When an advisor spots a potentially complex community property issue, it is best to seek the advice of an attorney who is knowledgeable about all the quirks of community property law in that state.

When Do the Rules Collide? When are community property issues likely to come up with retirement plans? When should advisors be on the look-out for potential issues? Well, generally, there are two significant times when community property rules will mix with retirement plan rules. For clients in community property states, when it comes to determining who gets the retirement plan at death or after a divorce, community property rules will come into play.

Naming IRA Beneficiaries - Proceed with Caution!

In common law states, each spouse is a separate Since community property law can dictate who gets individual with separate legal and property rights. In an IRA after death, it must be taken into account when community property states, the underlying theory is a client names a beneficiary on an IRA. In a community very different. Community property is everything a property state, state law may recognize a spouse as the husband and wife own together. In general, this includes beneficiary of some or all of the IRA. Therefore, IRA all money earned and property acquired during the owners may need to get a spouse’s written marriage. However, certain exceptions, consent to name someone else as the such as inheritances received during the Assets held in a beneficiary of their IRA. marriage and kept in separate accounts, may company plan or in an apply. In community property states, each spouse typically shares equally in profits IRA will be community Some IRA custodians have beneficiary and income. In essence, each spouse owns property to the extent designation forms with language for spousal a half interest in all community property, that contributions were consent to name a non-spouse beneficiary. Others do not. Even if a beneficiary regardless of which spouse actually acquired made to the account designation form does include spousal the community property. and earnings accrue waiver language, some experts caution How do retirement plans fit in? Assets during the marriage. against relying on it. To be sure that all goes as planned, the safest approach is for each held in a company plan or in an IRA will spouse to have their own separate counsel and for an be community property to the extent that contributions experienced attorney to draft the necessary documents. were made to the account and earnings accrue during the marriage. Clients with no connection to a community property state can name whoever or whatever they want as their Usually, property acquired by gift or inheritance is IRA beneficiary. No written spousal consent is necessary. not considered community property and property owned What about company plans? It depends on whether the before the marriage generally remains separate property. plan is covered under ERISA’s spousal rules. In general, For example, consider the timing of Facebook founder ERISA-covered plans require that a spouse be the Mark Zuckerberg’s wedding. He lives in California and participant’s beneficiary unless that spouse has waived he married his college sweetheart. The pair said “I do” their rights to the plan assets. In contrast, this ERISA a day after Facebook went public. By marrying after the requirement meant to protect spouses does not apply to initial public offering, Zuckerberg protects his Facebook non-ERISA-covered plans or to IRAs. assets in the event of a divorce, since they achieved their 2

ED SLOTT’S IRA ADVISOR • August 2016

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Community Property and Retirement Plans My IRA is Not Always Your IRA

Summary of Key Points The community property system has been adopted by nine states: Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, Washington and Wisconsin. Alaska has adopted an optional community property system. Community property is everything a husband and wife own together. In general, this includes all money earned and property acquired during the marriage. For community property rules to apply, a client must have two things; a valid marriage and a domicile in a community property state. Community property rules can determine who gets a retirement plan at death or after a divorce, Clients should get a spouse’s written consent when naming someone else as the beneficiary of their IRA when community property rules apply. The U.S. Supreme Court ruled in the Boggs case that when there are conflicting claims, ERISA trumps community property law. When a spouse has been determined to have a community property interest in the company plan benefits of the other spouse, a qualified domestic relations order (QDRO) is necessary to direct the payment of those benefits after a divorce. A QDRO is not necessary when there is a community property claim to an IRA in a divorce. Instead, a court order for a transfer incident to the divorce is needed. The Tax Court ruled in the Bunney case that even though spouses are equal owners of an IRA under community property law, the IRA owner pays the tax on a distribution he gives to an ex-spouse. In PLR 201623001, the IRS ruled that a surviving spouse could not roll over her deceased spouse’s IRA, even though a state court awarded her a community property interest, because the state court order could not be accomplished under federal tax law.

ERISA Trumps Community Property Sometimes there are conflicting claims as to who gets company plan funds. What happens when state community property rules conflict with the retirement plan rules? In the landmark case of Boggs v. Boggs, 520 U.S. 833 (1997), the U.S. Supreme Court ruled that when there are conflicts, ERISA trumps community property law. The Boggs case involved a dispute over Isaac Boggs’ plan benefits. After his death, his second wife faced off with his children from his first marriage. The children argued that they had received an interest in the plan benefits through their mother’s will because she had a community property interest in the plan under state law. The Court said “sorry, but no,” and in a 5-4 decision held that the children’s rights derived from community property law were trumped by the second spouse’s protection under ERISA. The Boggs case has been cited as precedent by many other courts. To Order Call: (800) 663-1340

QDROs and Community Property Interests in Plans What happens to community property in a company plan when there is a divorce? Well, once a spouse has been determined to have a community property interest in the company plan benefits of the other spouse due to the divorce, a qualified domestic relations order (QDRO) must be obtained to direct the holder of the retirement plan to retitle the plan account to the ex-spouse. This is because a QDRO is an exception to ERISA’s requirement that plan assets cannot be assigned or alienated during the participant’s lifetime. Community property concerns make the already complex QDRO process even more complicated. Advisors will want to be sure that clients find knowledgeable legal counsel. In contrast, IRAs are not governed by ERISA, and a QDRO is not necessary to divide community property in an IRA in a divorce. ED SLOTT’S IRA ADVISOR • August 2016

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IRAs and Community Property What about IRAs? Well, they come with their own set of issues when it comes to community property. Community property rules may determine who is entitled to the IRA after divorce or death. However, for federal tax purposes, the IRS has said that IRAs are deemed to be separate property. Therefore, taxable IRA distributions are separate property, even if the funds in the account would otherwise be community property. These distributions are taxable to the spouse whose name is on the IRA. That spouse is also liable for any penalties and additional taxes on the distributions. In the seminal case of Bunney v. Commissioner; 114 T.C. No. 17; No. 20713-97, (April 10, 2000), the Tax Court held that even though spouses are equal owners under community property law, the IRA owner pays the tax on a distribution he gives to an ex-spouse. In this case, Michael Bunney and his wife divorced. He withdrew funds from his IRA and then gave the funds to his former wife as payment for her interest in their home. Mr. Bunney claimed that under community property law half of the IRA already belonged to his former wife from the time it was created. Therefore, the distribution was not taxable to him since it already belonged to her. The Court disagreed and handed Mr. Bunney the tax bill because the distribution came from his IRA. IRS

she and Tim owned. She then negotiated a settlement with Tim’s estate under which her community property interest in the estate was valued at an agreed upon amount (let’s say $500,000). A state court approved the settlement and ordered that the IRA custodian assign $500,000 of Jake's inherited IRAs to Denise as a spousal rollover IRA. After her success in state court, Denise requested a PLR. She asked the IRS for a favorable ruling on four issues. Here is the wish list that she brought to the IRS. 1) $500,000 from the inherited IRAs for Jake would be classified as Denise's community property interest; then 2) Denise would be treated as a payee of the inherited IRAs; then 3) The IRA custodian can distribute the agreed upon amount to Denise; then 4) Denise can do a spousal rollover, which would not be a taxable event. The IRS declined Denise's requests. Bottom line, the IRS said “the order of the state court cannot be accomplished under federal tax law.”

said “the order of the state court cannot be accomplished under federal tax law.”

Clients facing a community property claim to their IRA in a divorce will want to avoid Mr. Bunney’s fate. A court order for a transfer incident to the divorce, often found in the marital separation agreement, will be needed. The funds will move directly from one spouse’s IRA to the other spouse’s IRA. By doing a trustee-to trustee transfer, the amounts awarded as a community property interest in a divorce can be moved from one spouse’s IRA to the other spouse’s IRA without negative tax consequences.

State Court Order Cannot be Accomplished Under Federal Tax Law PLR 201623001 Released June 3, 2016 While the Bunney case dealt with community property and IRAs during divorce, in the recently released PLR 201623001, the IRS addressed community property in an IRA after the death of the IRA owner. The story began with a couple (let’s call them Tim and Denise) who were married and lived in a community property state. They had a son, (let’s call him Jake). Tim named Jake as the sole beneficiary of his three IRAs. When Tim died, a couple of things happened. First, the IRA custodian retitled the IRAs as inherited IRAs for Jake. In addition, Denise filed a claim against Tim’s estate for her one-half interest in the community property that 4

ED SLOTT’S IRA ADVISOR • August 2016

The IRS declined to issue a ruling on Denise’s first request, which was whether $500,000 of the inherited IRAs is classified as Denise's community property interest. The IRS declined because that issue is “a matter of state property law and not a matter of federal tax law.”

Then why did the IRS deny Denise’s second, third, and fourth requests? The IRS said that because Jake was the named beneficiary of Tim’s IRAs, the IRAs became inherited IRAs for Jake. Denise was not the named beneficiary. Since community property interests are disregarded under federal tax law, Denise cannot be treated as a payee of the inherited IRAs and may not roll over any amounts. Additionally, since Jake was the named beneficiary of the IRAs and because Denise's community property interest is disregarded, any “assignment” of an interest in the inherited IRAs to Denise would be treated as a taxable distribution... to Jake. Ouch! From the PLR “Section 408(g) provides that section 408 shall be applied without regard to any community property laws, and, therefore, section 408(d)'s distribution rules must be applied without regard to any community property laws.” Advisors should take note of this PLR. While it is only binding on the taxpayer who requested it and the IRS has not issued numerous similar PLRs, it is a cautionary tale about what can happen when the community property To Order Call: (800) 663-1340

and retirement account rules mix. For this widow, all seemed to be proceeding according to plan in the state court. However, that was only half the battle and things fell apart when the matter came before the IRS. While the IRS has often been generous to surviving spouses in PLRs, allowing spousal rollovers even when a trust or an estate was the named beneficiary on an IRA, that was not the case here with a spouse who had a community property interest. Instead, the IRS said that the state court order could not be accomplished under federal tax law.

Advisor Action Plan • Ask clients where they have lived in the past and where they plan to live in the future to identify community property concerns that may impact their retirement plans. Don’t assume because clients currently reside in a common law state that any community property concerns are off the table.

• Address potential community property issues with a client when completing the IRA beneficiary designation form. Suggest to clients that they consult separate counsel before waiving any community property interests in a retirement account. • Remember that the U.S. Supreme Court has said that ERISA preempts community property law when there is a conflict. • Handle dividing community property interests in a divorce with care. Be sure the client’s attorney is aware of the special rules for retirement accounts. Use a QDRO for plan assets and a trustee-to-trustee transfer pursuant to a court order for an IRA to avoid adverse tax consequences. • Watch out for federal tax issues with IRAs and community property interests. A state court order awarding a client a community property interest in an IRA may not be effective for federal tax purposes. While the property may be theirs, there may also be a tax bill.

Dude, Where’s My IRA? Late 60-Day Rollover Allowed After IRA Escheatment PLR 201611028 Released March 11, 2016 In a recent private letter ruling, the IRS allowed a taxpayer to complete a late 60-day rollover after his IRA was escheated by his State. Ultimately, the taxpayer was able to recover his IRA from the State and avoid taxation on his distribution, but not without first wasting a great deal of time and money.

Facts of the PLR “Peter” had two IRA accounts, IRA A and IRA B. For some reason, Peter stopped receiving statements for IRA B, so from time to time, he would go to the bank holding the account and find out what the prior year-end balance was for required minimum distribution (RMD) purposes. He would then take his cumulative IRA RMD from IRA A only. Apparently, not getting any statements with respect to his IRA was OK with Peter, as this seems to have gone on for several years.

he had a fully taxable distribution. To rectify these issues, Peter “immediately began to reclaim the funds from [his State].” On February 12, 2015, Peter received a check for the amount the State had taken, plus interest, thus fixing part of the problem. To resolve the outstanding tax issue, he then submitted a PLR request to the IRS asking them to allow him to return the funds to his IRA via a late 60day rollover. The IRS granted Peter’s request, based on the fact that he had been unaware of the IRA distribution. From the PLR “The information presented and documentation submitted by Taxpayer A is consistent with his assertion that his failure to accomplish a timely rollover of Amount 1 was due to him being unaware of the escheat distribution to State E.”

Understanding Escheatment

On August 7, 2013 Peter’s bank escheated IRA B to Peter’s State, withholding a portion of the distribution for federal income tax purposes. In late 2014 – most likely over a year after IRA B had been escheated – Peter went to his bank to get his prior year-end balance for RMD purposes. It was only then did he learn that his IRA no longer existed and was now State property.

Escheatment ain’t what it used to be! The legal theory of escheatment dates all the way back to feudal England where land that was held by a person with no heirs or by someone committing a felony could revert back to the King. Over time, common law evolved and escheatment became the right of a government to claim abandoned and/or unclaimed property. You might think of this as a government-run financial asset lost and found.

Naturally, Peter was none too pleased with this series of events. Not only had his IRA been taken from him, but

Unfortunately, in recent years, many states have turned escheatment from a process intended to make sure

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abandoned and unclaimed property does not lay stagnant forever, to a process intended make up for budget gaps and shortfalls. To that end, many states have changed the laws governing their escheatment process to make it easier to classify funds as abandoned. This has been done in a variety of ways by states, including:

keep an account from being considered inactive in some cases. For clients’ accounts that are on “autopilot” for one reason or another, this might be a good item for advisors to add to the annual review. If an account has not been accessed during the past year, do a cursory log-in of the account to protect it from being considered abandoned.

• Changing the definition of abandoned – For years, the typical definition of “abandoned” centered on whether mail sent to an account holder’s address of record was returned as undeliverable by the post office. However, many money-hungry states have changed this definition to be entirely, or in some cases, potentially, driven by “inactivity.” But what constitutes inactivity? That is something that must be addressed on a case-by-case basis, but in some cases even accounts set up to automatically reinvest dividends or have those dividends sent directly to a bank account may be deemed “inactive” if other actions are not taken within a specified period of time.

In the event that property is escheated, a state will often liquidate the property and turn it into state funds. However, if a client has a valid claim to the property, there is generally a procedure they may follow to have their escheated funds returned.

• Reducing the period of time an account must be inactive for it to be considered abandoned – Historically, most states had laws that called for property to be considered abandoned after a period of five years or more. However, over the last decade or so, states have, en masse, been reducing that length of time. In many states, the threshold for abandonment is now down to just three years. In reality, preventing escheatment should not take too much effort on the part of a client, especially if they are working with an advisor. A simple log-in to a password protected website or a vote of proxies may be enough to

Advisor Action Plan • Know your state law and regulations. Make sure you understand state law regarding the definition of abandoned property and the steps for clients to follow should they need to reclaim escheated property. • It’s generally best to make sure clients are receiving statements of some kind every now and then. If they’re not, work with them to find out why. • Make sure that clients are accessing their accounts or otherwise taking actions that would deem their accounts “active” in order to avoid potential escheatment. • Let clients and prospects know about escheatment. No one wants to have their property confiscated by the government, but few people are aware of the relatively liberal definitions of abandonment used by many states. This is a great talking point at seminars, workshops, etc.

Mistake in an IRA? Who Pays the Taxes? There are many ways to make a mistake in an IRA. Some of the most common mistakes are not made by IRA owners, but are made by IRA custodians or advisers. For example, an IRA distribution or transfer gets put into a non-IRA account or a Roth IRA. A client is told that the company offering a “great” investment could hold it as an IRA. A client is told that they could rollover more than one IRA distribution in a year. An IRA beneficiary is told that they can do a 60-day rollover of inherited IRA funds. These mistakes and many others are all too common. IRAs are surrounded by many rules governing what can and cannot be done with those funds. And, by the way, these rules for the most part come from Congress. IRS is responsible only for the procedures to enforce those rules. All too often, advisors and employees of the IRA custodians are giving misinformation to the unwary IRA account owner.

is just plain wrong? Usually there is some sort of penalty. The penalties are set by Congress and are paid by the IRA owner, even if an advisor steals money from an IRA. Why are those penalties owed by the innocent IRA owner? Because the “I” in IRA stands for “individual.” The tax code is structured so that the IRA owner is totally, 100%, responsible for the correct operation of their IRA. All distributions from an IRA must be made using the Social Security number of the IRA owner, thus any taxes, penalties or interest are owed by, you guessed it, the IRA owner.

Penalties for retirement plans include:

• A 6% additional tax (penalty) on excess contributions (amounts not eligible to be in an IRA or Roth IRA)

IRA Penalties

• A 10% additional tax on distributions made before age 59½ when an exception to the penalty does not apply

What happens when someone other than the IRA owner makes a mistake with the IRA or gives advice that

• A 50% additional tax on required minimum distributions (RMDs) that are not taken

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ED SLOTT’S IRA ADVISOR • August 2016

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• A complete distribution of an IRA as a result of a prohibited transaction and the subsequent ordinary income tax due on the distribution.

Reporting IRA Penalties Penalties are reported on IRS Form 5329 which is filed with the individual’s tax return for the year the penalty is due. The form is considered a standalone return because it has a signature line. It can be filed on its own if it is being filed for prior years. When Form 5329 is not filed, as is what happens when an individual is not aware of an error that creates a penalty, the statute of limitations does not start to run on the penalty. When the problem finally surfaces, which can be many years after the fact, the penalty is owed by the IRA owner.

excess contribution penalty is due for each year that the excess amount remains in the account.

Beneficiary Form Issues There is another type of common mistake with IRAs – the wrong beneficiary on the beneficiary form. While this mistake does not include penalties, per se, it does force larger amounts out of the inherited IRA each year, thus increasing the amount of taxes due each year and reducing the life of the IRA and the amount of time for tax deferred compounding of gains in the IRA. Let’s look at an example of this type of mistake. In a recent set of three private letter ruling requests (PLRs 201628004, 201628005, 201628006), the beneficiaries lost the ability to stretch their inherited IRAs over their own life expectancies and ended up with a much shorter distribution period. All because of a simple error on the beneficiary form.

IRS can also assess failure to file penalties and/ or accuracy related penalties, and interest on some or all of those items, against the The tax code is IRA owner. IRS often uses these additional penalties when the IRA owner has engaged in structured so that the IRA owner is a flagrant abuse of the IRA or Roth IRA rules. The penalty amounts can quickly add up to totally, 100%, large sums of money when the transaction in responsible for the question happened several years ago.

correct operation of

“Steve” decided to transfer his IRAs to a new custodian. In error, his financial advisors gave Steve a new beneficiary designation form to sign that named his estate as the sole beneficiary of his new IRA instead of his three trusts. Steve just went ahead and signed that form.

IRS does not have the authority to waive At Steve’s death, the error was their IRA. most of these penalties. The one exception is discovered. After a state court reformed the the 50% penalty for not taking an RMD. IRS can waive beneficiary form, three PLRs were requested from the this penalty for good cause but individuals have to ask IRS asking the IRS to allow distributions to be paid from them to waive it. the IRA to the three trusts over the life expectancy of the beneficiary of each of the trusts. The IRS denied the Correction Procedures requests and said that the inherited IRA must be paid out over Steve’s remaining life expectancy because there was Some mistakes can be, or in some cases must be, no designated beneficiary on the IRA. corrected. But it may not be as easy and straightforward The result is a highly accelerated payout to Steve's as simply undoing the transaction. Many times there is beneficiaries over, at best, 15 years. Steve was over 70½ at a process that must be followed to undo the error. For the time the trusts were named on his beneficiary form. example, a common error is doing a Roth conversion before taking the RMD for the year. The RMD is not Advisor Action Plan eligible to be converted to a Roth IRA. This mistake cannot be fixed by simply removing the RMD amount which is now an excess contribution in the Roth IRA. That only makes the situation worse. You still have an excess contribution and have now taken an unnecessary distribution because there are rules for correcting an excess contribution. These rules set October 15th of the year after the year of the excess contribution as the date for removing the excess. There is also a net income calculation that must be done and the excess amount, plus/minus the gains/losses, is what is distributed from the IRA. The 1099-R shows a return of an excess contribution. And, just to make things more fun, there is a different set of rules if you are removing the excess amount after the October 15th deadline. And, the 6% To Order Call: (800) 663-1340

• Be sure clients fully understand the investments that are recommended for their IRA. • Follow-up on all transfers or deposits of funds to IRA accounts to ensure that they are timely made to the correct account. • Warn clients about engaging in self-dealing with their IRA.

• Check beneficiary forms.

• Educate clients on the basic rules of IRAs – IRS Publications 590 A and B are a good place to start. ED SLOTT’S IRA ADVISOR • August 2016

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ED SLOTT’S IRA Advisor Contributing Writers Beverly DeVeny Jeffrey Levine Sarah Brenner Disclaimer and Warning to Readers: Ed Slott’s IRA Advisor has been carefully researched to provide accurate and current data to financial advisors, taxpayers, and others who seek and use the information contained in this newsletter. Readers are cautioned, however, that this newsletter is not intended to provide tax, legal, accounting, financial, or professional advice. If such services are required, then readers are advised to seek the aid of competent professional advisors. This news­ letter contains timely information about complicated tax topics that may eventually be changed, outdated, or rendered incorrect by new legislation or official rulings. The editor, authors, and publisher shall not have liability or responsibility to any person or entity with respect to any loss or damage caused or alleged to be caused, directly or indirectly, by the information contained in this newsletter.

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