IRA Distribution Was Not a Transfer Incident to Divorce Kirkpatrick, TCM 2018-20
In Kirkpatrick,1 the Tax Court held that a distribution from an IRA did not qualify for the exclusion from gross income on account of being a transfer incident to divorce because the distribution did not go directly from the taxpayer to his wife.
Mr. Kirkpatrick was ordered by a court in his divorce proceeding to transfer to Ms. Kirkpatrick “the sum of $100,000 directly (and in a non-taxable transaction) into an IRA appropriately titled in Ms. Kirkpatrick’s name within fourteen (14) days of the entry of this Order.” Mr. Kirkpatrick did not transfer any money into an IRA titled in Ms. Kirkpatrick’s name at any time after the order was entered. However, Mr. Kirkpatrick did make payments directly to Ms. Kirkpatrick by withdrawing funds from his IRA, depositing those disbursements into his checking account, and then writing checks to Ms. Kirkpatrick.
After those distributions, Mr. Kirkpatrick received an IRS Form 1099-R (Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.) from the IRA custodian. On his federal income tax return, Mr. Kirkpatrick reported the distribution as nontaxable. On audit, the IRS issued a notice of deficiency finding that the IRA distribution was taxable.
The sole issue for consideration by the Tax Court was whether the distribution from the IRA distribution that Mr. Kirkpatrick received was taxable income under Section 408(d)(1) or a nontaxable transfer of an account incident to divorce under Section 408(d)(6) .
Section 408(d)(1) provides that any amount distributed from an IRA is included in gross income for the tax year in which the distribution is received. However, Section 408(d)(6) sets forth an exception by providing that the transfer of an individual’s interest in an IRA to his or her spouse or former spouse under a divorce or separation instrument is not considered a taxable transfer made by such individual. Thus, two requirements are mandated by Section 408(d)(6) :
(1) There must be a transfer of the IRA participant’s “interest” in the IRA to his spouse or former spouse.
(2) The transfer must have been made under a divorce or separation instrument.
Mr. Kirkpatrick argued that the distribution qualified under Section 408(d)(6) as a transfer of an account incident to divorce and the fact that the funds passed through his checking account on the way from him to Ms. Kirkpatrick’s IRA should have no bearing on the taxability of the distribution. On the other hand, the IRS argued that the distribution from the IRA did not satisfy the requirements of Section 408(d)(6) because Mr. Kirkpatrick did not transfer any interest in his IRA to Ms. Kirkpatrick, no IRA was opened in her name; and there was no transfer of funds from Mr. Kirkpatrick’s IRA to any IRA owned by Ms. Kirkpatrick.
In addition, the IRS argued that Mr. Kirkpatrick did not comply with the order’s terms: The order required Mr. Kirkpatrick to transfer in a nontaxable transaction $100,000 into an IRA titled in Ms. Kirkpatrick’s name within 14 days of the order’s entry, which he failed to do. Thus, the IRS asserted, the transfer should not be considered as made under a divorce or separation instrument or written instrument incident to such as required by Section 408(d)(6) .
The court held in favor of the IRS, finding that the distribution from the IRA did not qualify for the exclusion from gross income provided by Section 408(d)(6) . The court observed that two commonly used methods of transferring an interest in an IRA are to (1) change the name on the IRA to that of the nonparticipant spouse or (2) direct the IRA’s trustee to transfer the IRA assets to the trustee of an IRA owned by the nonparticipant spouse. The court cited Bunney, 2 in which the Tax Court rejected the contention that taking a distribution from an IRA and then making a payment to one’s spouse qualifies as a transfer of an interest in that IRA. The court also referred to Jones, 3 in which the Tax Court held that the Section 408(d)(6) exception is limited and that “interest” is not synonymous with the money or other assets held in an IRA, and that the withdrawal of funds from an IRA extinguishes the owner’s interest in that IRA.
In holding for the IRS, that court found that the words of the relevant statute are specific and state: “interest in an individual retirement account” rather than “assets from an individual retirement account,” or more broadly, “interest in or assets from an individual retirement account.” Therefore, the court concluded that taking distributions from an IRA and writing a check to one’s spouse is not the appropriate form for a tax-free transfer of an account incident to divorce under Section 408(d)(6) .
While it is possible to transfer some or all of the funds in an IRA tax free to the soon-to-be ex-spouse pursuant to a divorce, specific rules need to be followed. Mr. Kirkpatrick, by failing to adhere to these rules, made a very costly mistake. Mr. Kirkpatrick could have avoided this result by consulting a knowledgeable tax advisor. This case also illustrates the importance of advisors being fully knowledgeable of the rules before providing advice to clients, as the Tax Court in this case rejected the implicit argument of the taxpayer that “close enough” was “good enough.”
2 114 TC 259 (2000).
3 TCM 2000-219 .
Frank Baldino is an estates and trusts attorney who helps people throughout the greater Washington, DC area protect assets for their families and future generations through careful estate tax planning. For more information, contact Frank at 301-657-0175 or [email protected].