Erroneous Rollover of IRA to Widow Increased Her Tax
In Ozimkoski v. Commissioner, TC Memo 2016-228, the trustee of a deceased husband’s IRA incorrectly rolled over the account balance to the decedent’s widow’s IRA. The widow then made distributions from her IRA, and the court held that those distributions were subject to both regular income tax and the Section 72(t) penalty tax on early IRA distributions because she had not yet attained the age of 59½.
Thomas Ozimkoski, Sr. (Senior) died in August 2006, domiciled in the State of Florida, survived by his wife, Suzanne Ozimkoski. He had a simple two-page last will and testament that left all of his property, with the exception of some tangible personal property, to his wife and named her as personal representative of his estate. At the time of his death, Senior owned a traditional IRA with Wachovia Securities. During the probate proceeding of Senior’s estate, one of his sons, Thomas Ozimkoski, Jr. (Junior), who was Suzanne’s step-son, filed petitions with the probate court seeking the revocation of Senior’s will and for declaratory relief. Wachovia froze Senior’s IRA pending the outcome of the probate litigation.
In March 2008, Suzanne and Junior reach a settlement agreement through mediation pursuant to which they agreed that Suzanne would pay Junior $110,000 and that she would transfer to Junior title to a 1967 Harley Davidson motorcycle in full and final settlement of all claims. The settlement agreement provided that payment would be made within 30 days of Wachovia unfreezing the IRA.
In July 2008, Wachovia transferred approximately $236,000 from the IRA to Suzanne’s IRA which was also at Wachovia. In 2008 Suzanne withdrew approximately $175,000 from the IRA. In 2009, Wachovia issued to Suzanne a Form 1099-R, Distribution From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., with respect to the distributions from the IRA during 2008. The distribution code on the Form 1099-R represented that the distributions were early distributions because Suzanne had not yet attained the age of 59½ in 2008.
On Suzanne’s 2008 Form 1040, U.S. Individual Income Tax Return, she did not report any of the IRA distributions as income. In November 2010, the IRS issued a notice of deficiency to her for 2008, determining an income tax deficiency of $62,185, which included a Section 72(t) additional tax of $17,460 for an early withdrawal from a retirement account, as well as penalties.
Suzanne timely filed a petition with the Tax Court challenging the notice of deficiency. Suzanne argued that the distributions should not be included in her income because Junior was entitled to $110,000 of Senior’s IRA through the probate litigation and the ensuing settlement agreement. The IRS argued that the distributions were taxable to Suzanne because they were from her own IRA.
The court noted that under Florida law, there appeared to be only two scenarios in which Wachovia could properly freeze Senior’s IRA during the pendency of the probate litigation: (1) his estate was the named beneficiary of the IRA, or (2) there was no named beneficiary of the IRA. In contrast, if there had been a named beneficiary for his IRA, the funds would have been paid to the trustee of the account and then distributed according to the terms of the IRA. If no proper claim was made on the IRA proceeds within six months of Senior’s death, the proceeds would have been paid to his personal representative.
Under either scenario Wachovia incorrectly rolled over the entirety of Senior’s IRA to Suzanne’s IRA. The court noted that an IRA beneficiary designation cannot be reformed after the IRA owner dies. Reg. 1.401(a)(9)-4, Q&A-4(a) provides that “In order to be a designated beneficiary, an individual must be a beneficiary as of the date of death.” The court found that Suzanne was not a named beneficiary of Senior’s IRA on the date of his death, and therefore she cannot be named a designated beneficiary after his death. Therefore, the court concluded that under Florida law Wachovia should have distributed the IRA assets to Senior’s estate because either it was named as the beneficiary or there was no named beneficiary, and because the settlement agreement made no direction as to the disposition of the IRA. Although the court found that Wachovia incorrectly rolled over Senior’s IRA to Suzanne’s IRA, the court concluded that it had no jurisdiction to unwind the transaction and must decide Suzanne’s tax liability on the basis of Wachovia’s erroneous transfer of Senior’s IRA assets to Suzanne’s IRA and the subsequent distributions from her IRA.
The court noted that Suzanne was represented by counsel during the probate litigation and the negotiations that led to the settlement agreement. The settlement agreement required payment of the $110,000 within 30 days after Wachovia unfroze Mr. Ozimkoski’s IRA. The court noted that what was clear from the record was that Suzanne’s probate attorney failed to counsel her on the full tax ramifications of paying Junior $110,000 from her own IRA. The court stated that while it was sympathetic to Suzanne’s argument, the distributions she received were from her own IRA and therefore were taxable income to her for 2008.
The court next considered whether the distributions to Suzanne from the IRA were subject to additional tax under Section 72(t)(1) which provides for a 10% additional tax on an early distribution from a qualified retirement plan unless the distribution falls within a statutory exception. The relevant exception in this case is found in Section 72(t)(2)(A)(ii), which provides that distributions “made to a beneficiary (or to the estate of the employee) on or after the death of the employee” are not subject to the 10% additional tax. The court noted that it has been previously held that a beneficiary loses the entitlement to claim the exception under Section 72(t)(2)(A)(ii) if the beneficiary rolls over the funds from the deceased spouse’s IRA into his or her IRA and thereafter withdraws funds from his or her own IRA. Therefore, the court held that Suzanne was liable for the Section 72(t) additional tax on early withdrawals for the distributions from her IRA in 2008.
The court strongly implied that Suzanne could bring an action against Wachovia for the wrongful rollover of the IRA and an action for malpractice against the probate attorney who represented her in the settlement of the suit brought by Junior for failure to advise her regarding the tax consequences of paying Junior the $110,000 from the IRA. This case also highlights one of the disadvantages of rolling over an IRA into the surviving spouse’s own IRA as opposed to retaining the IRA as an inherited IRA.
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].
This article originally appeared in the April 2017 edition of Estate Planning, a monthly periodical directed to estate planning professionals that offers readers the newest and most innovative strategies for saving taxes, building wealth, and managing assets.