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No Equitable Remedy to Avoid Additional Tax on IRA

Estate Planning Journal

In Summers,1 despite facts sympathetic to the taxpayer, the Tax Court held that equitable remedies could not be applied to avoid the 10% additional tax imposed on early distributions from IRAs.

Facts

Jeremy and Karie Summers mutually concluded that their marriage had become irretrievably broken and decided to separate. In order to minimize costs, they decided to accomplish their divorce without involving lawyers. The couple reached an agreement concerning child custody, visitation rights, child support, spousal maintenance, and division of property. In March 2013, Jeremy filed for dissolution of the marriage incorporating these agreements into the petition, including requesting that the proceeds of his IRA with a balance of $17,378 be divided equally between him and Karie.  In order to enable Karie to pay off some debts, Jeremy agreed to split the value of the IRA prior to the divorce decree becoming final. Accordingly, in April 2013, Jeremy withdrew the entire proceeds of the IRA and used one-half of the proceeds to pay off Karie's car loan. In June 2013, the court entered a consent decree of dissolution of the marriage which incorporated all of the agreements of Jeremy and Karie that were set forth in the petition. Because Jeremy and Karie had already divided the IRA, however, the decree provided that "[n]either party has a retirement, pension, deferred compensation, Section 401(k) Plan and/or benefits."

Jeremy timely filed an IRS Form 1040 for 2013 and properly reported as a taxable distribution the $17,378 distribution from his IRA. However, he did not report any additional tax attributable to the fact that the withdrawal from the IRA was an early distribution. The IRA custodian issued an IRS Form 1099-R reporting the withdrawal from the IRA as an early distribution. In September 2015, the IRS issued to Jeremy a notice of deficiency determining that he was liable for the 10% additional tax under Section 72(t)(1). Jeremy timely filed a petition with the Tax Court.

Analysis

Section 72(t)(1) imposes a 10% additional tax on early distributions from qualified retirement plans. A qualified retirement plan includes an IRA. Section 72(t)(2) sets forth various types of distributions that are excepted from the additional tax on early distributions. The most commonly applicable exception is for distributions to a taxpayer age 59½ or older set forth in Section 72(t)(2)(A)(i). Jeremy argued that the exception in Section 72(t)(2)(C) applied to his withdrawal. That exception applies to a withdrawal made "to an alternate payee pursuant to a qualified domestic relations order."  Section 414(p)(8) defines an alternate payee as "any spouse, former spouse, child or other dependent." Section 414(p)(1)(B) defines a domestic relations order as a "judgment, decree, or order" relating to "the provisions of child support, alimony payments, or marital property rights" that "is made pursuant to a State domestic relations law."

The court upheld the determination of the IRS that Jeremy was not entitled to the Section 72(t)(2)(C) exception for early distributions for two reasons:

(1) The distribution from the IRA was made directly to Jeremy not to Karie. Section 72(t)(2)(C) requires that the distribution be made to a spouse or former spouse.

(2) The distribution from the IRA was not made pursuant to a domestic relations order as required by Section 72(t)(2)(C). Although Jeremy's petition for dissolution of the marriage requested a 50-50 division of the IRA, the court's decree recited that neither party had a retirement benefit or account because Jeremy withdrew the entire balance from the IRA a month before the divorce decree was entered.

The court recognized that its prior decisions have held that a taxpayer must strictly comply with the requirements of Section 72(t)(2)(C) in order to qualify for the exception.2

The court concluded by stating that it had considerable sympathy for Jeremy's position and recognized that his willingness to help Karie resulted in his inability to satisfy the requirements of Section 72(t)(2)(C). However, the court stated that it was not at liberty to add equitable exceptions to the statutory scheme that Congress enacted. Therefore, the court sustained the 10% additional tax on Jeremy's distribution from the IRA.

Comments

While Jeremy's situation was certainly sympathetic, based on its prior holdings requiring strict compliance with the requirements of Section 72(t)(2)(C), the court in this case reached the proper result. For this couple, the money saved on legal counsel proved to be illusory after paying the early withdrawal penalty. For practitioners, this case is a reminder that the Code contains landmines for the uniformed or under-informed, and that practitioners must always be mindful of the tax considerations of any transaction.

1 Summers v. Commissioner, TCM 2017-125.

2 See Hartley, TC Memo 2012-311; Bougas, TC Memo 2003-194.

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 fsbaldino@lerchearly.com.

This article originally appeared in the October 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.

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