Transfer of IRA in Divorce…Pay Attention to Details or Transfer Will Be Taxable!

Unfortunately, even though a divorce settlement agreement (the “Agreement”) may be properly drafted, unless the parties to the Agreement comply with the terms of the Agreement, favorable tax consequences may not apply.

In Kirkpatrick V. Commissioner, a divorced husband did not comply with the tax law which, unfortunately created adverse tax consequences. In 2012, Wife filed for divorce in Maryland. Husband moved out of the house to Michigan. In the consent order filed in 2012 (the “Order”),  Husband was to transfer to Wife the sum of $100,000 directly (and in a non-taxable transaction) into an individual retirement account (“IRA”) appropriately titled in Wife’s name within 14 days of the entry of the Order. The Order also required him to pay Wife $40,000 for attorney fees.  The divorce was finalized on June 30, 2014.

In 2013, Husband made payments directly to Wife by withdrawing funds from 2 of his IRAs, transferring those monies to his checking account and then writing checks to Wife. Husband received Form 1099s-R for the 2013 taxable year which showed $411,155 as distributions. Husband and Wife filed a joint 2013 return and showed only $116,489 as taxable. The IRS determine a deficiency and a substantial understatement penalty . Husband disputed the taxation of $140,000 received from his IRA.

Generally, any amount distributed from an IRA is included in gross income. However, an exception is provided for a transfer of an IRA incident to a divorce. “The transfer of an individual’s interest”… in an IRA “to his spouse or former spouse under a divorce or separation instrument …. is not to be considered a taxable transfer made by such individual ….. and such interest at the time of the transfer is to be treated” as an IRA of such spouse and not of such individual (the “Exception”).

Husband argued that the $140,000 transferred to Wife met the Exception requirements. He argued that the transfer was made within the appropriate time frame and pursuant to the Agreement. The funds passing through his checking account to his spouse should have no bearing on the taxation of the exchange because the funds were moved within the time limit for this type of transaction.

The IRS argued that none of the payments Husband received and distributed to Wife met the Exception. No IRA was opened in Wife’s name nor was there a transfer of funds from his IRA to her IRA.  A prior case held that the Exception does NOT apply to proceeds from an IRA cashed out or otherwise transferred to a nonparticipant spouse. Further, the transfer was not made in the time frame of the Order and thus, not in accordance with the Agreement.

Finally, Husband argued that Wife did not undertake the necessary steps on her part of establishing an IRA and he should not be responsible for taxes as Wife did not meet her responsibility.

The court clarified that, if applicable, the Exception only applied to the $100,000 as the $40,000 was clearly for attorney fees and would be taxable and not part of the Exception. The court also clarified that federal tax law applied and addressed issues… (1) was there a transfer of the IRA participant’s interest in his IRA to his spouse or former spouse? and (2) was the transfer made under a proper divorce agreement?

Citing the Bunney case, the court rejected the idea that taking a distribution from an IRA and then making a payment to the spouse qualified as a transfer of an interest in that IRA.  The court determined that the participant’s INTEREST in the IRA must be transferred, not the “assets’ in an IRA. The court determined there was NO transfer of Husband’s interest in the IRA to Wife.  The court did not have to answer the second inquiry of whether the transfer was made in accordance with the Agreement.

Also noting their decision in Jones v. Commissioner, the court confirmed that the Exception is limited and that an “interest” in an IRA is NOT synonymous with money or assets held in an IRA. The court then found Husband did not transfer an interest in his IRAs to his then wife.

ADVICE: When complying with terms of an Agreement, be sure to follow the details and terms of the Agreement. Also consult with a tax lawyer BEFORE completion of the drafting of the Agreement to be sure all parties understand the tax implications of the Agreement and agree to follow steps necessary to receive favorable tax consequences.

WORD OF THE WEEK:  Decanting is the process of “pouring” or transferring assets from one irrevocable trust into another trust. The name comes from a similar process such as wine decanting. Decanting arose from an old Florida Supreme Court case. The theory is that a trustee who has complete discretion to distribute assets to the beneficiaries should be able to distribute trust assets in further trust for those beneficiaries. For example, a trustee has the sole discretion to distribute assets among beneficiaries but at age 25 a beneficiary has the right to his or her share. As the trustee could have distributed ALL the assets away from the beneficiary to another beneficiary prior to the specific beneficiary attaining age 25, the trustee has the power to distribute the trust assets to another trust to be held for such beneficiary’s lifetime.

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