Distribution from Decedent's IRA to Wife to Settle Suit with Stepson Is Subject to Tax and Penalties

(Parker Tax Publishing January 2017)

The Tax Court held that the distributions from a taxpayer's IRA to effect a settlement agreement with her stepson were taxable to her and subject to the 10 percent early distribution penalty tax as well. The court also held that the taxpayer was liable for the failure to timely file penalty under Code Sec. 6651(a)(1), but was liable for only a portion of the accuracy-related penalty under Code Sec. 6662(a). Ozimkoski v. Comm'r, T.C. Memo. 2016-228.

Background

Suzanne Ozimkoski's husband, Thomas, died in August 2006. Approximately six months before his death, Thomas had executed a simple, two-page last will and testament that left all of his property, with the exception of some tangible personal property, to Suzanne and named her as personal representative of his estate. At the time of his death, Thomas owned a traditional IRA with Wachovia Securities.

In 2006, during the probate proceedings for Thomas's estate, one of his adult children and Suzanne's stepson, filed two petitions with the probate court - one for revocation of Thomas's will and one for declaratory relief. Wachovia froze Thomas's traditional IRA pending the outcome of the probate litigation. On March 7, 2008, Suzanne and her stepson reached the following settlement agreement:

"Respondent [Mrs. Ozimkoski] shall pay to petitioner [Mr. Ozimkoski, Jr.] the sum of $110,000 and shall transfer title to petitioner [Mr. Ozimkoski, Jr.] to that certain 1967 Harley Davidson motorcycle in full and final settlement of all claims raised or which could have been raised in this action. Payment shall be made within 30 days of the date on which decedent's IRA is unfrozen by Wachovia Securities. All payments shall be net payments free of any tax."

Notes from a Wachovia employee journal stated that Suzanne's probate attorney understood that someone would have to pay income tax on the $110,000 allocated to the stepson under the settlement agreement.

On July 2, 2008, after unfreezing the IRA assets, Wachovia transferred $235,495 from Thomas's IRA to Suzanne's traditional IRA, which was also with Wachovia. On July 14, 2008, Suzanne received a distribution of $141,997 from her IRA. On July 15, 2008, Suzanne wrote a personal check for $110,000 to her stepson to make the payment required under the settlement agreement. Suzanne also received approximately $174,600 of distributions from her IRA in 2008.

In 2009, Wachovia issued a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., with respect to the distributions from Suzanne's IRA for 2008. The distribution code 1 on the Form 1099-R represented that the distributions were early distributions with no known exception because Suzanne had not reached the age of 59-1/2 in 2008. On May 9, 2009, Suzanne untimely filed her 2008 Form 1040 and did not report any of the IRA distributions as income for 2008.

The IRS determined that the distributions were includible in Suzanne's income and issued a deficiency notice, assessing additional taxes, a 10 percent early withdrawal penalty under Code Sec. 72(t), a Code Sec. 6651(a)(1) penalty for late filing, and an accuracy related penalty under Code Sec. 6662(a).

Analysis

At trial, Suzanne argued that the distributions should not be included in her income because her stepson was entitled to $110,000 of his father'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.

An IRA owner can designate beneficiaries to inherit his IRAs in the event that the owner dies before receiving all of the IRA distributions, but there is no exception from inclusion in gross income for distributions to a beneficiary following the death of the account owner. Therefore, distributions to beneficiaries of a decedent are includible in the gross income of the beneficiaries.

Under Code Sec. 401(a)(9)(B) and Code Sec. 408(a)(6), if an IRA owner dies before distributions were required to begin, the owner's interest in the IRA generally must be distributed to the beneficiary within five years of the decedent's death. Additionally, if an IRA owner dies before distributions were required to begin and the named beneficiary is the decedent's estate, the assets must be distributed within five years of the decedent's death. If an IRA owner dies after distributions were required to begin, the IRA assets generally must be distributed to the beneficiary of the IRA at least as rapidly as under the method of distribution to the owner.

The Tax Court held that the distributions from Suzanne's IRA were taxable to her and that she was liable for the 10 percent early distribution penalty tax. The court also held that she was liable for the failure to timely file penalty under Code Sec. 6651(a)(1) and was liable for a portion of the accuracy-related penalty under Code Sec. 6662(a), but not the portion relating to the $110,000 payment to her stepson.

Generally, the Tax Court said, an IRA payable to a specific beneficiary, other than the decedent's estate, is not a probate asset and is not included in the decedent's probate estate. The court noted that under Florida law there appeared to be only two scenarios in which Wachovia could properly freeze Thomas's IRA assets during the pendency of probate litigation. 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 Thomas's death, the proceeds would have been paid to his personal representative. The court noted that, under Florida law, the only two scenarios in which Wachovia could have correctly frozen Thomas's IRA pending the outcome of the probate litigation were that: (1) his estate was the named beneficiary of the IRA, or (2) there was no named beneficiary of the IRA. Under either scenario, the court said, Wachovia incorrectly rolled over the entirety of Thomas's IRA to Suzanne's IRA.

Under Florida law, the court observed, Wachovia should have distributed the IRA assets to Thomas'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 Thomas's IRA to Suzanne's IRA, it said it had no jurisdiction to unwind that transaction and had to decide Suzanne's tax liability on the basis of Wachovia's erroneous transfer of Thomas's IRA assets to her IRA and the subsequent distributions from her IRA.

The court said it was clear from the record that Suzanne's probate attorney failed to counsel her on the full tax ramifications of paying her stepson $110,000 from her own IRA. While the court was sympathetic to Suzanne's argument, the distributions she received were from her own IRA and therefore were taxable income to her.

For a discussion of distributions from traditional individual retirement arrangements, see Parker Tax ¶134,500.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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