Taxpayer Constructively Received Early IRA Distribution Due to Criminal Forfeiture

(Parker Tax Publishing February 2024)

The Tax Court held that a taxpayer whose individual retirement account (IRA) was forfeited to the government after he was convicted and sentenced to prison for distributing controlled substances was liable for the additional tax on early distributions under Code Sec. 72(t) as a result of the forfeiture. The court found that the taxpayer constructively received the income because, by forfeiting the funds in his IRA, he realized the benefits of them and therefore had to recognize the funds as gross income to the same extent as if he had physically received them. Hubbard v. Comm'r, T.C. Memo. 2024-16.

Background

In 2015, Lonnie Hubbard was indicted, as modified by subsequent superseding indictments, for various crimes related to the distribution of controlled substances and listed chemicals. Before his criminal conviction, Hubbard was a pharmacist in Kentucky. The indictments included allegations with respect to Hubbard's assets, including a T. Rowe Price Associates, Inc. employee IRA (T. Rowe Price IRA). In 2017, following a jury trial, Hubbard was found guilty on most of the counts in the superseding indictment, and Hubbard's property listed in the indictment, including the IRA, was condemned and forfeited to the United States. In addition to forfeiture of his assets, Hubbard was sentenced to imprisonment for a term of 360 months, three years of supervised release, and a criminal monetary penalty of $7,100.

T. Rowe Price issued Hubbard Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., for the 2017 tax year, reporting an early taxable distribution of $427,518 from Hubbard's T. Rowe Price IRA. Hubbard, who was in prison, did not file a federal income tax return for the 2017 tax year. In connection with his not having filed a federal income tax return, Hubbard did not report the $427,518, which was forfeited directly to the USA.

Hubbard made no payments with respect to his 2017 federal income tax liability. The IRS prepared a substitute for return (SFR) for Hubbard's 2017 tax year. In 2020, the IRS notified Hubbard that it had not yet received Form 1040, U.S. Individual Income Tax Return, from him for 2017 and warning him that tax would be assessed if he failed to file by March 19, 2020. In November 2020, the IRS issued a notice of deficiency. In the notice, the IRS also determined that Hubbard was liable for additions to tax under Code Sec. 6651(a)(1) for failure to timely file and under Code Sec. 6651(a)(2) for failure to timely pay. Hubbard took his case to the Tax Court.

The IRS filed a motion for summary judgment. Hubbard objected to the deficiency on the basis that his IRA funds were transferred directly to the USA and that he never constructively received them. Hubbard also argued that he had reasonable cause for his failure to timely file a return and failure to timely pay the tax shown on the SFR because he was incarcerated and his assets were criminally forfeited. He further asserted that he had earned no income since his indictment in December 2015 and was unable to pay the tax deficiency because of lack of funds. Additionally, he asserted that he did not receive the Form 1099-R from T. Rowe Price because his wife divorced him, did not communicate with him, and was not forwarding his mail. Hubbard maintained that he lost most of his assets in his divorce, as his wife received their shared home, all possessions in the home, and the contents of their joint bank account. Finally, he emphasized his history of paying his income tax from 2002 through 2015.

Constructive Receipt of Income

Code Sec. 61(a) provides that gross income means "all income from whatever source derived." Under Code Secs. 61(a)(10) and 408(d)(1), pension and IRA distributions are generally taxable as income. Gross income also includes items of income that the taxpayer has constructively received. In Estate of Caan v. Comm'r, 161 T.C. No. 6 (2023), the Tax Court explained that under the constructive receipt doctrine, "funds [or other property] which are subject to a taxpayer's unfettered command and which he is free to enjoy at his option are constructively received by him whether he sees fit to enjoy them or not."

In Carione v. Comm'r, T.C. Memo. 2008-262, the Tax Court held that a taxpayer was liable for tax on the proceeds from the sale of his assets pursuant to a criminal forfeiture order. The taxpayer, the sole shareholder of an S corporation, was indicted on charges of money laundering, conspiracy, and other crimes under the Racketeer Influenced and Corrupt Organizations Act (RICO). The indictment also asked for forfeiture of assets acquired or maintained by the taxpayer in violation of RICO. The taxpayer, with a court's permission, sold the S corporation's assets to a third party and deposited the proceeds into an escrow account to be withdrawn only by an order of the court. As part of the taxpayer's plea agreement, the district court ordered the forfeiture of the proceeds from the sale of the S corporation's assets to be applied to the forfeiture judgment. The taxpayer paid tax on the forfeited proceeds and sued for a refund, asserting that the proceeds were not income to him because they were directly forfeited to the government and he never had dominion and control over them. The Tax Court rejected that argument and held that the proceeds were taxable to the taxpayer because he received the economic benefit of them when the district court ordered the sale proceeds to be released from escrow to satisfy the taxpayer's obligation under the criminal forfeiture.

In Murillo v. Comm'r, T.C. Memo. 1998-13, a taxpayer pleaded guilty to several financial crimes, including structuring cash deposits into bank accounts for the purpose of avoiding federal currency transaction reporting requirements. In a related civil proceeding, the taxpayer agreed to forfeit several financial accounts, including two IRAs, to the USA. The taxpayer reported the total amount forfeited from the IRAs as taxable income on his return for the year of the forfeiture but did not include the 10 percent additional tax on early distributions pursuant to Code Sec. 72(t). The taxpayer also claimed a loss on Schedule C, Profit or Loss From Business, as a result of the forfeiture. The court disallowed the Code Sec. 165(a) loss deduction because allowing the taxpayer a loss deduction for losses arising from illegal activities would undermine a clearly defined public policy against structuring transactions. Next, the court considered whether the Code Sec. 72(t) additional tax on early distributions applied. The court rejected the IRS's argument that the Code Sec. 72(t) tax applies regardless "of actual receipt by or benefit to the taxpayer or the voluntary nature of the distribution."

In this case, the IRS contended that Hubbard constructively received gross income when he criminally forfeited his T. Rowe Price IRA. Hubbard responded that he was not liable for the tax under Code Sec. 72(t) because he did not take any willful or voluntary act to distribute the IRA that was forfeited. According to Hubbard, the Tax Court's decision in Carione was inapposite because the taxpayer in Carione willfully sold his business and then applied the sale proceeds toward a criminal forfeiture. Hubbard also contended that that Murillo did not support the IRS's position because the taxpayer in Murillo purposefully distributed his IRA accounts and voluntarily reported the income on his return.

Analysis

The Tax Court held that Hubbard constructively received, and had to include in his gross income, a taxable distribution of $427,518 from his T. Rowe Price IRA. The court found that the funds from Hubbard's T. Rowe Price IRA were forfeited to the USA as an involuntary distribution. Though they were not under his control, the court concluded that Hubbard constructively received the funds by having received the economic benefit of the funds through satisfaction of his forfeiture liability to the USA. The fact that Hubbard did not willfully or purposefully cause the distribution was, in the court's view, irrelevant.

The court explained that it has consistently applied the constructive receipt doctrine to cases involving both voluntary and involuntary forfeitures. The court noted that in Carione, the taxpayer made the same argument that Hubbard made here. In that case, the proceeds from the sale of assets were forfeited to satisfy a judgment against the taxpayer. The taxpayer argued that because the proceeds were paid directly to the government, the taxpayer never had dominion or control over them such that he could not have constructively received those amounts. The court concluded that the sale proceeds were taxable to the taxpayer because he received the economic benefit of the proceeds when the court ordered them to be used to satisfy his obligation under the criminal forfeiture.

The court also found that Hubbard misread Murillo. The court found that in the Murillo, the Tax Court expressly stated that "[w]e do not believe the circumstances surrounding the plea agreement were such as to impart a 'voluntary' patina to the IRA withdrawals. In the final analysis, [the taxpayer] had no realistic choice." The Tax Court held that the taxpayer constructively received the IRA distributions when they were made by the IRA administrator in satisfaction of the taxpayer's obligations and that he could not escape taxation because the funds were disbursed to third parties. The Tax Court noted that the fact that the transfer was involuntary had no significance.

In considering whether Hubbard was liable for the penalties asserted in the notice, the court concluded that although it was sympathetic to Hubbard's difficulties, he did not have reasonable cause for his failure to timely file a return and pay tax. The court found that Hubbard was aware of his general duty to file a return and of the forfeiture that was part of his criminal case. In response to Hubbard's claim that he never received the Form 1099-R issued by T. Rowe Price, the court found that nonreceipt of a tax document does not constitute reasonable cause to prevent the application of an accuracy-related penalty. The court said that Hubbard should have recognized that there might be tax implications as a result of the forfeiture of his IRA and should have sought the advice of a tax professional.

For a discussion of early distributions from an IRA, see Parker Tax ¶134,555. For a discussion of constructive receipt of income, see Parker Tax ¶241,620. For a discussion of abatement of penalties due to reasonable cause, see Parker Tax ¶262,127.

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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