Compliance is Key!

Kirkpatrick v. Comm’r, T.C. Memo. 2018-20, 2018 WL 1040955 (2018)

(a) Facts: The wife sued the husband for divorce in Maryland. A Maryland court issued a pendente lite order, providing for temporary support. In addition, the order required the husband to “transfer to Ms. Kirkpatrick the sum of One Hundred Thousand Dollars ($100,000.00) directly (and in a non‑taxable transaction) into an IRA appropriately titled in Ms. Kirkpatrick’s name” and to “pay to the Plaintiff a lump sum of Forty Thousand Dollars ($40,000.00) . . . for Pendente Lite Attorney’s Fees and Suit Money.” 2018 WL 1040955, at *4. The parties were eventually divorced.

The husband did not transfer any money into an IRA in the wife’s name, but he did make a series of payments to her in the amounts required by the above order. The payments were made with funds withdrawn from two IRAs.

The parties filed a joint tax return for the year in which the payments were made. They reported distributions of $411,155, of which only $116,489 was reported as taxable. Among the deductions claimed was a $140,000 deduction under § 408(d)(6) for payments under the Maryland order. The IRS disallowed the deduction, and the parties sought relief in the Tax Court.

(b) Issue: Were the parties entitled to a deduction under § 408(d)(6)?

(d) Summary of Rationale: The parties were not entitled to deduct the $40,000 in temporary attorney’s fees. The Maryland court simply ordered payment of that amount; it did not order that payment be made from an IRA or, indeed, from any specific source. Section 408(d)(6) applies only where the order or agreement requires “[t]he transfer of an individual’s interest in an individual retirement account.” I.R.C. § 408(d)(6) (emphasis added).

The $100,000 payment was also not deductible. “[T]his Court has held that for section 408(d)(6) to apply . . . there must be a transfer of the IRA participant’s interest in the IRA to his spouse or former spouse.” Kirkpatrick, 2018 WL 1040955, at *15. The Maryland order did not require the husband to transfer to the wife an interest in an IRA. It required him to pay $100,000 into an IRA and to do so in a nontaxable manner, but it did not state a specific source from which the payment had to come.

Because the husband was free to make the payment from any source he desired, the order did not require the husband to transfer to the wife an interest in an IRA. “[T]aking distributions from IRAs and writing checks to one’s spouse is not the appropriate form for a tax-free transfer of an account incident to divorce under section 408(d)(6).” Id. at *17. The court relied directly on Bunney v. Commissioner, 114 T.C. 259 (2000), which reached the same result.

Observations:

The parties created their tax problem. The husband made payments that did not comply with the state court order. Instead of objecting, the wife appears to have accepted the payments. When planning to claim a deduction for payments made under a state court order, it is usually a good idea to comply with what the order requires.

But even 100% compliance with the order would probably not have allowed a deduction under § 408(d)(6), as the order did not require that the $100,000 come from an IRA.

“[T]wo commonly used methods of transferring an interest in an IRA are to (1) change the name on the IRA to that of the nonparticipant spouse or (2) direct the IRA’s trustee to transfer the IRA assets to the trustee of an IRA owned by the nonparticipant spouse.” Id. at *15. The state court should have either transferred title to an IRA or directed the trustee of a specific IRA to transfer $100,000 into an IRA for the wife.

Would it have been sufficient if the state court had ordered the husband to pay $100,000 from an IRA for the husband into an IRA for the wife? Quite possibly not:

The transfer of IRA assets by a distributee to a nonparticipant spouse does not constitute the transfer of an interest in the IRA under section 408(d)(6). See Bunney v. Commissioner, supra at 265; Czepiel v. Commissioner, T.C. Memo.1999-289. The fact that petitioner endorsed the distribution check to his wife, rather than first depositing the funds into his own bank account, does not change the result. Section 408(d)(6) offers a means to avoid having the interest transfer treated as a distribution. See sec. 1.408-4(g)(1), Income Tax Regs. It does not permit the IRA participant to allocate to a nonparticipant spouse the tax burden of an actual distribution. See Bunney v. Commissioner, supra at 265, n. 7. We recognize that where a nonparticipant spouse in a divorce prefers to receive cash rather than an interest in an IRA, the parties may find it desirable to have the participant simply withdraw the IRA funds. However, such withdrawals do not fall under the limited exception set forth in section 408(d)(6).

Jones v. Comm’r, T.C. Memo. 2000‑219, 2000 WL 1005079, at *2 (2000) (footnote omitted).

The fundamental problem is that if the state court orders payment by the spouse who owns the IRA, the federal courts are likely to treat the transaction as a distribution to the owning spouse, followed by a payment to the non-owning spouse, and that will not support a deduction. To justify a deduction under § 408(d)(6), the order or agreement must require transfer without distribution. Thus, it must either require a transfer of title to the IRA or that payment be made by the trustee, e.g., the financial institution holding the funds.

One easy way to meet the above requirements would be to order that the owning spouse create a new IRA, fund that IRA with a specific sum from the original IRA in a tax-free rollover under I.R.C. § 408(d)(3); then transfer the new IRA to the non-owning spouse. But tax-free rollovers are tricky; there are various requirements, including a limit of one tax-free rollover per year, which is subject to various exceptions. Seek advice from a tax expert before finalizing any agreement or order intended to allow a deduction under § 408(d)(6).