IRAs and
Divorce From Divorce Magazine
If you're transferring your
interest in an IRA to your (former) spouse, you could get hit with extra tax and
penalties if the transfer is not made correctly. Here's the right way -- and a
couple examples of the wrong way -- to transfer these funds.
By Bruce L. Richman, CPA, ABV,
CVA
We have all heard about
"substance over form", but when it comes to transferring IRAs, it is "form over
substance". The IRS is very clear that an early distribution from an IRA is
subject to a 10% penalty as provided in Section 72(t) of the Internal Revenue
Code ("IRC"). The IRC also provides that any amount distributed from an IRA
"...shall be included in gross income by the payee or distributee, as the case
may be, in the manner provided under IRC Section 72". However, the IRC does
provide for an exception -- which is contained in IRC Section 408(d)(6) --
whereby a transfer of an individual's interest in an IRA to his/her spouse or
former spouse under a divorce or separation instrument is not considered a
taxable transfer. This exception only applies if the following two requirements
are met:
(a) there must be a
transfer of the IRA participant's interest in the IRA to his/her spouse or
former spouse; and
(b) such transfer must have been made under a divorce or
separation instrument.
It is important to note
that IRC Section 408(d)(6) deals with the "transfer" of an individual's interest
in an IRA and does not deal with "distributions" from an IRA.
If, as part of the divorce
or legal separation, you are (or your client is) required to transfer some or
all of the assets in a traditional IRA to your spouse or former spouse, there
are two commonly used methods to effect this transfer. IRS Publication 590
describes the two methods for transferring an interest in an IRA tax-free as
follows:
(a) "Change the name on the
IRA" -- if you are transferring all of the assets of the IRA, you can simply
make the transfer by changing the name on the IRA from your name to the name of
your spouse or former spouse.
(b) "Direct transfer" -- simply direct the
trustee of your traditional IRA to transfer specific assets to the trustee of a
new or existing IRA set up in the name of your spouse or former
spouse.
This appears to be
straightforward, but these simple rules often are not followed, and problems
arise. This is illustrated in two recent tax cases, which demonstrate the
importance of "form over substance". In Jones v. Commissioner TC
Memo 2000-219, the taxpayer had an IRA. In 1992, the taxpayer and his wife filed
for divorce. In April of 1994, the husband and wife drafted a marital settlement
agreement requiring the husband to transfer his IRA to his wife as part of the
property settlement. In May of 1994, the husband cashed out his IRA (he received
a check for $68,000) and endorsed the check he received to his wife. The IRS
sought to have the $68,000 included in the taxpayer's income for 1994. It was
the Court's opinion that the endorsement of the check to the wife was not a
"transfer" of the husband's interest in the IRA, because his interest in the IRA
was depleted at the time he withdrew the funds. It is important to note that the
fact that the check for the IRA balance was endorsed rather than deposited into
the husband's account did not affect the outcome of the case. The courts stated
that the transfer of IRA assets by a distributee to a non-participant spouse
does not constitute the "transfer" of an interest in the IRA under IRC Section
408(d)(6). The purpose of IRC Section 408(d)(6) was to offer a means to avoid
having the interest transferred treated as a distribution. It does not permit
the IRA participant to allocate to a non-participant spouse the tax burden of an
actual distribution.
Following the same logic
was the case of Bunney v. Commissioner 114 TC No. 17 (April 2000).
The husband and wife, both residents of California, a community property state,
were divorced in 1992. Per their divorce settlement, the husband's IRA, which
was funded with contributions that were community property, was to be divided
equally between the husband and wife. The husband withdrew the $125,000 balance
of his IRA and deposited the proceeds into his money-market savings account.
During the same year, he transferred $111,600 to his former spouse as part of
divorce settlement. Mr. Bunney only reported $13,400 of the IRA distribution on
his 1993 federal income tax return.
Just as in the Jones case,
the main issue revolved around the question of whether the husband's gross
income should include the distributions he received from his IRA. Again, the
Court turned to the two requirements that must be fulfilled in order for the
exception of IRC Section 408 (d) (6) to apply, and again the husband did not
satisfy the first requirement calling for a 'transfer" of the IRA interest to
the spouse. Mr. Bunney cashed out his IRA, deposited the funds into his
money-market savings account, and then paid his former spouse some of the
proceeds.
As demonstrated by these
two cases, the simple "form over substance" is important in transferring an IRA
tax free pursuant to a divorce or separation agreement. An easy way to avoid any
potential problems is to have the actual transfer papers made available and
incorporated into the divorce settlement. A mishap with the form of the
transaction can have significant tax consequences.
Since 1980, Bruce Richman (CPA/ABV, CVA,
CDFA™) has been actively involved in
valuations, mergers and acquisitions and other financial and tax consulting
matters. He is a Managing Director of Trenwith Valuation, LLC and until June
2004 was Partner in the Business Valuation Consulting Services Group for BDO
Seidman, LLP. In his current position, Mr. Richman is responsible for various
valuation projects and consulting services in the United States and, for U.S.
clients, internationally. You can read about his firm in his
Divorce
Magazine profile or visit his website at www.trenwith.com/valuation/. or visit his website at
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