IRA Distribution Funded by Community Property Was Taxable Solely to Participant

In Bunney, 114 TC No. 17 (2000), a case of first impression, the Tax Court ruled that an entire IRA distribution was taxable solely to the participant, even though he transferred most of the distribution to his former spouse, who owned one-half of the IRA as community property. The participant could have avoided this result by complying with the "transfer incident to divorce" provisions of Sec. 408(d)(6). The Tax Court also reaffirmed its prior ruling that the distribution of a community property interest in a retirement plan is taxed one-half to each spouse, except when Congress has specified otherwise, as it has for IRA distributions.

Sec. 219(f)(2) specifies that IRA contributions are deductible without regard to any community property laws. Sec. 408(d)(1) includes IRA distributions in the payee's or distributee's gross income, as provided under Sec. 72. Although neither "payee" nor "distributee" is defined in the Code or regulations, the Tax Court has interpreted "distributee" under Sec. 402(b)(2) as "the participant or beneficiary who, under the plan, is entitled to receive the distribution." Sec. 408(g) requires that Sec. 408 be applied "without regard to any community property laws."

Sec. 408(d)(6) specifies that a transfer of a participant's interest in an IRA to a spouse or former spouse incident to divorce is not a taxable transfer if made under a Sec. 71(b)(2) divorce or separation instrument. The IRA is thereafter treated as the spouse's. IRS Pub. 590, Individual Retirement Arrangements, Important Changes, states that an IRA interest can be transferred by either changing the name on the IRA to the nonparticipant spouse's or by directing the IRA trustee to transfer the IRA assets to the trustee of the nonparticipant spouse's IRA. However, receiving a cash distribution and transferring it to the former spouse is not a qualifying transfer under Pub. 590. (Sec. 414(p) qualified domestic relations orders do not apply to IRAs, but transfers qualifying under Sec. 408(d)(6) achieve the same objective of shifting tax to the nonparticipant spouse.)

In Bunney, Michael Bunney's IRA was funded with community property; therefore, each spouse owned half. In 1992, the Bunneys divorced, and the divorce court ordered an equal division of the IRA. In 1993, Michael withdrew $125,000 from his IRA and subsequently transferred $111,600 to his former spouse and received her interest in their residence. Michael reported only $13,400 of the IRA distribution on his return. The IRS contended that, because Michael was the sole recipient of the distribution, he was the sole taxable distributee. Michael argued that, because his spouse owned half of the IRA from its inception, she should be taxed on half of the distribution. Alternatively, he argued that his $111,600 transfer qualified for nonrecognition as an IRA transfer incident to divorce.

Disagreeing with the Service's reasoning but not its conclusion, the Tax Court ruled that the entire distribution was taxable to Michael, because Sec. 408(g) prevents his spouse from being treated as a distributee, regardless of her community property interest. In addition, the court noted that the interpretation of Sec. 408 language for the creation of an IRA, IRA rollovers and required distributions would be problematic if applied to two individuals rather than one. The court also noted that, if the distribution in a community property state were from a Sec. 401(a) qualified retirement plan instead of from an IRA, the nonparticipant spouse would be treated as a distributee and taxed on half of the distribution, because Congress did not specify that community property laws should be disregarded in determining the taxation of distributions from such plans (Powell, 101 TC 489 (1993)). Finally, the Tax Court rejected Michael's alternative argument, ruling that receiving a cash distribution and paying his former spouse the proceeds did not constitute a qualifying transfer of his IRA to a former spouse under Sec. 408(d)(6).

In addition to the tax, the Tax Court ruled that Bunney was liable for the Sec. 72(t) 10% early distribution penalty on the $125,000 distribution. Also, the court sustained the Sec. 6662(a) 20% negligence accuracy-related penalty on $49,100 ($62,500 – $13,400 he reported). The court did not sustain the penalty on the $62,500 that was his spouse's community property interest in the IRA, but presumably would sustain it in post-Bunney cases.

With the booming stock market, many taxpayers have large IRA balances, including Sec. 408(a)(1) rollovers from qualified retirement plans and amounts that were originally IRAs. The best strategy for a participant undergoing a divorce is to satisfy the Sec. 408(d)(6) transfer requirements. If Sec. 408(d)(6) is not met, IRA distributions are taxed solely to the participant in every state, because, as the Tax Court ruled in Bunney, community property laws are disregarded for IRA distributions.

From Peter Barton, MBA, CPA, J.D., Professor of Accounting, Clayton Sager, Ph.D., Associate Professor of Accounting, and Roy C. Weatherwax, Professor of Accounting, University of Wisconsin-Whitewater, Whitewater, WI (Not associated with Summit International)