10% Penalty Applied to Beneficiary’s IRA Distribution

On her husband’s (B’s) death, A rolled over a distribution from his IRA into her own separate IRA. She received a distribution from her IRA four years later, which she claims is exempt from the 10% tax on early distributions, under Sec. 72(t)(2)(A)(ii), because it came from B’s IRA. The IRS disagreed and determined a deficiency based on 10% of the distribution, as well as a Sec. 6662(a) accuracy penalty.

10% Penalty

Sec. 72(t) imposes a 10% additional tax on early distributions from a qualified retirement account; Sec. 72(t)(2) provides certain exceptions. The only relevant exception is Sec. 72(t)(2) (A)(ii), which provides that distributions “made to a beneficiary (or to the estate of the employee) on or after the death of the employee” are not subject to the 10% additional tax.

A argues that the entire distribution that she received from her IRA was an amount received on or after the death of her husband, B.

 The Tax Court has not previously decided whether an IRA distribution retains its character as a distribution to a beneficiary “on or after the death of an employee” if the distribution is of funds that were rolled over to the IRA on the employee’s death.

The IRS argues that once A, as surviving spouse, decided to maintain the funds in an IRA account in her own name, she became the owner “for all purposes of the Code,” relying on Regs. Sec. 1.408-8, Q&A-5 and -7. A counters that the funds from B’s IRA did not lose their character as funds from his IRA. Even though she rolled over the funds from B’s IRA into her separate IRA, she did not make any additional contributions after he died and did not “redesignate” the account as her own under Regs. Sec. 1.408-8, Q&A-5(b).

A received the distribution from her own IRA, not from an IRA of which she was a beneficiary on or after the death of an employee. The source of the amount received is irrelevant, whether originating from B’s IRA or A’s own contributions. Although A may not have technically redesignated the IRA as her own, she did not need to “redesignate” it, because the IRA was her previously existing account.

A rolled over the entire amount received from B’s IRA into her own IRA. She is and was the sole owner of her separately created IRA. The distribution was not occasioned by B’s death, nor made to her in her capacity as beneficiary of his IRA. Once A chose to roll the funds over into her own IRA, she lost the ability to qualify for the exception from the 10% additional tax on early distributions. The funds became her own and were no longer from B’s IRA. Thus, they no longer qualify for the exception and the IRS’s determination is correct.

Accuracy Penalty

The Sec. 6662(a) accuracy-related penalty under does not apply to any portion of an underpayment if it is shown that there was reasonable cause for the taxpayer’s position and the taxpayer acted in good faith as to that portion; see Sec. 6664(c)(1) and Regs. Sec. 1.6664-4(a). The determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all the pertinent facts and circumstances. The most important is the extent of the taxpayer’s effort to assess his or her proper tax liability for the year; see Regs. Sec. 1.6664-4(b)(1). Circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of law that is reasonable in light of all of the facts and circumstances.

The Tax Court has “specifically refused to impose…[a penalty] where it appeared that the issue was one not previously considered by the Court and the statutory language was not entirely clear” (Hitchins, 103 TC 711 (1994)).

A made a reasonable attempt to comply with the Code in circumstances involving an issue of first impression. There are no cases that have previously answered the question before the court. Accordingly, in light of all the facts and circumstances, A acted reasonably and in good faith as to the underpayment and is not liable for the accuracy-related penalty under Sec. 6662(a).

Charlotte T. Gee, 127 TC No. 1 (7/24/06)