Spouse Asserts Rights to IRA under Community Property Law – Decedent’s Son Gets Hit with Tax

Thomas J. Nichols
Christopher R. Little

Earlier this summer, the IRS released a Private Letter Ruling taking the position that a non-spouse IRA beneficiary would be liable for federal income tax on assets transferred from an inherited IRA to the IRA decedent’s former spouse as required by the state’s community property laws. I.R.S. Priv. Ltr. Rul. 201623001 (June 9, 2016).

Prior to the IRA owner’s death, the owner and his spouse resided in a community property state and made contributions to his IRA. The IRA owner and his spouse later divorced. After the divorce, the IRA owner named his son as the sole beneficiary of his IRA. After the IRA owner’s death, the IRA owner’s former spouse sued his estate for half of the decedent’s IRA. She took the position that she was entitled to that portion under the community property laws of their state, and the court agreed. However, by the time of the court’s award, the decedent’s IRA had already been retitled as a non-spouse inherited IRA for the decedent’s son. So, the parties sought guidance from the IRS regarding how they could transfer the ex-spouse’s half interest without triggering federal tax liability.

In response, the IRS’s reasoning went like this: Section 408(d)(3)(C)(ii) of the Internal Revenue Code defines an inherited IRA as one where “(I) the individual for whose benefit the IRA is maintained acquired the IRA by reason of the death of another individual and (II) such individual was not the surviving spouse of such other individual.” This was the case here. The IRA owner’s son was named the sole non-spouse beneficiary of the decedent’s IRA, and the IRA was retitled as an inherited IRA for the benefit of the decedent’s son upon the IRA owner’s death. Section 408(d)(3) only permits rollovers by “the individual for whose benefit the [IRA] is maintained,” which means an IRA owner may only roll over IRA assets into another IRA for the IRA owner’s own benefit. Further § 408(d)(3)(C) provides that rollovers are not permitted from inherited IRAs. In addition, § 408(g) provides that § 408 “shall be applied without regard to any community property laws.” Since § 408(g) states that § 408 shall be applied without regard to any community property laws, § 408(d)’s distribution rules must be applied without regard to any community property laws or court orders under those laws. Therefore, because the IRA owner’s former spouse was not the named beneficiary of the decedent’s IRA, and because the IRS disregards the IRA owner’s former spouse’s community property interest under § 408(g), the IRA owner’s former spouse may not be treated as a payee of the inherited IRA for the IRA decedent’s son, nor may the IRA decedent’s former spouse roll over any amounts from the son’s non-spouse inherited IRA into her own IRA under § 408(d)(3).

The IRS went on to note that if the IRA owner’s former spouse used the proceeds from a distribution from the son’s non-spouse inherited IRA to make a contribution to her own IRA, that contribution would still be subject to the normal contribution limits governing IRAs under § 219 ($5,500 with an extra $1,000 for participants age 50 or older the calendar year 2016)— no doubt much less than the court awarded her. Even worse, the IRS concluded that, because the IRA owner’s son was named the sole beneficiary of the IRA, any assignment of an interest in the non-spouse inherited IRA to the IRA owner’s former spouse under the court order would be treated as a taxable distribution to the son under § 408(d)(1), which provides that “any amount paid or distributed out of an individual retirement plan shall be included in the gross income of the payee or distributee.”

Needless to say, this seems pretty harsh. A better analysis would seem to be that, since the spouse owned a one half interest in the IRA to begin with, the transfer of her interest into her own IRA should not have resulted in any tax consequences. Internal Revenue Code § 408(d)(6) treats IRA transfers incident to divorce as tax-free. Even though the IRA owner died prior to the transfer, the IRA change here seems to be more properly understood as reflecting a prior ownership interest, rather than a subsequent transfer. Perhaps the result could have been different if the IRA not already been retitled into an inherited IRA for the benefit of the son prior to the court order. Form—rather than substance—appears to govern the IRS’s analysis in this ruling.

This cautionary tale obviously indicates that care should be taken when titling and designating beneficiaries other than the surviving spouse for IRAs, especially in Wisconsin and other community property states.

Thomas J. Nichols and Christopher “Chal” R. Little specialize in business entity, tax and estate planning matters.