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. 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.