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:
“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.