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By Deborah M. Beers, Esq. Buchanan Ingersoll & Rooney PC Washington, D.C.
In PLR 201623001, the IRS determined that, because surviving Spouse was not the designated beneficiary of Decedent's individual retirement account (IRAs), she could not roll over the amount of the IRA assigned to her by a state court as her community property interest. Further, the IRS ruled that any assignment to her by the designated beneficiary, Child, would be treated as a taxable distribution to Child.
Decedent and Spouse were married in 2004 and lived in a community property state. Child is the child of Decedent and Spouse. Decedent, prior to his death, named Child as the sole beneficiary of his three IRAs.
After Decedent's death, Spouse filed a claim against the Decedent's Estate for Spouse's one-half interest in the community property Decedent and Spouse owned. By this point, the IRA had already been retitled as an inherited IRA for Child. Spouse and Estate negotiated a settlement under which Spouse's community property interest in the Estate was valued at a certain amount. A state court approved the settlement and ordered that the custodian of the IRAs assign a portion of the inherited IRA for Child to Spouse as a spousal rollover IRA. Spouse's portion in the inherited IRA was thereafter assigned to Spouse as her community property interest in accordance with the state court order.
In general, a surviving spouse of an IRA owner has two options: the spouse may elect to treat the spouse's entire inherited interest in the deceased spouse's IRA as the spouse's own IRA; or s/he may elect to roll over the inherited IRA into the spouse's own IRA. The second option allows the surviving spouse, as “owner” of the IRA, to take advantage of additional deferral opportunities, both during his/her lifetime and after his/her death. The spouse may also execute a rollover of his/her own IRA during his/her lifetime under §408(d)(3), which permits rollovers by “the individual for whose benefit the [IRA] is maintained.”
In PLR 201623001, the IRS ruled that none of these options were available to Spouse with respect to her community property interest in Child's inherited IRA because:
First, §408(d)(3)(C) provides that rollovers are not permitted from inherited IRAs, which are defined as IRAs 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. In this case, Spouse acquired the IRA as a distribution from Child's inherited IRA that was ordered by a State court.
The IRS noted that:
… [Child] was the named beneficiary of the IRA of Decedent and the IRA has been retitled as an inherited IRA for [Child]. Section 408(g) provides that section 408 shall be applied without regard to any community property laws, and, therefore, section 408(d)’s distribution rules must be applied without regard to any community property laws. Accordingly, because [Spouse] was not the named beneficiary of the IRA of Decedent and because we disregard [Spouse's] community property interest, [Spouse] may not be treated as a payee of the inherited IRA for [Child] and [Spouse] may not rollover any amounts from the inherited IRA for [Child] (and therefore any contribution of such amounts by Spouse to an IRA for Spouse will be subject to the contribution limits governing IRAs). Additionally, because [Child] is the named beneficiary of the IRA of Decedent and because we disregard [Spouse's] community property interest, any “assignment” of an interest in the inherited IRA for [Child] to [Spouse] would be treated as a taxable distribution to [Child]. Therefore, the order of the state court cannot be accomplished under federal tax law.
As a result, Spouse's contribution to her IRA was not treated as a rollover, and could subject Spouse to penalties for excess contributions. In addition, the IRS ruled that Child would have to pay taxes on the amount distributed to his parent (Spouse) out of his inherited IRA, despite the fact that the distribution was ordered by the court.
Query: Could the parties have accomplished their goals and achieved their desired result had the IRA custodian not “retitled” the IRA as an inherited IRA for Child prior to surviving Spouse's community property interest being recognized by the court?
Additionally, given that this PLR involves a mother and her son, it is entirely possible that this ruling request and transaction was a disguised attempt to maximize the overall post-tax benefit of the IRA. For example, the parties could have sought to shift the IRA income from a taxpayer with a higher marginal tax rate (Child) to a taxpayer with a lower marginal tax rate (Spouse) (assuming that the Child is taxed at a higher rate). Further, the parties could have gone through the trouble of obtaining a court's blessing to make it all “look good.” However, on its face, the PLR suggests that the Spouse and Child were at odds with respect to the division of the IRA. After obtaining the court order, it was the Spouse who requested the PLR. Although it appears that surviving Spouse “lost” because the IRS did not give her the rulings she requested, in the end she actually won. Sort of losing the battle but winning the war. In the end, and as a result of this ruling, surviving Spouse should get the funds from her deceased husband's IRA and her Child will be required to pay the income tax on those funds. Had she gotten the rulings she requested, surviving Spouse would have received spousal rollover treatment but would have eventually been required to pay taxes on those funds when she received a distribution. With this ruling surviving Spouse gets the funds and the Child is liable for the taxes at the point in time when the funds were “assigned” to the surviving Spouse in the inherited IRA.
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