Taxpayer Taxable on IRA Distribution Despite Following Father's Wishes that Siblings Receive Part of Account Balance Left to Him

The situation the taxpayer faced in the case of Morris v. Commissioner, TC Memo 2015-82 is one that will be all too familiar to many of us—a case of a taxpayer doing something unaware of the negative tax consequence.  It also is a case of a client reading more into advice received than the adviser expected the taxpayer would do—and, again, with negative consequences.

The result in this case should not be surprising to any tax adviser reading this—Elroy was the primary and sole beneficiary of his father’s IRA.  Elroy received a distribution of his father’s IRA as he was the sole beneficiary of the IRA.  But his father had indicated that he wanted a portion of the IRA to be shared with Elroy’s two siblings, so he paid checks to them for $37,000.

In addition Elroy had sought legal counsel when dealing with his father’s estate. Elroy was the personal representative of his father’s estate and retained the services of a local law firm to assist him in settling his father’s estate.

A paralegal in the law firm did most of the work and she looked into the issue of whether the estate would face a federal estate tax or state inheritance tax.  She advised Elroy that neither tax would be due on his father’s estate, including on the IRA distribution.  Unfortunately Elroy understood her to say no tax would be due on the distribution—and took that to mean taxes of any kind. 

Faced with his father’s wishes and what he believed was advice that said there were no taxes due on an IRA distribution Elroy took the distribution, paid the funds to his siblings that he believed was the amount his father wished each of them to have and did not report any income on his own return.  Of course the IRA custodian issued Forms 1099R in Elroy’s name for the distributions and the IRS eventually came calling to inquire about why that income had not been shown on Elroy’s return.

As the Court noted:

Although petitioner acted honorably in executing what he believed to be his father's wishes, his good conduct has no bearing on whether the IRA distributions were includible in his gross income under the Internal Revenue Code. And whereas the advice he thought he received from the law firm might have affected his liability for the accuracy-related penalty, it is irrelevant in determining the taxable status of the distributions themselves. We thus find that petitioners failed to include in their gross income for 2011 taxable distributions totaling $95,984 from an IRA.

The case reminds us of some issues we need to keep in mind in our practice. 

First, many elderly clients may not understand the consequences to their child of leaving assets that have income in respect to a decedent (IRD) in them with instructions that they want the asset shared with other siblings.  To the parent this most likely seems to be simpler than having to list multiple beneficiaries and allows one child (most often the child geographically closest to the parent) to manage everything.  As well, it means that “other people” (meaning the bank) won’t know all about the parent’s personal matters.

So having a discussion with the parent regarding beneficiary designations and explain why leaving it all to one child can have significant (and bad) income and gift tax consequences to the child if they follow the parent’s instructions.  If the parent truly wants to “keep things confidential” the CPA can advise the parent to seek legal advice regarding establishing trusts that could accomplish the goal of centralizing and keeping confidential these estate matters without harming the child who will control administration.

We also should take note of the mistaken impression that Elroy had regarding the advice he was given by the paralegal.  Too often we may become laser focused on the specific issue in front of us and the specific advice we are rendering, not stopping to think about how our advice will sound to someone who is not as familiar with the matters as we are.  And it’s also important to be specific when are giving advice about tax consequences—if we are addressing only one type of tax it is important to remind the client that we are telling them only that this particular tax does not apply.

While we don’t know the exact state of mind of the paralegal when she made her statement, it would certainly be plausible to believe that she just took it for granted that “everyone knows” you pay income tax on IRA distributions so specialized advice should only be needed on the transfer taxes.  But it’s just as understandable to see how someone not trained in tax very well might no “know” that IRA distributions are generally taxable.