Disability Pension Payments Converted to Taxable Amounts in Hands of Former Spouse Receiving Them Under a QDRO

Payments from a disability pension being paid to a former spouse under a qualified domestic relations order (QDRO) will not qualify for an exclusion from income pursuant to IRC §104(a)(1) per the ruling in PLR 201521009.  That will be true even if the amounts are excludable from income under that provision when paid to the original recipient of the payments.

The plan requesting the ruling had previously received a private letter ruling holding that a portion of payments under a particular program it had would qualify for exclusion from income under IRC §104(a)(1).  The plan now was wondering about what they should do when such an employee, receiving a payment stream, went through a divorce and the right to the payments were divided pursuant to a QDRO.

Generally a QDRO represents the sole means under ERISA by which the rights to payments, at the plan level, may be divided between the spouses.  If a proper QDRO is delivered to the plan, the plan divides the benefits as provided for in the QDRO and the amount designated to be paid to the non-employee (that is, normally the former spouse) is treated as if it was the benefit of that person.

If a QDRO is not used but rather the original beneficiary simply agrees to pay a portion of the payment stream to the former spouse, the original beneficiary is taxed on the distribution.  With a QDRO, the payment is taxed to the recipient.

But in this case the payment was one that was for disability under a payment plan that is in the nature of workers’ compensation, qualifying for an exclusion from income under IRC §104(a)(1) and Reg §1.104-1(b).  Does the QDRO now serve to convert the payment stream into a fully taxable one when it is received by the former spouse?  The IRS concluded that it does.

The ruling holds:

Section 104(a)(1) is strictly construed to conform to the general purview of section 61 that all income is taxable unless explicitly excluded. The accidental disability retirement benefits are specifically paid to State employees for their work-related injury or sickness, and not the work-related injury or sickness of the former spouses. Moreover, section 1.104-1 of the regulations explicitly limits the exclusion from income to employees and their survivors. Neither the Code nor the regulations provide an exclusion from income for amounts paid to former spouses pursuant to a domestic relations order. See, Fernandez v. Commissioner, 138 T.C. 378 (2012).

The ruling concludes that, in this case, “[t]he entire amount paid to the former spouses is includible in taxable income.”

Advisers who are advising a taxpayer in a divorce case with a disability pension involved should take note of this case.  If a “standard” QDRO is used it must be recognized that it will convert nontaxable income into a taxable amount. 

That may still be desirable—most former spouses will feel better about being paid from a retirement plan rather than being dependent on a payment coming from their former spouse (the most obvious alternative is to substitute a payment stream specifically designated as not alimony for tax purposes).  But an adviser who does not mention the issue to their client may find themselves in an uncomfortable position when the client discovers the issue—and then concludes that “if I would have known I would have acted differently” to justify looking to the adviser to make good the tax that they now have to pay.