Assignment of Portion of Decedent's IRA to Spouse as Community Property Interest in Lawsuit Settlement Creates Taxable Distribution to Named Beneficiary

Community property law and federal tax collided and the tax result can be best called “messy” in PLR 201623001.  The final result created a harsh result and tax being due from a taxpayer who had a portion of an inherited IRA that was treated as community property taken away.

The taxpayer (referred to as “Taxpayer A” in the ruling) applying for the ruling was the surviving spouse.  Her deceased husband had three IRAs but named their child (referred to as “Taxpayer B” in the ruling) as the sole beneficiary of the IRA.  While the ruling doesn’t tell us the full details, we know the spouse filed suit against the decedent’s estate for her community property interest in the assets owned by her and her deceased spouse.  Thus it’s possible her deceased spouse had effectively “disinherited” her by leaving all of his assets to the child.

Of course in a community property state each generally has an undivided interest in the assets acquired during marriage, though the specifics of what is and is not community property will vary due to the specific state law and the actions of the parties. Nevertheless, almost certainly a large portion of the assets held by the couple were community property.  In such a case, the husband’s will could only transfer ownership of his portion of the assets.

Eventually a settlement was reached with the estate and the assets were divided.  As part of that division it was agreed that ½ of the IRA would be assigned to the surviving spouse and a State Court approved an order to the Custodian that it assign an amount of the IRA to the surviving spouse and treat it as a spousal rollover IRA.

The surviving spouse sought the following rulings:

  • Amount 1 of the IRA of Decedent naming Taxpayer B as sole beneficiary should be classified as Taxpayer A’s community property interest; then
  • Taxpayer A may be treated as a payee of the inherited IRA for Taxpayer B; then
  • The custodian of the inherited IRA for Taxpayer B can distribute Amount 1 to Taxpayer A in the form of a surviving spouse rollover IRA; and
  • The distribution of Amount 1 from the inherited IRA for Taxpayer B to Taxpayer A will not be considered a taxable event.

The IRS declined to issue any of the above rulings.

The IRS noted that the first ruling was solely an issue of state law, and the IRS did not have any authority to issue that ruling.  Rather that question was one to be decided by the State Court—but, as we’ll note, it isn’t a relevant issue in any event.

IRC §408(g) throws a monkey wrench into the proposed tax treatment.  It simply states:

(g) Community property laws

This section shall be applied without regard to any community property laws.

That one sentence manages to wreak havoc with the desired tax result in this situation.  While federal law generally looks to state law with regard to property rights, in some cases (and this is one) Congress has opted to override the state property law determination and base the tax result on a different standard.

In the ruling the IRS goes on to explain the rather harsh tax results of this settlement agreement:

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 Taxpayer A was not the named beneficiary of the IRA of Decedent and because we disregard Taxpayer A’s community property interest, Taxpayer A may not be treated as a payee of the inherited IRA for Taxpayer B and Taxpayer A may not rollover any amounts from the inherited IRA for Taxpayer B (and therefore any contribution of such amounts by Taxpayer A to an IRA for Taxpayer A will be subject to the contribution limits governing IRAs). Additionally, because Taxpayer B is the named beneficiary of the IRA of Decedent and because we disregard Taxpayer A’s community property interest, any “assignment” of an interest in the inherited IRA for Taxpayer B to Taxpayer A would be treated as a taxable distribution to Taxpayer B. Therefore, the order of the state court cannot be accomplished under federal tax law.

What about the fact that the State Court had ordered that the amounts be treated as a Spousal IRA?  The problem is that a State Court does not have the right to rewrite federal tax law, so an order signed off on by a State Court that demands a result contrary to federal law (as this one did) has no effect.

The only potential piece of good news is the fact that this ruling was issued.  Hopefully someone (very possibly the Custodian that had been ordered to do the impossible) raised the objection that the Court Order simply couldn’t accomplish its stated goal before the actual assignment took place.  That would explain why the ruling was sought and very possibly may have saved a lot of grief for the parties in this matter and their counsel who appear to have failed to consider this issue.

In tax practice it’s not unusual to find legal agreements and/or State Court orders that attempt to dictate a federal tax result that the parties involved have no right to dictate.  But before feeling too smug about tax professional’s superiority, tax advisers are just as likely to be blind to the impact of their actions in other areas of the law.  The real lesson here is to remember that our area of expertise, as is that of most every professional, is only a portion of the overall set of issues facing our clients.  We should remain very aware of the limitations of our expertise and be aware of when we are stepping outside that limited area.