The courts and the IRS have been very active recently in the divorce arena. Developments in the areas of nonalimony designations, dependency waivers, interest, retirement plans, IRAs, stock options, and stock redemptions significantly affect the negotiation of divorces and the taking of tax return positions after a divorce.
This is part two of a two-part series on those developments. In the February 2005 issue of Investment Advisor, the authors, who teach at Tennessee Technological University, focused on nonalimony designations and pension plans. This month, the focus is on the challenges surrounding IRAs and stock options. Both parts of the series are reprinted with permission from the September 2004 issue of the The CPA Journal, the official publication of the New York State Society of CPAs.
Transfers of IRA Interests to a Former Spouse
IRC section 408(d)(1) requires a taxpayer to include amounts paid or distributed from an IRA in gross income. Under the section 408(d)(6) exception, however, the transfer of an individual’s interest in an IRA to a former spouse under a divorce decree is not taxable to the individual. The interest is treated as the former spouse’s IRA. Nonetheless, taxpayers must meet two requirements: There must be a transfer of the IRA participant’s interest in the IRA to the spouse or former spouse, and this transfer must be made under an IRC section 71(b)(2) divorce or separation agreement. Case law contains many examples of taxpayers who withdraw funds from IRAs and then write checks to ex-spouses in order to comply with divorce judgments. These taxpayers must include the amount of the distribution in gross income and sometimes pay the 10% early-distributions penalty.
The 10% penalty on early distributions from qualified retirement plans does not apply to distributions made to an alternate payee pursuant to a QDRO within the meaning of IRC section 414(p)(1). [A QDRO is a Qualified Domestic Relations Order, pronounced "QUAD row" or "CUE dro".] A “domestic relations order” is defined as any judgment involving the provision of marital property rights to a spouse, or former spouse, of a participant that is made pursuant to a state domestic relations law. A QDRO is a specific type of domestic relations order that creates an alternate payee’s right to receive all or part of the benefits payable with respect to a participant under a plan, clearly specifies certain facts, and does not alter the amount of the benefits under the plan.
To qualify for this IRC section 72(t)(2)(C) exception, the distribution must be made by the plan administrator to an alternate payee in response to a QDRO. IRC section 414(p) provides certain procedural rules for domestic relations orders to provide guidance to plan administrators. Implicit in these rules is the requirement that a domestic relations order be presented to the plan administrator and adjudged “qualified” before any distribution by the plan to the spouse or former spouse [Rodoni v. Commissioner, 105 T.C. 29, 36 (1995)]. This was the crux of the dispute in Bougas v. Commissioner (T.C. Memo 2003-194). The divorce judgment ordered Bougas to pay a lump sum of $150,000 tax free to his ex-wife, $47,000 to various credit card companies, and $10,000 to her attorney. The divorce judgment also contained a provision that Bougas’s 401(k) and IRA accounts were his sole and exclusive property, free and clear of any claims by his spouse. The divorce judgment did not provide for a specific source of funds from which Bougas was to pay his divorce obligations. There was no mention of a QDRO nor any reference to making the wife an alternate payee on Bougas’s IRA.
After depositing a $250,000 distribution from his IRA into his personal checking account, Bougas wrote checks to satisfy the terms of the divorce judgment. He reported the $250,000 as income on his tax return, but did not report the 10% penalty for early withdrawal. The Tax Court said the divorce judgment was a domestic relations order under section 414(p)(1)(B), but that it did not qualify as a QDRO under section 414(p). It did not qualify as a QDRO because the divorce judgment did not create or recognize the wife’s right to receive any portion of her husband’s IRA as an alternate payee, nor did it award her any interest in the IRA. In addition, Bougas never submitted a copy of the divorce judgment to the plan administrator prior to requesting and receiving the distribution from his IRA.
The taxpayer tried to make the argument that he was only following the directions of the New Jersey court, which required him to make the IRA distributions to pay his divorce obligations. The court rejected the same argument in Czepiel [2001-1 USTC para. 50,134 (CA-1, 2000), aff'g T.C. Memo 1999-289]: The taxpayer was not required to pay his divorce obligations from his IRA; he chose to use the IRA because he had no other source of funds.