The recent United States Tax Court case of Jeremy Ray Summers v. Commission, T.C. Memo 2017-125, is an example of the old adage that “no good deed goes unpunished.” The case also highlights how sometimes form triumphs over substance in tax matters.
The facts are not complicated. Jeremy Ray Summers (Jeremy) was married to Karie Rae Summers (Karie). When their marriage broke down, they decided to accomplish their divorce in the least acrimonious manner possible and to minimize costs, they did so without involving lawyers. In Jeremy’s petition for divorce, he requested that the proceeds of his IRA be divided 50% to Jeremy and 50% to Karie.
The facts also indicate that Karie did not work outside the home and that she had several debts. Karie, with the divorce pending, was apparently anxious to get her financial affairs in order and wanted to get off to a fresh start quickly. Jeremy accommodated her wishes by splitting the IRA about one (1) month before the divorce decree became final.
His IRA had a total balance of $17,378 – so Karie was to receive a benefit of $8,689. Jeremy withdrew the entire balance – and he used $8,618 to pay off Karie’s car loan and he transferred another $71 to her so that she would receive the economic benefit of her full 50% interest (or $8,689) in his IRA.
The IRA distribution to Jeremy triggered a Form 1099-R which noted “early distribution, no known exception.” This triggered an audit and the issuance of a notice of deficiency that Jeremy was liable for 10% additional tax, which is generally imposed under IRC §72(t)(1) for early distributions.
IRC §72(t)(2) lists various types of distributions that are excepted from this additional tax. Jeremy argued that the exception in IRC § 72(t)(2)(C) – which applies to distributions made to an alternate payee pursuant to a qualified domestic relations order (QDRO) – should be applicable in his case. An alternate payee includes a spouse or former spouse. A domestic relations order includes a judgment, decree, or order relating, among other things, to the provision of marital property rights.
The Tax Court found that the QDRO exception did not apply because 1) the distribution was made directly to Jeremy (not to Karie), and 2) the distribution – even though it was made by Jeremy’s “well-intentioned” effort to divide the IRA a month before the decree was entered – was not made pursuant to an order or decree. The Court states that the taxpayer must “strictly comply” with the requirements of IRC 72(t)(2)(C) and that all of the requirements of the QDRO provisions must be “rigidly observed.”
The Court then concludes by stating as follows:
We have considerable sympathy for petitioner’s position: In effect, his willingness to help minimize stress on his soon-to-be ex-wife disabled him from satisfying the statutory requirements. But we are not at liberty to add equitable exceptions to the statutory scheme that Congress enacted, and we thus have no alternative but to sustain the 10% additional tax that respondent has determined.
While the end result seems unfair in this instance, it appears the case could be used in the future to structure IRA divisions so as to avoid the 10% additional tax. In this author’s experience, QDROs are generally not applicable (and are therefore not needed or used) for dividing IRAs – rather, QDROs are usually only applicable for ERISA-governed retirement programs. Having said that, if one can (and does) use a QDRO for an IRA, it appears that the alternate payee (ex-spouse) may be able to save the 10% additional tax if there was a distribution pursuant to such QDRO.
On a final note, it is worth pointing out that in Summers v. Commission, Jeremy was pro se. This seems rather prudent – given that the amount of the tax deficiency was $1,738. On the other hand, not wanting to leave anything to chance, the decision shows the IRS used three (3) lawyers in the case in order to seal its victory.