Penalty Applies Despite Taxpayer’s Good Intentions

Post Date: 7/24/17
Last Updated: 7/24/17


Cross References
- Summers, T.C. Memo. 2017-125, June 26, 2017

The taxpayer, age 35, and his wife decided that they should get a divorce. To minimize costs, they decided to accomplish their divorce without involving lawyers. They reached an agreement concerning child custody, visitation rights, child support, spousal maintenance, and division of property.

On March 18, 2013, the taxpayer filed a petition for dissolution of marriage, incorporating these agreements, in the Superior Court of Arizona, Maricopa County. At that time, the taxpayer had an IRA that he believed should be split 50-50 with his wife. His petition for divorce accordingly request that the proceeds of the IRA should be divided 50% to himself and 50% to his wife.

With the divorce petition pending, his wife was eager to simplify her financial affairs in order to get a fresh start. To accommodate her wishes, the taxpayer agreed to split the value of the IRA before the divorce decree became final. In late April of 2013, the taxpayer withdrew the total amount of the IRA and deposited the money into their joint checking account. The next day he wrote a check to pay off his wife's car loan, which was almost half the amount of the IRA withdrawal. He then directly gave her the rest of her half.

On June 3, 2013, the Arizona trial court entered a consent decree of dissolution of marriage. This decree incorporated substantially all of the agreements set forth in the taxpayer's March 18 petition. However, since he had already divided his IRA with his wife, the decree stated that neither party had a retirement, pension, deferred compensation, 401(k) plan, and/or benefits.

The taxpayer reported the IRA distribution on his tax return, but did not include the 10% penalty for early distribution of an IRA. He claimed the penalty did not apply because it was made to an alternate payee pursuant to a qualified domestic relations order under IRC section 72(t)(2)(C).

The court said the taxpayer did not qualify for this exception for two reasons:
1) The IRA distribution was made directly to the taxpayer who deposited the check into a joint bank account. While his ex-wife was ultimately the one who received the benefit of the proceeds, the IRA distribution itself was made to the taxpayer, not to a former spouse.
2) The distribution was not made pursuant to a qualified domestic relations order. The petition for dissolution of marriage requested a 50-50 division of the IRA, but then the taxpayer gave the proceeds to his wife before the divorce decree was entered. Accordingly, the decree said that neither party had a retirement, pension, deferred compensation, 401(k), and/or benefits. Thus, the IRA distribution was not made pursuant to that order or any other judicial decree.

The court said it had considerable sympathy for the taxpayer's position. In effect, his willingness to help minimize stress on his soon-to-be ex-wife disabled him from satisfying the strict statutory requirements for avoiding the early withdrawal penalty. Although the transaction could have been organized to avoid the early withdrawal penalty, the court said it was not at liberty to add equitable exceptions to the statutory scheme that Congress enacted. The 10% early distribution penalty applied despite the taxpayer's good intentions.
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