IRAs Can Be Taxing

Under a 1995 divorce judgment, Richard Czepiel was ordered to pay, “as a further division of the marital property,” $29,000 to his ex-wife Kathleen. Czepiel’s only assets at the time were $33,000, which he had on deposit in two separate IRAs.

In order to satisfy the terms of the judgment, Czepiel directed his banks to liquidate the IRAs and issue him checks for the proceeds. He then wrote a check to his ex-wife as full payment of the divorce judgment.

The next year, Czepiel failed to include the IRA withdrawals as income on his 1995 tax return. Subsequently, the IRS issued a deficiency notice, claiming he was liable for taxes related to the IRA distributions under IRC section 408(d)(1).

Czepiel took the IRS to court. In Commissioner v. Richard D. Czepiel (TC Memo. 1999–289), he argued that the divorce judgment was a qualified domestic relations order (QDRO), as defined in IRC section 414(p), because the Family Court had in effect ordered him to make the withdrawal. He contended that since the divorce judgment was a QDRO, his ex-wife should be taxed on the IRA proceeds. He also argued that the 10% penalty for early withdrawal of funds from an IRA (IRC section 72 (t)) should not apply to him because the withdrawals had been involuntary.

To succeed in this defense, Czepiel had to show that IRC section 408(d)(6) applied. Under that section, if he could prove the court had ordered him to transfer the IRAs to his spouse, he would not have to include the distributions in his gross income for tax purposes.

The IRS countered that Czepiel had not transferred his IRAs to his ex-wife—he’d converted them into cash first and then given her the amount ordered. Thc IRS argued that the court had not ordered Czepiel to transfer all or a portion of the IRAs to his ex-wife. It simply had ordered him to pay her $29,000.

The Tax Court agreed with the IRS and held that the IRA distributions should be included on Czepiel’s 1995 tax return as income. It concluded that he had “initiated, received, and controlled the withdrawals.” The Court also found Czepiel liable for the 10% early withdrawal penalty.

Observation. The taxpayer’s problems could have been avoided if he had hired a competent tax practitioner to advise him in this situation. In this case, a CPA would have secured a QDRO that required him to make the IRA withdrawals as part of his divorce settlement.

—Michael Lynch, CPA, Esq., professor of tax accounting at Bryant College, Smithfield, Rhode Island.