Mistaken IRA rollover creates problems for taxpayer

The Tax Court held that distributions received by a taxpayer from her individual retirement account (IRA) funded by an erroneous rollover into that account from her late husband’s IRA was gross income and subject to the 10% early withdrawal penalty. Despite the fact that the brokerage service acting as trustee of both spouses’ IRAs should not have transferred the funds into the taxpayer’s IRA, the Tax Court held that her tax liability must be determined based on the source of the distributions after the improper rollover.

Facts: Suzanne Ozimkoski was married to Thomas Ozimkoski Sr. until his death at age 61 in August 2006. Under the terms of his will, Mrs. Ozimkoski was to receive the traditional IRA that he owned through Wachovia Securities. Later in 2006, Wachovia froze Mr. Ozimkoski Sr.’s IRA after the taxpayer’s stepson, Thomas Ozimkoski Jr., contested the will in probate court. As part of a settlement reached in March 2008, Mrs. Ozimkoski had to pay $110,000 (free of any tax) to her stepson within 30 days after Wachovia released the IRA.

In 2008, Wachovia transferred $235,495 from Mr. Ozimkoski Sr.’s IRA into the taxpayer’s traditional IRA. Later in 2008, she received distributions of $174,597 from her IRA, $110,000 of which was used to pay the settlement owed to her stepson. She filed her 2008 Form 1040, U.S. Individual Income Tax Return, on May 9, 2009, reporting only her wages of $14,960. In 2010, the IRS issued a deficiency notice of $62,185 for (1) the tax on the IRA distributions she failed to report as income; (2) the 10% premature withdrawal penalty tax on those distributions; (3) a penalty for the failure to file a timely income tax return; and (4) an accuracy-related penalty due to a substantial understatement of income tax. Mrs. Ozimkoski petitioned the Tax Court for relief.

Issues: When an IRA owner dies before his or her required beginning date for minimum distributions and there is no designated beneficiary, the account must be liquidated by Dec. 31 of the fifth year following the owner’s death. The five-year rule applies whether the decedent’s estate receives the IRA or someone inherits it. Distributions from an inherited traditional IRA are income to the recipient of those distributions. Generally, distributions received from an IRA before age 59½ are subject to the 10% early withdrawal penalty; however, an exception exists for distributions from an IRA inherited from a deceased owner. Mrs. Ozimkoski argued that the distributions were not income because her stepson was entitled to $110,000 of his father’s IRA due to the settlement. The IRS argued the distributions were taxable to her because they were distributed to her from her IRA.

Holding: The court held that the distributions were taxable to Mrs. Ozimkoski because she received them from her IRA, even though under Florida law the assets in her late husband’s IRA should not have been transferred into her IRA but instead should have been distributed to his estate. Although the court found that Wachovia incorrectly rolled over the funds to Mrs. Ozimkoski’s IRA, it also determined that it had no jurisdiction to unwind that transaction and was required to decide Mrs. Ozimkoski’s tax liability on the basis of Wachovia’s erroneous rollover of the funds to her IRA and the subsequent distributions from it.

The court also held that the 10% penalty applied because she did not qualify for the exception for distributions from an IRA of a deceased IRA owner. According to the court, once her late husband’s IRA was rolled over into her IRA, the distributions were from her IRA, not her deceased husband’s IRA, and thus the inherited IRA exception did not apply.

Also, despite the taxpayer’s argument that the late filing of her 2008 tax return was due to her being overwhelmed by the contesting of the will, the court upheld the late-filing penalty because, under Tax Court precedent, litigation is not a reasonable cause for the failure to file a timely tax return. The court did hold that Mrs. Ozimkoski was not liable for the entire accuracy-related penalty for substantially understating her income tax. Given her experience, knowledge, and education and the fact that Wachovia had incorrectly transferred the amount into her IRA, the court held that she had acted in good faith and had reasonable cause for failing to include in her 2008 income the $110,000 of the distributions that she received to pay her obligation to her stepson.

• Ozimkoski, T.C. Memo. 2016-228

—By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota—Duluth.