by Bradford N. Dewan, J.D., MBA
In PLR 201623001, the IRS refused to allow a surviving spouse to roll over a portion of the deceased spouse’s IRAs that had been “assigned” to her by the couple’s son. The son was the sole beneficiary named on the beneficiary designation forms. This family lived in a “community property” state. Thus, the surviving spouse claimed that she had a “community property” interest in her deceased spouse’s three IRAs. The son, the decedent’s estate, and the local state court accepted the claim. The IRS denied the request to have the assigned funds treated as a spousal rollover based on the community property claim. The IRS based its decision on IRC section 408(g) which states: “This section shall be applied without regard to any community property laws.”
A married IRA owner, who resided in a community property state, named his child as the sole beneficiary of his three IRAs. After the owner passed away, the IRAs were retitled as an inherited IRA for the child beneficiary. The surviving spouse then filed a claim against the decedent’s estate for one-half interest in the community property that the deceased spouse and the surviving spouse owned. The surviving spouse and the decedent’s estate negotiated a settlement under which the surviving spouse’s community property interest in the estate was valued at “Amount 1”. Importantly, the settlement was with respect to the community property interest in the total of the decedent’s estate (not just in the decedent’s IRAs). A state court in the community property state approved the settlement and ordered that the custodian of the IRAs assign Amount 1 of the inherited IRA for the child to the surviving spouse as a spousal rollover IRA.
The surviving spouse requested a PLR from the IRS asking that:
the negotiated amount (i.e. Amount 1) of the child’s inherited IRA should be classified as the surviving spouse’s community property interest;
the surviving spouse may be treated as a payee of the child’s inherited IRA;
the custodian of the child’s inherited IRA can distribute the Amount 1 to the surviving spouse in the form of a surviving spouse rollover IRA; and
the distribution of Amount 1 from the child’s inherited IRA to the surviving spouse will not be considered a taxable event.
IRS Denies Request
The IRS first references Section 408(d)(1) which provides that “any amount paid or distributed out of any individual retirement plan shall be included in the gross income of the payee or distributee.” Section 408(d)(3) is then referenced which permits rollovers by the “individual for whose benefit the [IRA] is maintained.” The IRS notes that rollovers are not permitted from inherited IRAs.1 Inherited IRAs are defined as IRAs where (i) the individual for whose benefit the IRA is maintained acquired the IRA by reason of the death of another individual, and (ii) such individual was not the surviving spouse of such other individual.2 Section 408(g) is then referenced which states that Section 408 “shall be applied without regard to any community property laws.”
Regarding the first ruling request, the IRS declined to make a ruling on whether an amount of the inherited IRA for the child should be classified as the surviving spouse’s community property since the IRS deemed that this is a matter of state property law and not a matter of federal tax law.
In regard to the second, third, and fourth ruling requests, the IRS noted that the child was the named beneficiary of the IRA of the deceased spouse and that the IRA had been retitled as an inherited IRA for the child. The IRS then denied all of these requests mainly due to Section 408(g) (i.e. Section 408 will be applied without regard to any community property laws.) Therefore, the IRS ruled, Section 408(d)’s distribution rules must be applied without regard to any community property laws. Consequently, since the surviving spouse was not the named beneficiary of the decedent’s IRA and since the surviving spouse’s community property interest is to be disregarded, the surviving spouse may not be treated as a payee of the inherited IRA for the child. In addition, the surviving spouse may not rollover any amounts from the inherited IRA for the child. Moreover, since the child was the named beneficiary of the decedent’s IRA and because the IRS disregarded the surviving spouse’s community property interest, any “assignment” of any interest in the inherited IRA for the child to the surviving spouse would be treated as a taxable distribution to the child. In conclusion, the IRS states: “(T)he order of the state court cannot be accomplished under federal tax law.” Thus, the IRS may be implicitly saying that the state court was wrong in trying to address federal tax law issues regarding this IRA.
As a result, the spouse’s community property interest is disregarded under federal tax law and the child beneficiary would continue to be viewed by the IRS as the payee of the inherited IRA. Consequently, if the court order were to be carried out with the IRA funds being assigned to the spouse, the withdrawal would be a “double whammy” for the child. Not only would the child lose the inheritance (with the potential for tax deferred growth), but the assignment of the inherited IRA assets from the child to the spouse would be taxable to the child beneficiary and ineligible for rollover to the spouse’s IRA.
IRA owners who live in community property states, such as California, have wrestled with the question of how to recognize the alleged non-participant spouse’s community property interest in the participant’s IRA. Unfortunately, there are very few cases or rulings that address this issue. However, one such case was Bunney3 which held that when the participant withdrew funds from his IRA and paid them to his wife in satisfaction of her community property interest, that this was a taxable distribution to the participant and not a non-taxable spousal rollover. Thus, this PLR can be viewed as confirming Bunney in a post-death situation. Consequently, there is really only one solution to this issue in community property states. A married couple residing in a community property state and wanting to formalize each spouse’s community property interest in the other spouse’s IRA will need to name each other as beneficiary of their respective IRAs at least to the extent of the nonparticipant’s spouse’s community property interest in the IRA.
1. IRC Section 408(d)(3)(C).
2. IRC Section 408(d)(3)(C)(ii).
3. 114 T.C. 259 (2000).