Ozimkoski v. Commissioner,
T.C. Memo. 2016-228 (December 19, 2016)

Mrs. Ozimkoski (Suzanne) represented herself in this Tax Court case. She may also have represented herself in the final days of settling the litigation brought by her step-son against her after her husband died. Clearly not all of the pertinent facts were before the Tax Court much as they sought those facts, which only hurt Suzanne in the final outcome. At issue in this case is the taxation of the IRA owned by Suzanne’s husband prior to his death.

The facts, to the extent they were part of the record, were relatively simple. Mr. Ozimkoski provided in his simple two-page Will that all of his probate estate was to pass to Suzanne as his surviving spouse and that she was to serve as his personal representative. At the time of his death, Mr. Ozimkoski was the owner of an IRA held at Wachovia Securities, a brokerage house (“Wachovia”). After the death of Mr. Ozimkoski, his son who was Suzanne’s step-son, filed a will contest, seeking to invalidate Mr. Ozimkoski’s Will. Once the will contest was filed, Wachovia froze the IRA.

In settling the litigation, Suzanne agreed to pay the decedent’s son $110,000 within 30 days of the date Wachovia unfroze the IRA. The agreement further provided that “All payments shall be net payments free of any tax.” Wachovia’s manager of estate processing requested a certified copy of the agreement from the court and a letter from Suzanne “stating exactly how to divide Mr. Ozimkoski’s IRA account to accommodate the order.” The manager also informed Suzanne’s attorney that someone would have tax implications with respect to this settlement. After those communications, Wachovia apparently was instructed to roll the IRA into Suzanne’s IRA, which it did, and then was directed to distribute most of the funds from Suzanne’s IRA to her checking account. Suzanne then wrote a check to the decedent’s son for the $110,000. Suzanne apparently never provided Wachovia or the court with a copy of the settlement agreement and instructions regarding division of the IRA.

The following year, Wachovia issued its 1099 to Suzanne for the distribution, but despite the 1099, Suzanne did not report that income on her 1040 for the year she took the IRA distribution. The Service then issued a deficiency to Suzanne for (1) the income tax due on the amount of the withdrawal, (2) the early withdrawal penalty for withdrawing amounts from her IRA prior to age 59 ½, and (3) the underpayment penalty.

During the Tax Court case, Suzanne did not introduce any evidence as to the beneficiary of the IRA. The Court then concluded that the only reason Wachovia would have frozen decedent’s IRA as a result of a will contest was that the decedent’s estate must have been the IRA beneficiary. Therefore, the IRA should have been administered by the personal representative as part of the estate and assigned to the proper beneficiaries of the decedent’s estate after settlement of the litigation. It is not clear the basis used by Wachovia or by Suzanne for rolling the decedent’s IRA to Suzanne’s own IRA. Either Wachovia made a mistake in doing so, as was suggested by the Court, or the IRA was allocated to Suzanne as part of the settlement of the litigation.

Once the IRA funds were part of Suzanne’s IRA, the distribution of funds from that IRA to Suzanne’s bank account was a taxable distribution to her, and includible in her income pursuant to IRC § 408(d)(1). The record was unclear whether Suzanne’s attorney had counselled her as to the tax implications of the agreement, or as to the tax impact of rolling the IRA over to her own IRA. It is also unclear as to whether Suzanne sought her attorney’s counsel in settling the litigation or having received such counsel, whether she just ignored her attorney’s counsel. Unfortunately for Suzanne, the Court could not change the facts, and the facts that were either assumed or implied from the evidence before them led to Suzanne paying the tax on the distribution from her IRA.

Suzanne could have heeded the request from Wachovia to provide a copy of settlement agreement, the court order approving the settlement and a letter from her as the personal representative directing the manner in which the IRA was to be divided. In that case, Suzanne could have directed that some fraction of the IRA be assigned to the son and the remainder assigned to her. She could have rolled over her own portion into her IRA and the son could have taken his distribution from the IRA portion allocated to him. However, the son would have been taxed on the amount allocated to him, and the agreement provided that he was to receive his distribution net of income tax. Nevertheless, this tax provision in the agreement could have been addressed by increasing the amount allocated to him to the extent needed to result in the son receiving $110,000 net of income tax. It is possible that settlement would not have occurred at all except due to Suzanne’s willingness to structure the deal in the manner chosen. In any event, having made her deal, she was stuck with the tax consequences.

The salt in the wound, however, was that, Suzanne not only had to pay the income tax, plus interest, but she also was hit with a 10% early withdrawal penalty for having rolled over the funds into her own IRA prior to withdrawing the funds prior to reaching age 59½ to comply with the settlement with her step-son. There is no exception in IRC § 72(t) for withdrawals to settle litigation.

However, Suzanne could have easily avoided this penalty. If she had not rolled over the decedent’s IRA to her own IRA, and instead kept the IRA in an inherited IRA for her own benefit, she could have withdrawn the funds from the IRA without incurring the 10% early withdrawal penalty. That is because the rules regarding distributions are different for inherited IRAs, which can be withdrawn at any time without penalty. There is no requirement that a surviving spouse rollover funds inherited from a deceased spouse. Instead, good planning for a young surviving spouse calls for a determination of the amount the young surviving spouse will need to withdraw prior to age 59½. That amount should remain in an inherited IRA for the benefit of the surviving spouse and only the balance not needed prior to age 59½ should be rolled over to the spouse’s own IRA.

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