Don't blame the custodian for IRS levies

A lthough individual retirement accounts are tax shelters, a recent federal court ruling drove home the point that the retirement vehicles are taxable and that they are not sheltered from a demand for payment by the Internal Revenue Service (Mark Andres Green v. Pershing LLC, 10th U.S. Court of Appeals, June 6). Mark Green had an IRA with Next Financial Group. Pershing LLC is the securities clearing firm that held his IRA and provided services to Next Financial. In January 2010, the IRS sent a notice of levy to Pershing, attaching Mr. Green's IRA for unpaid taxes of more than $329,000. Pershing notified him in a letter dated Jan. 26, 2010, and informed him that it had to put a hold on his IRA until the tax levy was paid. At the time, the value of Mr. Green's IRA was more than $113,000. Mr. Green apparently didn't pay the taxes, so four months later, in May, the IRS sent a final demand for payment to Pershing, ordering it to turn over the IRA. The payment demand also said that Pershing would be liable for penalties if it didn't comply with the levy. Mr. Green notified Pershing that his IRA shouldn't be forwarded to the IRS, because he was fighting the levy, but the firm ignored his request and complied with the demand. The firm turned over his $113,457 IRA balance to the IRS and notified Mr. Green that it had done so.

SUIT AGAINST PERSHING

Mr. Green then filed a lawsuit against Pershing, claiming that Pershing shouldn't have complied with the levy. He argued that Pershing had erred, including that the levy procedures weren't followed correctly by the IRS and that Pershing had no authority to issue a check to the IRS. The lawsuit sought to recover Mr. Green's IRA funds plus $1 million in cumulative damages. Pershing moved to have the suit thrown out, arguing that the law expressly shields the firm from liability to the taxpayer when it surrenders someone's property as a result of an IRS levy. The U.S. District Court for the Northern District of Oklahoma ruled against Mr. Green and in favor of the IRA custodian. The court said that the levy procedures were followed correctly by the IRS and that the IRA custodian wasn't liable for turning over his IRA to the IRS in response to the tax levy. The court noted that the IRS is authorized under Internal RevenueCode Section 6321 to impose tax liens on “all property and rights to property, whether real or personal, belonging to [a] person.” As far as Mr. Green's claim for damages against the custodian, the court said that the tax code specifically absolved Pershing from any liability. Mr. Green disagreed with the court's ruling and filed an appeal, but the 10th U.S. Circuit Court of Appeals agreed with the Oklahoma district court decision and said that the IRA custodian wasn't liable for turning over his IRA. As a result of the appeals court decision, Mr. Green didn't get his IRA money back and couldn't sue the custodian for damages. In addition, the levied IRA distribution in 2010 was taxable.

NO PENALTY

The only saving grace for Mr. Green is that regardless of his age, no 10% early-distribution penalty would be owed on the levied funds, as there is a specific exception to the penalty for just such an event. A levied IRA is taxable. It is treated as though the client took a complete distribution of the levied assets and then paid those funds to the IRS. Despite the very black-and-white nature of this fact, there are many cases in which individuals have fought this in court. The courts have consistently ruled, however, that levied IRAs are included in income. Although an IRA distribution made pursuant to an IRS levy is taxable, there is a special exception to the 10% early-distribution penalty for such circumstances. Therefore, even if a client is younger than 591/2 at the time of the levy, he or she won't owe a penalty. This can create a strange tax- planning situation in certain circumstances. If a client younger than 591/2 owes money to the IRS and his or her only available asset is a retirement account, the client might actually want — as crazy as it sounds — the IRS to levy the account. If the client voluntarily used his or her IRA funds to pay off tax debt and was younger than 591/2 at the time, the 10% penalty would apply. By contrast, if the same funds were levied by the IRS to satisfy a tax debt, then no penalty would apply. Ed Slott (irahelp.com), a certified public accountant, created The IRA Leadership program and Ed Slott's Elite IRA Adviser Group.