In an unusual private-letter ruling, the Internal Revenue Service recently allowed a 13-year-old beneficiary of her father's company plan assets largely to undo a previously taxed lump-sum distribution and transfer the distributed plan funds to an inherited IRA for the child's benefit.
In an unusual private-letter ruling, the Internal Revenue Service recently allowed a 13-year-old beneficiary of her father's company plan assets largely to undo a previously taxed lump-sum distribution and transfer the distributed plan funds to an inherited IRA for the child's benefit.
The income tax owed on distributions that were to be transferred to that individual retirement account would be eliminated.
The child's mother, who was her legal guardian when she inherited the plan assets, had elected to take a fully taxable lump-sum distribution from the plan and then misappropriated some of the funds for her own benefit. A state court ordered those funds to be repaid and the IRS, in somewhat of a surprising ruling, granted a request to allow the repaid funds to be transferred directly to an inherited IRA for the child's benefit.
“Mary,” the minor taxpayer, was the sole beneficiary of her father's employer-sponsored retirement plan. Her father was unmarried when he died Sept. 3, 2008, and Mary's mother served as her legal guardian.
Although Mary was entitled to make a direct transfer of her inherited plan assets to a properly titled inherited IRA, her mother instead chose to take a lump-sum distribution of the plan assets. The distribution was reported on Mary's 2008 federal and state income tax returns properly, and the corresponding tax liabilities were paid.
MISAPPROPRIATED MONEY
Unfortunately for Mary, her mother used a portion of the girl's inheritance for her own benefit. Although the private-letter ruling doesn't indicate exactly how much of Mary's money was misappropriated, it appears to have been a sizable portion of her inheritance.
At some point, a court-appointed conservatorship was established for Mary's estate. The conservator filed a suit in state court contesting the distribution made from the plan and seeking reimbursement from Mary's mother for her misuse of the funds.
The state court ordered that Mary's mother repay within 120 days the funds that she stole.
The court further ordered that the child's conservator seek assistance to try to amend her 2008 tax return to recover the taxes that she paid on the plan distribution.
Mary's mother repaid only a portion of the misappropriated funds. A priority judgment claim was established that called for the remaining balance to be repaid in monthly installments.
In order to restore her inherited retirement savings, Mary (or more accurately, someone acting on Mary's behalf) submitted this private-letter ruling requesting that she be considered eligible to make a trustee-to-trustee transfer — a direct rollover — of her inherited plan assets to a properly titled inherited IRA. The letter further requested confirmation that the funds being transferred back to the inherited IRA would again be tax-deferred, even though she initially paid the tax on the distribution when it was taken in 2008.
The IRS granted both of Mary's requests. In its decision, the IRS first noted that she was the sole beneficiary of her father's retirement plan assets and, as such, had been entitled to make a trustee-to-trustee transfer of her inherited plan assets to a properly titled inherited IRA.
The ruling further noted that the only reason such a transfer wasn't made was because Mary's mother, who was acting as her legal guardian at the time, took a lump-sum distribution of the plan's assets and used some of them for her own benefit.
The IRS, therefore, said that a trustee-to-trustee transfer of the reimbursed funds including any tax refunds received would be permitted and that this total wouldn't be included as income on Mary's 2008 federal income tax return.
However, the IRS made it clear that its decision was solely in reference to the applicable federal tax laws, and that the scope of a conservator's powers — namely, whether they can direct a trustee-to-trustee transfer of the girl's funds back to an inherited IRA — is a matter of state law.
Previous IRS rulings held that once inherited funds have left the “cocoon” of an inherited IRA or company plan, they are taxable to the non-spouse beneficiary and can't be undone. But in this case, the IRS, along with a favorable court ruling, provided a way to make it happen.
The IRS' decision was certainly influenced by the unusual circumstance of a mother who abused her power and stole from her child. As a financial adviser, you never know when something like this will occur, so always have your antennas up.
Ed Slott (irahelp.com), a certified public accountant, created the IRA Leadership Program and Ed Slott's Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace.
