VOL. 110 | NO. 12 | Thursday, January 18, 1996
01/17 Law analys
Some Call It "Scorched Earth"
By DOROTHY SANDERS WELLS
Special to The Daily News
Imagine this scenario: A couple is about to divorce and "Husband" and "Wife" are preparing to divide their marital property. Husband, who is a participant in a tax-qualified pension plan, receives a lump-sum distribution from the plan. Anticipating the marital dissolution agreement soon to be entered with Wife, he gives the distribution to her as part of the marital property division. She, in turn, deposits the distribution into her Individual Retirement Account within 60 days, thinking that the distribution is eligible for rollover treatment. What could possibly be amiss in this picture?
1. According to the tax court in Rodoni vs. Commissioner, 105 T.C. No. 3 (1995), a "rollover distribution" can only be rolled into an IRA established for the benefit of the participant or beneficiary who actually receives a distribution from the plan. Since Wife did not receive the distribution from the plan, the tax court found that she was not entitled to roll it to her IRA.
2. What about the marital dissolution agreement: could it have been a qualified domestic relations order? The tax court points out that Wife received the funds prior to the time that her rights (as an alternate payee) would have arisen under the marital dissolution agreement, even if the agreement otherwise would have satisfied the requirements for a QDRO. Therefore, the "distribution" was not made pursuant to a QDRO.
3. What about the tax consequences? If the distribution had been made pursuant to a QDRO, the Wife as alternate payee would have been liable for taxes on the distribution to her and would have been able to roll the distribution to her IRA. Since the distribution was not made pursuant to a QDRO, Husband was liable for the taxes on the distribution, as well as the 10 percent excise tax on early distribution. Wife was subject to the 6 percent excise tax on excess IRA contributions (more than $2,000) since the distribution did not qualify for rollover treatment. The total? A pretty hefty price tag on an otherwise seemingly routine division of marital property.
4. Was there any way to salvage this transaction before it turned to disaster? One solution would have been for Husband to roll the distribution within 60 days of receipt to his IRA and then use Code Section 408 (d)(6) to effect a tax-free transfer from his IRA to Wifes IRA. Or, Husband could have delayed distribution from the plan until a QDRO could be entered, so that the distribution would have been made directly to Wife as alternate payee.
The Rodoni case is yet another of the divorce/distribution snafus, following that unfortunate tale of Dr. Hawkins, the orthodontist who took a $1 million distribution from his qualified plan in order to honor a court order requiring him to make the disbursement as part of his divorce settlement. Since the order itself was not a QDRO and, therefore, the distribution was not made pursuant to a QDRO Dr. Hawkins (and not his ex-wife) got stuck with the tax bill.
Tax ramifications are not the only reasons for making certain that a valid QDRO has been entered before making distributions when a participant is divorcing. Recall that one of the qualification provisions in both the Internal Revenue Code and Employee Retirement Income Security Act is that benefits accruing to a participant in a qualified pension or profit sharing plan may not be assigned or alienated (i.e., paid to any person other than the participant or a beneficiary). QDROs are exceptions to the anti-alienation rules. Payment to a former spouse or child of a participant where there is no valid QDRO means a violation of the anti-alienation rules and possible disqualification of the plan.
The moral of the story for attorneys and benefits professionals: make certain that a valid QDRO has been entered before making any distributions upon a participants divorce.
Wells is an attorney with Waring Cox PLC and practices primarily in the areas of employee benefits and taxation. This article was adapted with permission from The Benefits Update, copyright 1995 by Waring Cox PLC.