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George F. Bearup, J.D. Senior Legal Trust Advisor

13-Sep-19

Fixing IRA Beneficiary Mistake With a Court Order

Take-Away: We have yet another example of the IRS’s apparent move towards leniency in addressing IRA distribution ‘mistakes’ in a recent private letter ruling (PLR), where the IRS accepted a court order that changed the decedent’s IRA beneficiary from his children to his surviving spouse.

Private Letter Ruling: No. 201934006, Dated May 30, 2019, released August 23, 2019

Facts: The decedent IRA owner died after he had attained his required beginning date, i.e. 70 ½. At the time of his death, the decedent was married with children. The decedent’s children were named as the beneficiaries of his IRA, not his surviving spouse. “Subsequently, a state court named Taxpayer [the surviving spouse] the sole beneficiary of Decedent’s IRA and she represents that she remains the sole beneficiary and has unlimited right to withdraw the amounts from it.” This PLR does not tell us why the state court ruled as it did. All we have is the quote above, that a court order changed the beneficiary of the decedent’s IRA from his children to his surviving spouse. The surviving spouse sought assurances from the IRS that she could roll her late husband’s IRA into her own IRA.

Law: Treasury Regulations provide that a surviving spouse of an individual may elect to treat the decedent’s entire IRA as the surviving spouse’s own IRA. In order to make this election, the surviving spouse must be sole beneficiary of the deceased spouse’s IRA and he/she must possess the unlimited right to withdraw amounts from that IRA. If a trust is named as the beneficiary of the decedent’s IRA, this election option/requirement is not satisfied even if the surviving spouse is the sole beneficiary of the decedent’s trust. [Treasury Regulation 1.408, Q&A-5.]

IRS Ruling: Because the surviving spouse was the named beneficiary of her late husband’s IRA by virtue of the court order, she was permitted to roll over the distribution from her late husband’s IRA into her own IRA within 60-days of the funds receipt. [IRC 408(d) (3) (A) (i).] “Because Taxpayer [surviving spouse] is entitled to the proceeds of Decedent’s IRA as the sole beneficiary, for purposes of applying section 408(d)(3)(A) to Decedent’s IRA, Taxpayer is the individual for whose benefit the account is maintained. Accordingly, if Taxpayer receives a distribution of the proceeds of Decedent’s IRA, she may roll over the distribution (other than amounts required to have been distributed or to be distributed in accordance with section 401(a) (9) [i.e. the deceased spouse’s RMD for the year of death are not subject to a roll-over] into one or more IRAs established and maintained in her name.”

Frustration: Unfortunately, this PLR does not tell us why the state court ruled as it did, removing the children as the beneficiaries of their father’s IRA and replacing them with their mother.

  • There is no reference to the terms of the IRA custodial agreement, where maybe the surviving spouse was the default beneficiary, if the designated beneficiaries failed for some legal reason, e.g. fraud on their father, or mistake by the custodian.
  • Did the children disclaim their beneficial interests in their father’s IRA? If that was the case, why the need for a probate court order if the disclaimers automatically caused their mother to become the sole beneficiary of the decedent’s IRA?
  • Did the children consent (the equivalent of a taxable release) to the entry of the court order that removed them as IRA beneficiaries, which consent could be treated by the IRS as a taxable gift by the children to their mother?
  • Was the court order entered after contested litigation between the children and their mother, which adversarial contest is often looked upon by the IRS as indicia that the state court order is not an artifice used to avoid taxation?
  • Was the trial court order sustained by the highest court of the state, which the IRS often uses as a precondition, and definitive statement of the property rights of the litigants?
  • None of these questions were addressed in this short PLR, just that a state court order removed the children as beneficiaries and made the surviving spouse the sole beneficiary of her deceased husband’s IRA, which enabled her to rollover the balance of the IRA to her own IRA without any adverse income tax consequences.

State Court Orders: With regard to questions of state law:

  • A state probate court order or judgment is not binding on the IRS. The only state court whose judgment the IRS must defer to is the highest court in the state. Estate of Bosch, 387 U.S. 456 (1967).
  • If a court order resolves a probate court dispute settlement that was, in the IRS’s view, bona fide and the settlement is within the range of reasonable settlements, which can leads to a spousal rollover, it may be respected. [PLR 2001-27027.]
  • Similarly, if the state court order resolves adversarial litigation over an inheritance, the IRS may respect that court order that alters the distribution of an IRA.[PLR 2007-07158]
  • The IRS will refuse to recognize a post-death beneficiary designation reformation [or the reformation of a Will or Trust] by court order due to the possibility of a collusive reformation that is entered into solely for reducing federal tax liability. [PLR 2010-21038.]
  • A judicial reformation of an IRA beneficiary designation to add a contingent beneficiary when the primary beneficiary does not survive the IRA owner (which leaves the IRA owner’s probate estate as the default beneficiary) will be rejected by the IRS. [PLR 2007-42026.]
  • A state court’s interpretation of an IRA beneficiary designation, sometimes by a declaratory judgment, rather than its reformation will be rejected by the IRS. [PLR 2008-46028.]
  • There are, however, a few occasions where a reformation will be accepted by the IRS if an IRA beneficiary designation is found by a probate court to be signed while under the undue influence of the named IRA beneficiary [PLR 2007-07158], or the reformation of the beneficiary designation is a way to reduce probate costs by redirecting the IRA assets from the IRA owner’s probate estate (which is the named beneficiary) to a trust that is the residuary beneficiary of the IRA owner’s estate so the IRA assets are not used to pay creditors or expenses of estate administration. [PLR 2006-52028.]

Conclusion: PLRs are not binding precedent and they are not to be cited as precedent by any taxpayer other than the one who requests the PLR. Nevertheless, PLRs do provide some guidance to others when their factual circumstances are similar to the situation that is reported in the published PLR. This recent PLR is helpful in that it provides some optimism for IRS leniency when a probate order is entered that changes the beneficiary of a decedent’s IRA, which can lead to income tax deferral through a surviving spouse rollover. However, it is not helpful since it provides no guidance as to why the state court order was entered, it does not describe the type of state court order, e.g. a reformation or a change to address undue influence of the IRA owner, no grounds for the judicial change in IRA beneficiaries is provided, and no indication is given whether the order was simply a state trial court, or the order relied upon by the IRS was affirmed by the highest court of that state. Maybe the IRS is actually becoming more lenient in its willingness to respect post-death judicial changes to IRA beneficiary designations and I am just too cynical to accept that change. If so, a bit more guidance as to when and why a court order will be respected would be helpful.