Thursday, January 16, 2014

Are You Automatically Liable For Taxes On a Fraudulent IRA Withdrawal?

Sometimes people pursuing a divorce do stupid things.

I am looking this afternoon at Roberts v Commissioner.

The first thing I am thinking is that the wife will be fortunate to not be criminally charged. The second thing I am thinking is that the IRS could not present a more unfriendly face if they cast polar bears adrift on ice floes.

The Roberts in the case is the husband (H).

Roberts and his wife (W) married in 1990. They separated in 2008, permanently separated in 2009 and divorced in 2010.

Roberts and his wife kept joint bank accounts. After they separated, W kept the account at Washington Mutual and he kept his account at Harborstone. He did not have a checkbook for, write checks on or make withdrawals from Washington Mutual. In short, he had no idea about that account, despite the fact that his name was still on it.

In September 2009 one of his IRA custodians received a faxed withdrawal request for $9,000. The fax came from the company for which W worked. Coincidence, surely. The request was signed, but it was not signed the way Roberts normally signed his name.

A second IRA custodian also received two withdrawal requests, the first for $9,000 and the second for $18,980.

All the monies were deposited to that Washington Mutual account.

This took place over a two-month period. During that stretch, the wife deposited approximately $4,000 from her paycheck. She however spent over $41,000 from the account. The Court asked her about this discrepancy:

“We do not find credible [the wife’s] testimony that she was unaware of the sources of the deposits made to the Washington Mutual account when, in many instances, the deposits dwarfed the account’s balance at the time.”

Roberts let his wife prepare the 2008 tax return. Why not? She had prepared the returns for prior years.

She filed her return as “married filing separately.”

She filed his return as “single.”

She decreased the amount of his W-2 by $3,000. She increased his withholding by $3,000.

And she had his refund deposited to her bank account at Washington Mutual.

Roberts never saw the tax return.

You have figured out what was happening, of course.

Roberts continued oblivious to all this until he receives those pesky Forms 1099-R from the IRA custodians. Surely, they made a mistake. Alternatively he was the victim of a theft, he reasoned.

As the divorce grinds on he learned the truth of the matter. The divorce court considered the withdrawals when separating the property between the spouses.

In 2010 the IRS notified Roberts that they want almost $14,000 in tax and approximately $3,300 in penalties.

To say that the IRS took a strict reading of the tax law is to understate things. They argued: 

(1)  The income was his because he was the owner of the IRA accounts.
(2)  The monies were deposited into Washington Mutual, a jointly owned account.
(3)  The monies were used to pay for “family” expenses.
(4)  He never attempted to return the monies to the IRAs, even after he learned of the withdrawals.

Because of all this, the IRS argued that Roberts had unreported income in 2008.

It is pretty easy to tell that the Tax Court knew that the wife was lying. The Court also was brooking little patience for the IRS’ hyper-technical reading of the law, such as:

Roberts must include in income the amounts withdrawn from his IRAs even though he did not consent nor was he aware the distributions occurred.

Then the IRS trotted out two Tax Court decisions in Bunney and Vorwald.

In Bunney the IRS argued that the recipient of an IRA distribution was automatically the taxable party. 

COMMENT: The Court did not accept that argument in that case. Why would they do so now?  

In Vorwald the Court decided that a mandatory IRA distribution pursuant to a court-ordered garnishment for child support was income to the taxpayer.

            COMMENT: The IRS made more sense with this cite.

The problem with Vorwald is that the taxpayer had a legal obligation, and his IRA account was drained pursuant to that legal obligation. In the instant case Roberts was – essentially – robbed. He did not know that his wife was taking out monies to set up her post-divorce household, with a vacation sprinkled in.

The IRS then brought up their (in my opinion) best argument. In Washington state (where Roberts and his wife resided), an individual must discover and report unauthorized signatures within one year – essentially, a one-year statute of limitations.  Roberts did not do that. Granted, the withdrawals were taken into consideration when dividing marital property, but Roberts did not press for return of the monies.

And the Court did something unexpected: it paused. The IRS had a valid point. However, if there was a one-year statute of limitations, then Roberts had until 2009 to press his case. The Court looked at the tax years the IRS was challenging: year 2008 only. No year 2009.

Oops, said the Court. Sorry IRS. You flubbed.

The Court dismissed any taxes and penalties attributable to the IRA mess. It did allow taxes and penalties attributable to other minor issues on Roberts’ tax return.

We sometimes used to include a moral when reviewing tax cases. What would be the moral for today’s discussion? How about …

If you are divorcing, you may want to separate your finances, including your bank account – and your tax return – from the person you are divorcing.

Just saying.

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