Property settlements and divorce decrees frequently provide for the division of pension assets between spouses following divorce. The asset could involve a 401K Plan, an Individual Retirement Account, or a defined benefit type pension plan. Clients and practitioners need to pay special attention to the possibility that such a transfer will be deemed by the Internal Revenue Service as a taxable event unless precautions are taken to make sure that the division of the asset is done in accordance with applicable rules and regulations.

Under Section 408(d)(6) of the Internal Revenue Code, the transfer of an individual's interest in an Individual Retirement Account, or an Individual Retirement Annuity to his spouse or former spouse under a divorce or separation instrument described in subparagraph (A) of section 71(b)2, is not to be considered a taxable transfer made by such individual notwithstanding any other provisions of the tax code, and such interest at the time of the transfer is to be treated as an Individual Retirement Account of such spouse, and not of such individual. Given that language of the tax code, one would think that a distribution of one-half of an individual's IRA to the divorced spouse would not be treated as a taxable event.

In a recent divorce order, the Court ordered an IRA owner to give half of his IRA accounts to his ex-spouse pursuant to division of the parties' marital property. The husband withdrew the ex-spouse's share from the accounts and gave her the cash. Husband contended that the distribution and transfer of his IRA proceeds following the divorce decree was a non-recognition event for him under the Internal Revenue Code and that no tax liability was due.

Husband was assessed the entire tax liability on the distribution and transfer and also had to pay a 10 percent early withdrawal penalty since the distribution was made prior to age fifty-nine and a half. Husband challenged the tax ruling by the Internal Revenue Service and brought his case before the Tax Court. The Tax Court in the case of Michael G. Bunney, Petitioner vs. Commissioner, 114T.C. No.17, held that the husband was liable for the full amount of the tax and penalty in that the tax payer failed to comply with IRS Code Section 408(d)(6) which provided that, in order to be a non-taxable event, there must be a transfer of the IRA participant's interest in the IRA to his spouse, or former spouse, pursuant to a divorce or separation instrument. In this case, the taxpayer merely liquidated a portion of his IRA account and transferred the proceeds to his ex-spouse. In this case, the taxpayer committed a technical violation of the rules and was assessed the full liability and penalty. Wife's interest in the IRA should have been transferred directly to her either in the form of a Qualified Domestic Relations Order or other appropriate transfer documents obtained from the financial entity where the IRA was held. This Tax Court case points out the need for competent legal and, in many instances, tax advice in the divorce area.