Yes, Virginia….

March 25, 2012

Authored by: Kathy Sherby and Stephanie Moll

In an unusual ruling, the IRS shows it has a heart when it comes to helping a minor recover inherited funds misappropriated by the minor’s mother.  In PLR 201139011, the Service permitted the minor to contribute funds to an inherited IRA that were inappropriately distributed in a lump sum from a qualified plan she inherited from deceased father.

The minor, whom we’ll call Alice, was 13 when her father, whom we’ll call Eric, died.  Eric, who was unmarried at the time of his death, had designated Alice as the beneficiary of his qualified plan.  While Alice could have arranged for a trustee to trustee transfer of the qualified plan benefits to an inherited IRA, Alice’s mother and guardian, whom we’ll call Francis, instead arranged for the plan administrator to make a lump sum distribution of the benefits.  Francis then reported the distribution on a Form 1040 filed for Alice for 2008 and paid the income tax on the distribution.  In 2009, a petition was filed (by an undisclosed person) seeking the appointment of a financial institution as conservator for Alice.  Once Bank was appointed as Alice’s conservator, Bank filed suit against Francis for recovery of the qualified plan distribution.

Francis provided evidence of her expenditures of the funds in part for Alice’s benefit.  The Court then ordered Francis to reimburse to Bank, as Alice’s conservator, the amount of the benefits she received less the amount expended for Alice’s personal expenses.  The Court also ordered Bank to determine whether Alice could amend her 2008 return to exclude the lump sum distribution and recover the income taxes paid.

Francis finally reimbursed Alice’s estate for part of the funds ordered by the Court and consented to a priority judgment for the balance to be reimbursed, which balance would be repaid by Francis in monthly payments until paid in full.

Upon request, the Service ruled in PLR 201139011 that (1) Alice would be permitted to set up an inherited IRA for her benefit and place the reimbursed funds in the inherited IRA, presumably as and when received, (2) Alice was authorized to amend her 2008 income tax return to exclude from her income for 2008 any amounts transferred into her inherited IRA represented by the distribution from the qualified plan being reimbursed by her mother.

Although the Service did not delineate its reasoning in permitting Alice to transfer these qualified plan benefits inappropriately distributed to her to an inherited IRA set up for her benefit, perhaps the Service is treating these transfers as restorative payments.  The Service in the past has permitted IRA owners to return misappropriated funds to the owner’s IRA as restorative payments, without treating the restored funds as contributions from the IRA owner.  However, this is the first ruling in which the Service has permitted what in essence are restorative payments to be placed into an inherited IRA.

This PLR does prove that, “Yes Virginia, there is a Santa Claus.”