In a surprising decision by the IRS, a taxpayer who did not take the full amount of a series of equal periodic payments (SEPP) was not considered to have modified the SEPP, saving the taxpayer a 10% early distribution penalty.
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In PLR 201051025, the IRS also ruled that even though the amount of the annual SEPP payment was paid in a single sum in Year 1 and in monthly distributions for subsequent years, it did not constitute a modification of the SEPP.
In this PLR, the taxpayer, who was under age 59½, had an IRA which was taking an SEPP (i.e. an exception to the ten percent early distribution penalty under IRC Sec. 72(t)).
When setting up the SEPP, the taxpayer directed the IRA custodian to distribute the SEPP in a single sum in Year 1 and in equal monthly installments thereafter.
The taxpayer discovered that the IRA custodian distributed an incorrect amount from the IRA for Month 1 of Year 2. The taxpayer subsequently sent a letter to the IRA custodian regarding the error. The taxpayer directed the IRA custodian to make a corrective distribution from the IRA to make up for the shortage. The IRA custodian again distributed an incorrect amount from the IRA in Month 2 of Year 2. The IRA custodian subsequently made a corrective distribution for Months 1 and 2 of Year 2.
In Year 6, the IRA custodian only made 11 monthly distributions to the taxpayer, instead of 12. The taxpayer represented that he first learned that the IRA custodian distributed only 11 monthly payments of Year 6 when he reviewed the Form 1099-R.
The taxpayer submitted a request for a ruling that the failure to distribute the entire required distribution amount for Year 6, and a proposed makeup distribution in Year 7 not be considered a modification of a SEPP, and (ii) a ruling that the fact that the amount of the annual SEPP payment was paid in a single sum in Year 1 and in monthly distributions in subsequent years not be considered a modification of the SEPP.
The taxpayer represented that he did not intend to modify the series of substantially equal periodic payments and had no reason to believe that the IRA custodian would not distribute the property amount in Year 6 because they had done so in each of the previous years, following their correction of the distribution errors during the early part of Year 2.
The taxpayer proposed to receive a "make- up" distribution in Year 7 that would satisfy his annual payment distribution requirement for Year 6 as determined under the fixed amortization method.
The IRS ruled that the failure to distribute the entire required annual payment in Year 6 and the subsequent “make-up” distribution for the in Year 7 was not considered a modification of a series of substantially equal periodic payments under Code section 72(t)(2)(A)(iv) and, therefore the taxpayer was not subjected to the 10 percent additional tax imposed on premature distributions. The IRS also concluded that the fact that the amount of the annual payment computed pursuant to IRC Sec. 72(t)(2)(A)(iv) was paid in a single sum in Year 1 and in monthly distributions in subsequent years was not considered a modification of the SEPP, provided that the total amount of the monthly distributions in any calendar year is equal to the amount of the annual payment for that calendar year computed pursuant to IRC Sec. 72(t)(2)(A)(iv).
If a taxpayer takes a distribution from their IRA before age 59½, a 10 percent penalty is imposed for an early distribution. This 10 percent early distribution penalty does not apply to distributions that are part of a series of substantially equal periodic payments (not less frequently than annually) made for the life (or life expectancy) of the employee or joint lives (or joint life expectancies) of such employee and his designated beneficiary. If, however, the series of payments is subsequently modified (other than by reason of death or disability) before the (I) close of the 5-year period beginning with the date of the first payment and after the employee attains age 59 1/2, or (II) before the taxpayer turns age 59½, then the taxpayer must pay the 10 percent early distribution penalty from the beginning of the series, plus interest.
There is no authority under the Code or Regulations for the relief the IRS granted in PLR 201051025. The IRS has, however, made allowances for such situations in the past. For example, in PLR 9514026, the taxpayer’s distributions were recalculated from the end of the month to the beginning of the month, which resulted in one less annual payment for that year. The IRS held the payment change to be “ministerial” and not a modification. In 200503036, the IRS ruled that the failure to distribute the entire required annual payment in Year X and the subsequent “make-up” distribution in Year Y was not considered a modification of a series of substantially equal periodic payments.
On the flip side, however, the IRS has also come down hard on taxpayers who violated the SEPP rules. In PLR 200720023 (a ruling also drafted by the authors), the IRS ruled that two trustee-to-trustee transfers performed at the advice of the taxpayer’s financial advisor and for the purpose of diversifying investments constituted a modification to a SEPP even though the amount of the SEPP payment did not actually change and the taxpayer, upon discovering the error, transferred by means of a trustee-to-trustee transfer, the balance back into the SEPP IRA in an attempt to rectify the error. In making its ruling in PLR 200720023, the IRS noted under Revenue Ruling 2002-62, a modification to the series of payments will occur if there is any nontaxable transfer of a portion of the account balance to another retirement plan.
The taxpayer (and the IRA custodian) in PLR 201051025 was very lucky that the IRS was lenient, given that nothing bound the IRS to provide such relief. Even with the high cost of obtaining a PLR (with a $10,000 IRS filing fee for starters), it may be worthwhile for similarly situated taxpayers to attempt their own ruling rather than automatically paying the 10 percent early distribution penalty retroactively to the beginning of the series, plus interest.