If you're looking forward to more than one nice, fat "lump-sum distribution" when you leave your company, prepare to handle them carefully. Otherwise, you may wind up with some nasty lumps from the taxman.
That became clear when the Tax Court recently backed the Internal Revenue Service in a surprisingly hardline stance. "This case is really bad news," says Alan Prigal, a New York tax attorney and a consultant to Bender's Federal Tax Week. The ruling can double the tax bite on the unwary and discourage those who learn of it from setting aside some of their boon as a tax-sheltered nest egg.
The taxpayer involved in the suit, Robert O. Fowler Jr. of Lexington, Mass., rolled over the lump sum from one of his employer's pension plans into an individual retirement account. And he applied a tax break known as "special averaging" to his payout from another of the employer's plans. By doing the rollover, the IRS said, Fowler disqualified himself for special averaging and lost a rate that might work out to as low as 15% or so. (Regular rates range up to 31%.) On one lump sum of about $176,000, the IRS demanded an extra $110,000 plus a $27,500 penalty (since dropped). "In its first decision on the point," Bender's reports, the court held that to qualify for averaging on a lump sum, "the taxpayer must elect that treatment for all lump-sum distributions received in the same year."
AN APPEAL? In general, that has been the IRS position. But the law refers to "all such amounts," notes an analyst by the Research Institute of America, a tax-information publisher. So, the issue was what's included in "such amounts." Fowler argued that the phrase logically refers only to taxable amounts. That way, the amount rolled over tax-free into an IRA shouldn't count.
Fowler has not decided whether to appeal, says his attorney, William Schmidt, a senior partner in Boston's Hale & Dorr. But in the meantime, Schmidt says, there's "a lesson to be learned: If you want to roll over one lump sum and take special averaging on another, make sure you receive them in two different years." And because of other complex pitfalls involved, make sure you get good, professional tax advice up front.