Forfeiture of IRA is not a taxable distribution

The Sixth Circuit, reversing the Tax Court, held that the IRS’s seizure of a taxpayer’s individual retirement account (IRA) under criminal forfeiture laws and its withdrawal of the funds from the IRA was not a taxable distribution to the taxpayer.

Background

Lonnie Hubbard was a pharmacist who owned and operated Rx Discount of Berea PLLC in eastern Kentucky. This business was very successful, and Hubbard used the money he earned from it to live an extravagant lifestyle, buying multiple homes, luxury cars, and other high–end assets. He also had Discount Rx establish a simplified employee pension (SEP) IRA on his behalf. By 2017, the untaxed money in the IRA had grown to $427,518.

However, it turned out that Discount Rx was such a resounding success because it was an illegal “pill mill,” generating most of its revenue by selling large amounts of oxycodone to addicts of that drug and large amounts of pseudoephedrine to methamphetamine manufacturers. Eventually, the federal government discovered the nature of Rx Discount’s business and indicted Hubbard on drug and money–laundering offenses. He was convicted of most of the offenses, and the district court in his criminal trial sentenced him to 30 years in prison.

The government also invoked the criminal forfeiture laws in 21 U.S.C. Section 853 and 18 U.S.C. Section 982(a)(1) against Hubbard, alleging that the various assets he owned were purchased with the proceeds from his crimes, and all the money in Hubbard’s financial accounts, including his IRA, were the proceeds of those crimes. The district court agreed and ordered the IRS to confiscate his property and money.

The IRS seized Hubbard’s IRA and withdrew the funds it contained in 2017, treating the seizure and withdrawal as a taxable distribution of the funds to Hubbard for 2017. Hubbard did not file a tax return for the 2017 tax year, and in November 2020, the IRS sent him a notice of deficiency for tax, penalties, and interest on the distribution from the IRA.

Hubbard challenged the IRS’s determinations in the notice in Tax Court. He argued that the government should pay the claimed deficiency because the IRA was forfeited to the government during his criminal case. The IRS, while conceding that Hubbard should not have to pay either the 10% penalty for withdrawing the IRA funds early or a small part of the penalties for late filing and late payment, otherwise moved for summary judgment on the remaining amounts in the notice.

The Tax Court granted the IRS’s motion, finding that, under its precedent, IRA funds qualify as income even when forfeited through an “involuntary distribution” to a third party to satisfy a taxpayer’s obligation (Hubbard, T.C. Memo. 2024–16). The court ultimately determined that Hubbard owed $180,836 in taxes and penalties. Hubbard appealed the Tax Court’s decision to the Sixth Circuit.

The Sixth Circuit’s decision

The Sixth Circuit held that the seizure and withdrawal of the IRA funds pursuant to the forfeiture order in Hubbard’s criminal case was not a taxable distribution to him. The court determined that the forfeiture order had made the IRS, not Hubbard, the owner of the IRA. Consequently, when the IRS withdrew the funds from the IRA, it was not taking Hubbard’s money to discharge a debt; it was only transferring its own money. Also, because the IRS owned and controlled the IRA and received the funds from it, the IRS was the payee or distributee of the withdrawn IRA funds, not Hubbard, and consequently, under Sec. 408(d), Hubbard was not liable for tax on the funds.

Forfeiture laws

Because the case required the court to consider the interaction of the forfeiture laws and the tax laws, the Sixth Circuit first discussed the forfeiture laws. For a variety of reasons, including to help ensure that crime does not pay, forfeiture laws have long allowed governments to seize property used in (or generated by) illegal activity (Kaley, 571 U.S. 320, 323 (2014)). The Sixth Circuit found that the federal appellate courts have recognized two general types of forfeitures — specific–property forfeitures and personal money judgment forfeitures.

Specific–property forfeiture: In this first type of forfeiture, the government identifies the specific property that the defendant must relinquish. The government becomes the owner of this property at the time of a conviction (or in some cases, under the relation–back doctrine, as of when the crime occurred that the defendant was subsequently convicted of). A forfeiture order for specific property permits the government to seize only the identified forfeitable property, not other property of the defendant.

Personal money judgment forfeiture: In this second type of forfeiture, a court imposes a “personal money judgment” identifying a sum that the defendant must pay to the government. Under this type of forfeiture, the court calculates the amount of money that a defendant owes, based on the value of the forfeitable property involved in the crimes of which the defendant is convicted, and the debt may be collected from any of the defendant’s current or future assets.

Forfeiture in Hubbard’s case: The Sixth Circuit concluded that Hubbard’s forfeiture was of the first type because the district court identified the specific property belonging to Hubbard subject to forfeiture, which included his homes, cars, and financial accounts, and ordered the IRS to seize and dispose of the identified property in accordance with the law. The order included Hubbard’s IRA in the list of forfeited property. After the government gave notice to the parties that might have an interest in the assets, the district court later ordered that they “shall be forfeited to the United States and no right, title, or interest in the property shall exist in any other party” (order at 2, Hubbard, No. 5:15–cr–00104 (E.D. Ky. 5/25/17)). According to the Sixth Circuit, this meant that the government became the owner of Hubbard’s IRA at this time.

Income in general and IRAs

The Sixth Circuit explained that, under Supreme Court precedent, income includes all economic gains of a taxpayer, whether lawful or unlawful (Banks, 543 U.S. 426, 433 (2005); James, 366 U.S. 213, 218—22 (1961) (plurality opinion)). In addition, taxpayers have income not just when they obtain a benefit but also when they avoid a burden (Kirby Lumber Co., 284 U.S. 1, 3 (1931)). Thus, as the Supreme Court recognized in Old Colony Trust Co., 279 U.S. 716 (1929), relief from a liability can amount to taxable income. The Tax Court has held that this principle applies even when a taxpayer does not voluntarily agree to the discharge of an obligation (such as wages garnished from a taxpayer’s paycheck to pay child–support debts (Chambers, T.C. Memo. 2000–218)). However, as the Sixth Circuit stated, “Despite this broad definition, Congress has never made taxpayers pay taxes on everything that qualifies as income. Rather, it has defined ‘taxable income’ as ‘gross income minus’ its many statutory deductions.”

Hubbard’s case concerned statutory deductions for contributions to IRAs. Taxpayers (subject to a number of exceptions) can deduct from their gross income the funds that they contribute to these accounts. However, the deduction is only a deferral of, not an exemption from, taxation. Although the Code does not tax the principal or earnings in an IRA, a taxpayer must pay taxes when they withdraw the funds from the IRA, with Sec. 408(d)(1) stating that “any amount paid or distributed out of an individual retirement plan shall be included in gross income by the payee or distributee, as the case may be, in the manner provided under section 72.”

Application of rules to Hubbard

Rx Discount had created a specific type of IRA for Hubbard, a SEP. Thus, the court determined that the funds Rx Discount deposited into the SEP were economic gain to Hubbard and thus income to him, even if, as the court had previously found, the funds were from illegal activities. Nevertheless, because the company deposited the funds into the account, Hubbard was exempt from paying tax on them until they were withdrawn.

However, as the Sixth Circuit pointed out, Hubbard never withdrew the funds. Instead, he forfeited them to the IRS under a criminal forfeiture order. The forfeiture laws, as the court had already concluded, made the IRS, not Hubbard, the owner of the IRA at the time of the order, which gave the Service the control over the account that any normal owner of an IRA would possess. Exercising this ownership interest, the IRS withdrew the funds from the IRA and deposited them into another government account.

Given that Hubbard no longer owned or controlled the IRA when the IRS seized the funds in it and withdrew them, the Sixth Circuit stated that it failed “to see why Hubbard must pay taxes on the IRS’s choice to withdraw the funds.” According to the court, Hubbard obtained no economic gains (i.e., income) when the IRS withdrew the IRA funds, and most people would describe Hubbard’s forfeiture as an economic loss rather than an economic gain.

Also, the court reasoned, the IRS’s withdrawal of the funds did not confer a benefit on Hubbard that might be considered income by reducing any “indebtedness” that Hubbard owed the IRS. The court found that “[s]ince the forfeiture order merely transferred ownership of the IRA to the IRS, that order no more created a ‘debt’ than did the forfeiture of Hubbard’s homes and cars.”

In summary, because Hubbard did not own the IRA at the time of the withdrawal, the Sixth Circuit concluded, he did not receive (and had no right to receive) its funds. Because the IRA was not Hubbard’s, in the court’s view, “[h]e should no more have to pay taxes on its funds than a person randomly selected from the Kentucky voter rolls.”

Finally, the Sixth Circuit also observed that under Sec. 408(d)(1), “any amount paid or distributed out of an individual retirement plan shall be included in gross income by the payee or distributee, as the case may be.” While the Code does not define “payee” or “distributee,” the court found that, under their ordinary meaning, once the IRS became the owner of the IRA, it was the payee or distributee of the IRA funds, and therefore the funds were not income to Hubbard.

The Sixth Circuit agreed that, as the Tax Court had previously stated (Roberts, 141 T.C. 569, 576 (2013)), the payee or distributee under Sec. 408(d)(1) will presumptively be the named “participant or beneficiary who is eligible to receive funds from the IRA.” However, the court found that this presumption does not apply under the facts in all cases, as, for example, where a person fraudulently withdraws funds out of a participant’s IRA without the participant’s knowledge. The Sixth Circuit determined that the result should be the same in Hubbard’s case when the IRS became the owner of his IRA.

Reflections

The IRS took the position that the forfeiture order relieved Hubbard of a debt by transferring ownership of the IRA from him to the IRS, which was extinguished by the forfeiture of the IRA. However, as the Sixth Circuit pointed out, because the forfeiture was a specific–asset forfeiture, under this logic, the forfeiture order should have given rise to a debt for Hubbard’s other assets included in the order, and the forfeiture of those assets should likewise have created income for Hubbard by reducing that debt. The Sixth Circuit stated, “We do not read the word ‘income’ in this unusual way.”

The Sixth Circuit also noted that if the district court in Hubbard’s criminal case had entered a personal money judgment against Hubbard, the judgment “may well have created a debt,” and in that event, the IRS’s withdrawal of the IRA funds might have created a tax obligation by reducing a debt that he owed. However, because the court did not enter a personal money judgment but instead ordered the forfeiture of specific assets, the Sixth Circuit found that it need not resolve that question.

Hubbard, No. 24-1450 (6th Cir. 3/19/25)

Contributor

James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser’s tax technical content manager. For more information about this column, contact thetaxadviser@aicpa.org.