IRA distribution - 1099R coded as 5 Prohibited Transaction

I have an IRA which was entirely funded with embezzled funds.  The employee embezzled funds from the employer into the er 401(k).  The 401(k) distributed the account into an IRA.  The IRA was distributed to the account owner.  (The embezzlement information did not come to light until after these events.)  I am thinking the appropriate code for the 1099-R distribution from the IRA is code 5 Prohibited Transaction as the account was funded by the employee who embezzled funds.  The gross distribution would be the amount distributed,, the taxable amount would be the earnings on the distributed funds.

My thoughts are that it would be ok and be the closest explanation as to why taxes and penalty taxes are not being withheld?

What do you think?

Interesting question. See below from the 2022 1099-R instructions. However, I haven't considered whether this person is an IRA "owner" or not, given the circumstances. That might require some substantial research, although there are folks here who can probably answer this easily. 

Prohibited transactions. If an IRA owner engages in a prohibited transaction with respect to an IRA, the assets of the IRA are treated as distributed on the first day of the tax year in which the prohibited transaction occurs. IRAs that hold non-marketable securities and/or closely held investments, in which the IRA owner effectively controls the underlying assets of such securities or investments, have a greater potential for resulting in a prohibited transaction. Enter Code 5 in box 7.

I question whether the IRA custodian is the one to make this determination.

I thought that tax code 5 was used when the IRA engaged in a transaction that violated IRC 4975? Even though the IRA was funded by embezzled funds, to me, this does not violate IRC 4975. My guess is that the funds will be clawed back and normally you would use a tax code 2 for that. 

On 3/21/2022 at 10:52 AM, GlacierNP said:

The gross distribution would be the amount distributed,, the taxable amount would be the earnings on the distributed funds.

My thoughts are that it would be ok and be the closest explanation as to why taxes and penalty taxes are not being withheld?

What do you think?

I agree with Bird that the IRA custodian will not want to make this determination. If the rollover form completed by the IRA owner showed it as a rollover from a 401(k) plan of pre-tax funds (i.e., not Roth), the custodian will likely have no basis to report it as other than a taxable distribution potentially subject to premature distribution tax.

Also, there is no withholding on distributions from IRAs.