Tax Court denies medical exception for early pension distribution

A taxpayer was subject to income tax on a distribution he received from his Sec. 401(k) plan and was not entitled to an exception from the 10% additional tax imposed by Sec. 72(t)(1) for early distributions because his medical condition did not cause him to be disabled as defined in Sec. 72(m)(7), the Tax Court held.

Facts: Robert Lucas worked as a software developer at a company called Life Cycle Engineering until 2017, when he lost that job and experienced financial difficulties. To supplement his income, Lucas obtained a $19,365 distribution from his 401(k) plan. When he received the distribution, Lucas had not yet attained the age of 59½. The plan administrator reported the distribution as an early distribution “with no known exceptions” (box 7, Code 1) on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.

Lucas reported the distribution on his 2017 Form 1040, U.S. Individual Income Tax Return, but did not include the distribution in taxable income, claiming that it was excludable from gross income because he had diabetes, which was first diagnosed in 2015 while he was working at Life Cycle.

The IRS issued a deficiency notice determining that Lucas’s 2017 tax return should have included the distribution from his 401(k) plan in gross income. In addition, since Lucas took the distribution before he attained age 59½, the Service also assessed the 10% additional tax imposed by Sec. 72(t)(1) for early distributions because his medical condition, in the IRS’s opinion, did not cause him to qualify for the exception to the addition to tax in Sec. 72(t)(2)(A)(iii) for disabled taxpayers.

Issues: Gross income, by definition, includes distributions from employees’ trusts for “any amount received as an annuity (whether for a period certain or during one or more lives) under an annuity, endowment, or life insurance contract” (Secs. 61(a) and 72(a)(1)). One type of trust is a 401(k) plan, which is a qualified cash or deferred arrangement “of an employer for the exclusive benefit of his employees or their beneficiaries” (Sec. 401(a)).

Lucas claimed that the distribution should not have been included as gross income because he had diabetes. In coming to this conclusion, Lucas relied on a website that, in his view, addressed the issue.

Distributions from a qualified retirement plan are subject to an additional 10% tax if the taxpayer is under 59½ years of age and cannot claim an applicable exception. One such exception is if the distribution is attributable to an employee’s being disabled within the meaning of Sec. 72(m)(7) (Sec. 72(t)(2)(A)(iii)).

Under Sec. 72(m)(7), taxpayers are disabled if they furnish proof that they are “unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration.” Substantial gainful activity is considered an activity or a comparable activity in which the individual customarily engaged prior to becoming disabled (Regs. Sec. 1.72-17A(f)(1)). The determination of whether one can work is based on the nature and severity of the impairment, as well as an individual’s education, training, and work experience. Individuals will not be deemed disabled if the impairment will not prevent them from engaging in their customary or any comparable substantial gainful activity (Regs. Sec. 1.72-17A(f)(4)).

Diabetes is identified under Regs. Sec. 1.72-17A(f)(2) as an impairment that would “ordinarily be considered as preventing substantial gainful activity.” However, as the Tax Court further explained, the regulations clarify that “[a]ny impairment … must be evaluated in terms of whether it does in fact prevent the individual from engaging in his customary or any comparable substantial gainful activity” (Regs. Sec. 1.72-17A(f)(2)(ix)).

After Lucas was diagnosed with diabetes, he continued to work for Life Cycle, performing his normal job duties, until his termination in 2017.

Holding: The Tax Court held that the distribution was includible in Lucas’s income and was subject to the 10% additional tax on early distributions. Regarding whether the distribution was includible in income, the court found that the website Lucas relied on “addresses the applicability of the early-withdrawal penalty in cases of disability, which is a distinct subject from whether the distribution counts as income for those suffering from disability.” Further, the court found that the website did not constitute legal authority. Accordingly, the court held that the distribution must be included in gross income on Lucas’s 2017 federal income tax return.

The court also found that Lucas’s medical condition did not rise to the level of an applicable exception under Sec. 72(m)(7). The court determined that since Lucas was engaging in his customary activity at Life Cycle after he was diagnosed with diabetes, he was not disabled under Sec. 72(m)(7), because his diabetes was not preventing his substantial gainful employment. Thus, the court determined he was also subject to the 10% additional tax imposed under Sec. 72(t)(1).

In a footnote, the Tax Court observed that another exception to the early-withdrawal penalty that Lucas failed to bring up during the litigation process applies if the distribution does “not exceed the amount allowable as a deduction” under Sec. 213 (medical, dental, etc., expenses) (Sec. 72(t)(2)(B)). This amount is determined irrespective of whether the employee itemizes deductions for the tax year. However, the court deemed this issue forfeited because Lucas did not claim that he qualified for this exception. According to the court, a litigant “has an obligation to spell out its arguments squarely and distinctly, or else forever hold its peace” (quoting Schneider v. Kissinger, 412 F.3d 190, 200 n.1 (D.C. Cir. 2005)).

■ Lucas, T.C. Memo. 2023-9

— John McKinley, CPA, CGMA, J.D., LL.M., is a professor of the practice in accounting and taxation in the SC Johnson College of Business; Matthew Geiszler, Ph.D., is a lecturer in accounting in the College of Human Ecology; and Marquise Riley, CPA, MPS, is a lecturer in accounting in the SC Johnson College of Business, all at Cornell University in Ithaca, N.Y. To comment on this column, contact Paul Bonner, the JofA’s tax editor.