Take-Away: The failure to timely repay a qualified plan loan results in a taxable deemed distribution along with exposure to  the early distribution 10% penalty, and possibly also a 20% substantial underpayment of tax penalty.

Background: We know that there is a 10% excise tax for taking a distribution from a retirement account before the account owner reaches the age of 59 ½. [IRC 72(t)(3)(A)(i).] A deemed distribution can also result in the same 10% excise tax when a qualified plan loan is not timely repaid by the plan participant. IRC 72(p) provides:

“Any amount distributed as a loan is not taxable when distributed under IRC 72 if the loan meets certain requirements, but it will become taxable as soon as the loan fails to satisfy any requirements and will be deemed a distribution.” See Owusu v. Commissioner, Tax Court Memo 2010-186 (2010.)

There are, however, exceptions when the additional 10% excise tax does not apply to certain plan distributions, such as those distributions that are attributable to the account owner’s disability or those made for the payment of medical expenses. [IRC 72(t)(2)(A) and (B).] If an exception is claimed with regard to the early distribution penalty, the account owner has the burden to prove his/her entitlement to either of these statutory exceptions. El v. Commissioner, 144 Tax Court 140 (2015.)

These technical rules were highlighted, to the taxpayer’s dismay, in a recent Tax Court Memo decision.

Magdy Ghaly vs. Commissioner, Tax Court Memo (April 3, 2023)

Facts: Magdy worked for Great West Trust Company. Magdy borrowed from his employer’s qualified plan account back in 2015. Apparently he diligently repaid that outstanding installment loan balance for the next 3 years. In 2018 Magdy was laid-off from work. In order to pay bills, Magdy withdrew $71,147 from his qualified plan account balance, which had $14,229 federal taxes withheld from that distribution. Accordingly, Magdy’s employer issued him a Form 1099-R for 2018.

However, also in 2018 Magdy also defaulted on his 2015 plan loan due to his layoff. Due to that default, Magdy’s employer issued to him a second Form 1099-R in 2018 for the deemed distribution of another $44,178, i.e. the balance of his outstanding plan loan.

This led to unreported gross income for Magdy of $115,325 in 2018.

Aside: A final seemingly irrelevant fact, but something Magdy claimed at trial, was that in 2020 he opened two new retirement accounts and that he contributed the maximum amounts to those new retirement accounts “to replace the amounts that had been withheld by Great West in 2018.”

IRS Assessment: The IRS assessed Magdy a tax deficiency for unreported gross income of $115,325 in 2018 of $38,213. In addition, the IRS imposed the 10% excise tax on these 2018 distributions because Magdy was under the age of 59 ½ at the time of the distributions. Finally, the IRS assessed Magdy a substantial understatement penalty of another $4,797. [IRC 6662(a).]

Tax Court Decision: The Tax Court found Magdy liable for all of these taxes and penalties. Magdy conceded that he received the 2018 distributions, which were all taxable. [IRC 402(a) and IRC 72(t).] Magdy did try to make some feeble arguments to thwart the penalties, but none were persuasive.

Medical Bill: Magdy did not argue that either the disability exception applied, although he did produce at trial a $34,000 medical bill resulting from his son’s surgery claiming that some of the distribution was used for his son’s surgery. The Court noted, though, that Magdy provided no evidence that he actually paid that $34,000 medical bill. Magdy had the burden of proof that he was entitled to the medical payment exception, which he failed to meet.

Subsequent Retirement Plan Contributions: With regard to Magdy’s testimony that he made contributions to two new retirement accounts in 2020, the Court only observed that even if those contributions had been made that “was not sufficient to show that the distributions he received in 2018 are not included in his gross income.” In short, what he did in later years was completely irrelevant to his tax liability arising in 2018.

Family Loans: Magdy claimed that $12,000 of the distributed funds were used to repay family loans that he obtained to pay for his education at Columbia University. The Court simply noted that the use of the distributions from Magdy’s retirement account to repay family loans was not an exception under the Tax Code to the imposition of the early distribution penalty.

Property Taxes: Magdy also provided testimony that some of the distributions that he received in 2018 was for the payment of real property taxes. Again, the Tax Court simply observed that how Magdy used the plan distributions was irrelevant if the use did not fall within the express  statutory exceptions to the 10% early distribution penalty, i.e. due to his disability or the payment of medical expenses.

Conclusion: There is nothing really new from this Tax Court decision, other than a reminder that if exceptions are claimed under the Tax Code, it is the taxpayer, not the IRS, who carries the burden of proof. This case is also a good reminder of how a deemed distribution arising from the default of a plan loan can escalate real quickly in unpaid income tax, early distribution penalties, and also substantial understatement of income penalties.