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George F. Bearup, J.D. Senior Legal Trust Advisor

28-Jan-20

Disability and the Tax Code – Not if Remedial

Take-Away: Earlier I addressed how a disabled beneficiary of an inherited IRA account is treated as an eligible designated beneficiary who is entitled to use stretch distributions over his/her life expectancy. However, the Tax Code’s definition of disability is very narrow, and thus hard to meet. A recent case that dealt with the disability waiver of the 10% penalty on the early IRA distribution shows how challenging it can be to meet the disability definition used in the Tax Code.

Reported Decision: Gillette v. Commissioner, 19-1343 (7th Circuit, 2020)

Facts: Fairly tragic facts led to this tax dispute. Ms. Gillette started taking the medication Mirapex in the early 2000’s for restless leg syndrome. As time passed, she continued to take more and more of that prescription medication. One of the side effects of that medication is that it leads to compulsive behavior traits. This medically induced condition ultimately led Ms. Gillette to become a compulsive gambler. In 2012, Ms.  Gillette reported gambling earnings of $1,317,348, and gambling losses of $1,315,227. In that same year Ms. Gillette, age 57 ½, also took a $104,001 distribution from her IRA.  In addition, fortunately for her, she reported rental income from 29 different rental properties that she owned in the amount of $126,465. Ms. Gillette and her husband did not pay any income taxes for 2012, nor did they pay the 10% penalty of $10,400 for Ms. Gillette’s early IRA distribution. [IRC 72(t) (1).]

IRS Negotiations: Compromises in settlement were exchanged but never got very far. Ms. Gillette claimed that her gambling addiction was a disability that relieved her from the Tax Code’s 10% penalty for the early distribution from her IRA. [IRC 72(t) (2) (A) (iii).] The IRS examiner responded that Ms. Gillette could sell two of her rental properties to satisfy the back income tax liability, penalties and interest; the 29 rental properties had an aggregate net value of $813,484. Ms. Gillette responded that she needed to retain those rental properties since they were going to provide for her income in retirement. Consequently, those IRS resolution-negotiations were futile. Ms. Gillette challenged the tax assessment and penalty in Tax Court.

Tax Court: The Tax Court judge sided with the IRS. The judge observed that the side effects of Mirapex were noted on the prescription’s label at least 6 years before Ms. Gillette increased her dosage of the medicine. In addressing her claim that she had a disability that relieved her from the 10% excise tax on the early distribution of her IRA, the Tax Court judge found that “even assuming that she suffered from a qualifying [disability] impairment, it was remedial.” Ms. Gillette appealed the judge’s remedial conclusion

Court of Appeals: The Tax Court Judge’s decision was sustained on appeal.

  • Disability Defined: To repeat earlier missive that describes when a disabled beneficiary is an eligible designated beneficiary, the Tax Code defines disability as: “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.” [IRC 72 (m) (7).]
  • Remedial: In finding Ms. Gillette’s disability to be remedial, and thus not a disability required by the Tax Code, the Court of Appeals found:

“Here, even if Gillette suffered from a condition that would otherwise satisfy that definition, the tax court permissibly concluded that she did not qualify for the exception because her impairment was ‘remedial.’ See, C.F.R. 1.72-17A (f) (4). An impairment is remedial if ‘with reasonable effort and safety’ it can be ‘diminished to the extent that the individual will not be prevented by the impairment from engaging in his customary or any comparable substantial gainful activity. The record suggests that Gillette’s condition did not prevent her from engaging in her customary or any comparable substantial gainful activity in 2012. Id 1.72-17A (f) (2). She continued to operate her rental property business and the petitioners still reported $126,465 in profit from the business on their tax return. Even assuming the Gillette was temporarily unable to operate her rental business, she received treatment for compulsive gambling in a reasonable and safe manner with the help of her family and doctors without interrupting her rental business.”

  • Fairness: In a last ditch effort to avoid the penalty (and now accumulated interest and penalties on her unpaid penalty) Ms. Gillette argued that the Tax Code’s definition of disability is outdated and inconsistent with the disability discrimination laws. The Court of Appeals had no trouble dismissing this argument: “This argument is for Congress, however, and not the judiciary.”

Observation: This court decision dealt with a claimed disability as a reason why a 10% premature withdrawal penalty should not be assessed on an early IRA distribution; it did not address whether a beneficiary was an eligible designated beneficiary for stretch IRA distributions. However, the same definition of disability is used for both situations: (i) a waiver of 10% penalty for early IRA distribution; and (ii) whether a disabled beneficiary can take stretch distributions from an inherited retirement account.

Conclusion: If an individual who seems to be disabled can remediate that condition with reasonable effort and safety, he/she will not be treated as disabled for the purpose of either Tax Code provision. The fact that Congress just incorporated the Tax Code’s definition of disability to define one of the five eligible designated beneficiary categories in the SECURE Act indicates, per the Court of Appeals, that in fact Congress just reinforced its narrow interpretation of disability for the administration of the Tax Code. If a disability can with effort be reasonably and safely mitigated, then it is not actually a disability under the SECURE Act.