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

17-Feb-21

Early Distributions: Apparently it is a Tax, Not a Penalty

Take-Away: In January, the Tax Court held that the ten percent (10%) obligation that is assessed when a distribution is taken from a retirement account by the owner under the age 59 ½ is not a penalty, nor an addition to tax, nor an additional amount.

Background: For that last 25 or so years I have described the 10% ‘charge’ when an IRA owner accesses their IRA prior to age 59 ½ as a penalty. I have been wrong with regard to this description I’ve used for the past quarter-century.  I apologize for misleading you. It is only a ‘tax.’  According to the Tax Court, the early distributions from a retirement account results in a 10% exaction on the distribution, but that extraction is onlt  a tax and not a penalty.  [IRC 72(t).] This revelation came to light in a dispute over $90.86!

Tax Court Decision: Grajales v Commissioner, 156 Tax Court No. 3, (January 25, 2021)

Facts: The petitioner, age 42, took loans from her New York state pension plan in 2015. The loans were not repaid by her. The N.Y. Pension system issued to the participant a 1099-R, reporting $9,026  in taxable distributions. Initially the Petitioner did not report this amount in her 2015 income. She later conceded that the $9,026 should have been included in her income for 2015. Accordingly, a deficiency was assessed against the participant in the amount of $3,030.

The dispute before the Tax Court was the assessment of the 10% ‘extraction’ on the early distribution amount from the participant’s retirement account under IRC 72(t). That ‘additional’ exaction amounted to $90.86. The IRS agent did not obtain written supervisory approval prior to imposing the 10% ‘extraction’ which is why the petition was filed with the Tax Court.

Dispute: The dispute centered on whether the $90.86 was a penalty or an additional tax. The Tax Code requires that if a penalty is to be assessed, written supervisory approval must be obtained by IRS personnel before the penalty can be formally assessed. [IRC 6751(b)(1).] The participant argued that she was not liable for the IRC 72(t) penalty because no written supervisory approval was obtained before that penalty was assessed on her taxable distribution.

  • Specifically, the participant claimed that the IRC 72(t) 10% exaction is either a penalty or an additional amount within the meaning of IRC 6751(c). Since there was no written supervisory approval to assess the penalty, addition to tax, or additional amount’ the attempt to collect the additional $90.86 from her was unlawful.
  • The IRS responded that no written supervisory approval was required because IRC 72(t) is neither a penalty, addition to tax, nor additional tax within the meaning of IRC 6751(b.) IRC 6751(c) defines penalty  to include “any addition to tax or any additional amount.” Rather, the 10% additional assessment under IRC 72(t) is only a tax, as no supervisor’s approval is required for the  10% assessment because it is calculated automatically through electronic means, i.e. no discretion is involved.
  • Putting this into context [remember, they hired lawyers to actually fight over $90.86] the actual words used in IRC 72(t) are “Imposition of Additional Tax.”  IRC 6751(c), the penalty provision that requires a supervisor’s prior written approval, uses the words ‘addition to tax, or additional amount.’

Tax Court: Despite some pretty weak arguments raised by the participant’s attorneys [hopefully they were representing her pro bono over the $90.86] the Tax Court swiftly decided in favor of the IRS.

  • “This Court has held repeatedly that the section 72(t) exaction is a ‘tax’ and not a ‘penalty’, ‘addition to tax,’ or ‘additional amount.’……The text of section 72(t) as well as the larger statutory structure supports the conclusion that the exaction is a tax.”
  • “Additional amount” appears in IRC 6751(c) in conjunction with the terms ‘penalty’ and ‘addition to tax’. Because section 72(t) exaction is not a civil penalty enumerated in Chapter 68, it is not an ‘additional amount’ within the meaning of section 6751(c).”

Conclusion: So I’ve misled you over the past 5 years. I’m sorry. The 10% exaction [now my favorite word for 2021; in 2020 my favorite word was comorbidities, as in how vulnerable I am for contracting the COVID-19 virus] is not, and per the Tax Court, has never been a penalty . It is only a tax. I just wonder how a dispute over only -$90 worked its way up to a multi-page Tax Court decision by a 42 year old plan participant who had to borrow from her retirement account and was unable to timely repay the loan balance.