Take-Away: An exception to the 10% penalty when a distribution is taken from an IRA before attaining age 59 1/2 is when the IRA owner is disabled. But being ill is not the same thing as being disabled.

Background: Normally a distribution from an IRA prior to attaining age 59 1/2 will result in a 10% additional tax. The Regulations make it clear that this is not a penalty, just an additional tax. [IRC 72(t).]

But the Tax Code, and its Regulations, provide a list of exceptions when that 10% additional tax will not be imposed. One exception is when the distribution is used to pay medical care expenses. [IRC 72(t)(2)(A)(iii).] Another exception is when the IRA owner is disabled. [IRC 72(t)(1), 2(A)(i).] But the disability exception is qualified by the phrase “disabled within the meaning of IRC 72(m)(7).”

Disability Defined: IRC 72(m)(7) defines disability as the following: a person is disabled if 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 term duration. Note the use of the word any.

This difficult standard to show disability was on display in a Tax Court decision reported last month.

Case: Christopher John Tottenham v. Commissioner, Tax Court Summary Opinion 2019-1, issued January 29, 2019. [Docket # 10691-14S]

Facts: Mr. Totten, under the age 59 1/2, was employed as a medical sales representative who worked full-time as a W-2 employee. He sold and repaired medical equipment, traveling in his own 2004 Mercedes,  to physican’s offices and hospitals to either sell, or repair, medical equipment. On any given day Mr. Totten drove 71 to 240 miles in central Florida in his assigned territory. While some of his expenses were reimbursed by his employer, Mr. Totten’s travel expenses incurred in his assigned territory where not reimbursed.

In 2010, the year in question, Mr. Totten earned $110,523 in W-2 wages. He also owned two rental condominiums that also provided income (and other challenged deductions) to him. In 2010 Mr. Totten became ill, but he managed to continue with his job, albeit a struggle for him. Also in 2010 Mr. Totten withdrew $43,503 from his IRA, calling it a rollover and claiming that he used the distribution to pay his medical expenses. On his Form 1040 Mr. Totten claimed an “IRA rollover” of $43,503, but he reported that $0.00 was taxable with regard to that distribution. Obviously there was no rollover if the distribution was spent by Mr. Totten.

Issue: Mr. Totten claimed that the IRA distribution was not taxable as he was disabled during 2010 and that he used the IRA distribution to pay his medical bills. No surprise, the IRS disagreed with Mr. Totten’s conclusions and it assessed income taxes on the entire IRA distribution, and it also imposed the additional 10% tax, since Mr. Totten was not yet 59 1/2 years old. Other penalities were assessed due to the underreporting of income and reporting an IRA rollover when none occurred. [There were many other issues raised at the Tax Court that also caused many more issued to be addressed in the 61 page Tax Court decision, but only the IRA distribution will be addressed here.]

Tax Court: Apparently there was plenty of proof that Mr. Totten was indeed ill during a large part of 2010. But the Tax Court, applying the definition of disability under IRC 72(m)(7), found that Mr. Totten was not disabled under IRC 72(t)(2)(A)(iii). The Court acknowledged that while Mr. Totten was in fact quite ill, that illness did not prevent him from continuing to engage in substantial gainful activity, as indicated by his reported W-2 wages in excess of $110,000 for the year, and the fact that in order to earn those W-2 wages, Mr. Totten had to drive between 71 to 240 miles each day in his assigned territory. [See Reg. 1.72-17A(f)(4).]

Somewhat more surprising is that the Tax Court also rejected the applicability of the other exception under IRC 72(t) which is that the IRA distribution was used to pay Mr. Totten’s medical expenses. The only mention of this exception in the Tax Court’s decision was the passing observation: “There was no showing that he paid his medical expenses from the IRA distribution.” This is a surprise since there was no question that Mr. Totten was ill during 2010, and apparently no question that he had incurred medical expenses of some magnitude to deal with his illness. Perhaps the ‘no showing’ observation was based on the fact that Mr. Totten represented himself in the Tax Court and thus he was unaware  that he had the burden of proof, to prove both (i) the medical expenses that he incurred, and (ii) to trace the payment of those medical expenses to his IRA distribution.

Conclusion: While there are exceptions to the 10% additional tax if an IRA owner takes a distribution from his/her IRA prior to age 59 1/2, it will be a challenge to fit within those exceptions. The IRA owner  must be actually seriously disabled and unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment that is long-continued. What constitutes long-continued is also debatable, since if you are the individual who is ill, that illness probably seems an eternity. So while an IRA distribution prior to age 59 1/2 used to pay medical expenses is one exception to explore, the distribution should be directly traceable to the payment of medical expenses that were incurred.