Tax Court in Brief | Lucas v. Comm’r

Deficiency for Early 401(k) Distribution; 10% Additional Tax; Exclusion for “Unable to Engage in Any Substantial Gainful Activity

Lucas v. Comm’r, T.C. Memo. 2023-9| January 17, 2023 | Urda, J. | Dkt. No. 2808-20

Summary: In 2017, Robert Lucas worked as a software developer, but he lost his job in that year. To make ends meet, he obtained a distribution of $19,365 from a section 401(k) plan. He had not reached 59 1/2 years old at the time. The administrator reported the amount as an early distribution with no known exception on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. Lucas reported the distribution on his 2017 return but did not include it as taxable income. His return reflected his understanding that the distribution did not constitute income because of his diabetic medical condition. The IRS issued a notice of deficiency for his 2017 tax year, determining a deficiency of $4,899 based on the inclusion of the retirement plan distribution in Lucas’s 2017 gross income and a ten-percent additional tax imposed by section 72(t).

Key Issues: Whether Lucas’s 401(k) plan account distribution is taxable and subject to the ten-percent additional tax imposed by 26 U.S.C. section 72(t)(1)?

Primary Holdings: Yes. Lucas received the distribution, he was not 59 ½ years of age at the time, and the “unable to engage in any substantial gainful activity” exclusion did not apply. Deficiency determination is sustained.

Key Points of Law:

Burden of Proof.  The IRS’s determinations in a notice of deficiency are generally presumed correct, and the taxpayer bears the burden of proving those determinations erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). In cases involving failure to report income in this jurisdiction (9^th Circuit), the IRS must establish “some evidentiary foundation” linking the taxpayer to an alleged income-producing activity before the presumption of correctness attaches to the deficiency determination. Weimerskirch v. Commissioner, 596 F.2d 358, 361–62 (9th Cir. 1979), rev’g 67 T.C. 672 (1977). Once the IRS establishes that, the burden of proof shifts to the taxpayer to prove that he is entitled to an exclusion from gross income. See Simpson v. Commissioner, 141 T.C. 331, 338–39 (2013), aff’d, 668 F. App’x 241 (9th Cir. 2016).

Treatment of 401(k) Distribution. Gross income includes all income from whatever source derived except as otherwise provided. I.R.C. § 61(a). This definition includes distributions from employees’ trusts, including 401(k) plans. See I.R.C. §§ 61(b), 72(a)(1), 402(a), (b)(2), 401(k).

Section 72(t) Additional Tax. “Distributions from a qualified retirement account (which includes a 401(k) account) to a taxpayer under 59½ years of age at the time of the distribution are subject to a 10% additional tax unless an exception applies.” Robertson v. Commissioner, T.C. Memo. 2014-143, at *5; see also I.R.C. §§ 72(t), 401(k), 4974(c). Section 72(t)(2)(A)(iii) provides one such exception for a distribution “attributable to the employee’s being disabled within the meaning of subsection (m)(7).” A taxpayer is considered disabled if, at the time of the disbursement, he is “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.” I.R.C. § 72(m)(7); see also Treas. Reg. § 1.72-17A(f)(1).

Substantial Gainful Activity. Substantial gainful activity refers to “the activity, or a comparable activity, in which the individual customarily engaged prior to the arising of the disability.” Treas. Reg. § 1.72- 17A(f)(1). The determination whether an impairment makes one unable to engage in substantial gainful activity depends on all the facts of the case, focusing primarily on the nature and severity of the impairment, as well as factors such as the individual’s education, training, and work experience. See id. subparas. (1) and (2). “An individual will not be deemed disabled if, with reasonable effort and safety to himself, the impairment 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.” Id. subpara. (4).

Although Treasury Regulation § 1.72- 17A(f)(2) may identify a particular condition as an impairment that “would ordinarily be considered as preventing substantial gainful activity,” the Regulation clarifies that “[a]ny impairment, whether of lesser or greater severity, 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.” Treas. Reg. § 1.72-17A(f)(2) (flush language).

Insights: Distributions from an employee trust to individuals who are not yet 59 ½ years of age may be subject to a 10% additional tax pursuant to 26 U.S.C. section 72(t)(1). Section 72(t)(2)(A)(iii) provides one exception for a distribution “attributable to the employee’s being disabled within the meaning of subsection (m)(7).” Before receiving the distribution, and if the circumstances permit, a taxpayer should consider whether or not the disability exclusion may apply. In doing so, the taxpayer should evaluate whether he or she is “unable to engage in any substantial gainful activity” as defined in section 72(m)(7) and related Treasury Regulations, 26 C.F.R. § 1.72- 17A(f)(1)-(4).

Have a question? Contact Jason Freeman, Freeman Law And Legal Team.