Guest Article

(From the July 23, 2007 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Tax Court Addresses Disability Exception to 10 Percent Excise Tax on Early Pension Distributions

A recent Tax Court decision addresses the disability exception to the IRC § 72(t) 10 percent excise tax on early distributions from pension plans and IRAs. Dykes v. Commissioner of Internal Revenue, No. 6488-06S (T.C. June 20, 2007). The Tax Court concluded an employee with hepatitis C who took a leave of absence, changed shifts, and ultimately quit his job was not "disabled" for purposes of the exception, and thus was required to pay the 10 percent excise tax on the distribution he took upon termination of employment at age 50.

Summary of IRC § 72(t)

Basically, IRC § 72(t) imposes a 10 percent excise tax on early distributions from tax-qualified retirement plans, 403(b) plans, and IRAs. The 10 percent tax does not apply to distributions --

Additional exceptions apply for distributions used to pay medical expenses, distributions to alternate payees pursuant to a qualified domestic relations order (QDRO), and for distributions to employees who have been called to active military duty. Other exceptions for health insurance premiums, higher education expenses, and first home purchases apply only to distributions from IRAs.

The "Disabled" Exception

At issue in this case is the exception for early distributions attributable to the employee being "disabled." In order to qualify for this exception, the employee must be "... 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).

Treasury Regulation § 1.72A-17(f) further explains that "substantial gainful activity" refers to "... the activity, or a comparable activity, in which the individual customarily engaged prior to the arising of the disability ...." Thus, an employee who can still work might be "disabled" if he or she cannot continue in the same job, or at least a comparable one. Also, the regulations clarify that a remediable impairment is not a disability. According to the regulation, "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."

In this case, the individual was employed as a detention officer. He was diagnosed with hepatitis C after suffering from an illness "characterized by profound fatigue" in the early 1990s and again in 2002-2003. The second bout of this illness started at the end of 2002, and was treated with medication from March to August of 2003. The medication apparently was successful in that it reduced the employee's problems with fatigue and attention, and thus contributed to improved work performance. Nonetheless, the employee apparently took a leave of absence from mid-March through July of 2003, and then took a later shift with a lighter workload. Finally, the employee quit his job in September of 2003.

Upon leaving his job, the employee took an early distribution of approximately $39,000 from his pension plan. He was 50 years old at the time of the distribution, so none of the age-based exceptions to the IRC § 72(t) 10 percent excise tax applied. However, when he filed his 2003 income tax return the employee claimed the excise tax did not apply because the distribution was attributable to him being "disabled." The IRS disagreed and issued a $3,900 notice of deficiency.

After reviewing the facts and the applicable law and regulations, the Tax Court sided with the IRS. Even though the Tax Court acknowledged the employee's illness may have prevented him from working during his treatment, it concluded he failed to show his illness was "expected to continue for a long and indefinite period." According to the Tax Court, "indefinite" means "it cannot reasonably be anticipated that the impairment will, in the foreseeable future, be so diminished as no longer to prevent substantial gainful activity." The Tax Court decided the employee's condition was not indefinite, in part because the employee testified at trial that he had recovered and "feels fine now."

The employee countered that, even though he feels better now, hepatitis C is "indefinite" in the sense that it is "an incurable and permanent disease." The Tax Court acknowledged this, but countered the condition is "remediable through medication." As noted above, the regulations provide a remediable impairment is not a disability.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Laura Edwards 202.879.4981, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Laura Morrison 202.879.5653, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2007, Deloitte.