More the exception than the rule

Recently, the Tax Court ruled that a taxpayer's continuing business activities and lack of credible evidence failed to qualify him as disabled under the tax code, and he was therefore subject to the 10% penalty on retirement account distributions he took prior to 591/2 (Simeon E. and Cynthia L. Isaacs v. Commissioner, Case No. 10514-09).

FACTS OF THE CASE

Simeon Isaacs was a doctor and a lawyer who also engaged in a number of other business ventures. After selling his podiatry practice in 1997, he worked in a managerial role for several businesses between 1998 and 2005. In 2001, Mr. Isaacs purchased National Candy & Toy Inc. During 2003, he spent about 35 hours a week working for the company. From 2003 to 2005, he also ran 24 Karat Systems Inc. Mr. Isaacs was also a partner in several other businesses and spent a significant amount of time actively working for them throughout 2006 and 2007. In 2003, he took distributions of $342,487, $16,000 and $148,807 from his retirement accounts. In 2005, Mr. Isaacs took a subsequent distribution of $8,000. Although each of these distributions was made before he was 591/2, he didn't report a 10% penalty for his early distributions. In January 2009, the Internal Revenue Service sent Mr. Isaacs a notice of deficiency for 2003 and 2005, claiming he was subject to the 10% penalty for early distributions for all of the retirement distributions he had taken during that time. In addition to the 10% penalty, the IRS hit Mr. Isaacs with the 6651(a)(1) penalty for failing to file a return. The court case doesn't indicate what return wasn't filed, but in all likelihood, it was being assessed for a failure to file IRS Form 5329: Additional Tax on Qualified Plans and Other Tax-Favored Accounts, and the 6662(a) accuracy-related penalty. All told, the penalties sought by the IRS exceeded $100,000. Mr. Isaacs contended that his distributions were made pursuant to his disability and thus weren't subject to the 10% penalty on early distributions. In court, he testified that prior to selling his podiatry practice, he had suffered from depression and had sought professional advice from a psychiatrist who “demanded that he stop practicing podiatry, because of its effect on his mental health,” which he subsequently did. Mr. Isaacs further claimed that his depression led to a failed suicide attempt in 2003 that resulted in his being hospitalized for a week. Finally, at the time of the trial, he was seeing a psychiatrist quarterly.

THE COURT'S DECISION

The court ruled in favor of the IRS, citing the lack of credible evidence on Mr. Isaacs' part that he met the strict definition of “disabled” under the tax code. First, the court noted that the only evidence provided by him related to his disability was that of his own testimony. There was no additional testimony provided by his psychiatrist or other physician, and no additional evidence that would have substantiated the severity or length of Mr. Isaacs' illness. Next, the court pointed out how even if it were to treat everything that he claimed as fact, he still wouldn't have met the meaning of “disabled” as defined by the tax code. The court noted that the regulations permit the disability exception to be used by people with mental disorders but that such disability also must be accompanied by institutionalization and/or continuous supervision of the individual. Furthermore, the definition of “disabled” under the tax code calls for a person to be unable to engage in any substantially gainful activity. The disability also must be expected to result in death or be expected to last for an indefinite period. Clearly, Mr. Isaacs' business activities during the years in which he took the distributions from his retirement accounts, as well as the years that immediately followed, showed that he didn't meet this definition. As such, the court held him liable for the 10% penalty for early distributions. As a result of the court's decision, Mr. Isaacs owed more than $100,000 in combined penalties. Although it appears that he did suffer from some psychological issues, this case serves as a reminder that “disability,” as defined by 72(m)(7) of the code, is a rigid definition that many taxpayers mistakenly think that they meet. Ed Slott, a certified public accountant, created the IRA Leadership Program and Ed Slott's Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com For archived columns, go to InvestmentNews.com/iraalert.