News
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Individual Retirement Accounts
Early Distribution Penalty
Gee, 127 TC No.1 (2006)
In the June 2006 issue of Tax Tips we provided a table of exceptions to the
Section 72(t) 10% penalty for the IRA and qualified plan withdrawals before age
59 ½ . The Tax Court’s recent Gee decision covers one of these penalty
exceptions - for distributions made after the death of an IRA owner – from an
angle not previously litigated (i.e., an issue of fist impression).
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Facts. Charlotte Gee opened an IRA in 1993. Her husband at that time,
Mr. Campbell, also opened an IRA in that year with the same financial
institution. Upon his death in 1998, Campbell was the sole owner of this IRA
and Gee was the sole owner hers. Gee received a distribution of Campbell’s
entire IRA balance (over $1 million) in 1998, after his death. The distribution
was made by a direct rollover to Gee’s separate IRA. She was age 51.
In 2000, Gee transferred her entire IRA, then work over $2.6 million, to
another financial institution. In 2002, she took $977,000-plus distribution
from his IRA.
Gee and her husband (the Gees) reported the IRA distribution on their joint
1040 for 2002, but included no 10% early distribution penalty. Although the
financial institution had reported the distribution as an early withdrawal, the
Gees attached a statement to their return stating that the institution has used
the wrong distribution code. They maintained that the correct code should have
been for “a distribution of IRA for her deceased husband”.
IRS position. The 2002 distribution would have been exempt from the 10%
penalty if it had been made directly to Gee from Mr. Campbell’s IRA, but the
funds became subject to the 10% penalty when distributed to Gee from her own
IRA. The Gees also are liable for the substantial understatement of income tax
accuracy-related penalty.
Court’s ruling. The 2002 distribution of over $977,000 is subject to the
10% penalty. However, the Gees aren’t liable for the accuracy-related penalty.
The 10% penalty exception claimed by the Gees was Section
72(t)(2)(A)(ii)-distributions made to a beneficiary of the employee’s estate on
or after the employee’s death aren’t subject to the penalty. They argued that
the 2002 distribution was an amount received on or after Campbell’s death.
With the Tax Court had not previously decided whether an IRA distribution
retains its character as a distribution to a beneficiary “on or after the death
of an employee” if the distribution is of funds that were rolled over to the
IRA upon the employee’s death, it wasted little time in reaching a conclusion
on the merit of the Gees’ argument: there was none. Mrs. Gee received the
distribution from her own IRA, not from an IRA of which she was a beneficiary
on or after Campbell’s death. The source of the amount received, whether
originating from Campbell’s IRA or Gee’s contributions, is irrelevant. She took
a distribution that was neither caused by Campbell’s death nor made to her as
beneficiary of this IRA.
The Court added that Mrs. Gee can’t have it both ways. She can’t roll the funds
over into her own IRA and later withdraw funds from her IRA without additional
tax liability because the funds were originally from Campbell’s IRA. Once Mrs.
Gee chose to roll the funds over into her own IRA, she lost the ability to
qualify for the exception from the 10% penalty. The funds became her own and
were no longer from her deceased husband’s IRA once she rolled them over into
hers. Thus, the funds no longer qualified for the exception.
The Gees’ fared better on the Section 6662(a) substantial understatement of
income tax accuracy-related penalty (a 20% penalty). The accuracy-related
penalty doesn’t apply to any portion of an underpayment if it is shown that
there was reasonable cause for the taxpayer’s position and that the taxpayer
acted in good faith with the respect to that portion. Circumstances that may
indicate reasonable cause and good faith include an honest misunderstanding of
law that is reasonable in light of all of the facts and circumstances.
Since the IRS produced no evidence that the Gees’ specific fact pattern had
been previously litigated, the Court determined that they made a reasonable
attempt to comply with the Code. Thus, they acted reasonably and in good faith
with respect to the underpayment for 2002 and were not liable for the
accuracy-related penalty.
Observation. Taxpayers bringing fact patterns similar to the Gees’
before the Tax Court in the future may not fare so well on the 20%
accuracy-related penalty. Since IRS’s favor, taxpayers with similar cases may
be found to not be acting “reasonably and in good faith.”
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