Additional Tax on Early IRA Withdrawals Doesn't Require IRS Supervisory Approval

(Parker Tax Publishing February 2021)

The Tax Court held that the written supervisory approval requirement under Code Sec. 6751(b)(1) for to the initial determination of a penalty, including any addition to tax or any additional amount, does not apply to the 10 percent exaction on early distributions from a qualified retirement plan under Code Sec. 72(t). According to the Tax Court, based on the language of the statute and the larger statutory structure, the exaction under Code Sec. 72(t) is a tax, rather than a penalty, addition to tax, or additional amount for purposes of Code Sec. 6751(b). Grajales v. Comm'r, 156 T.C. No. 3 (2021).

Background

In 2015, Kirgizia Grajales, age 42, took loans in connection with her New York State pension plan. The New York State and Local Employees Retirement System sent her a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., reporting gross distributions of $9,026. Grajales timely filed her tax return for 2015 but did not report any retirement plan distributions as income.

The IRS issued Grajales a notice of deficiency determining that the $9,026 should have been included in her income and was subject to a 10 percent additional tax on early distributions under Code Sec. 72(t). Grajales agreed that she took an early distribution in 2015. However, she did not think she was liable for the 10 percent additional tax, so she took her case to the Tax Court.

Grajales argued that she was not liable for the Code Sec. 72(t) exaction because the initial determination of it lacked the written supervisory approval required under Code Sec. 6751(b)(1). According to Grajales, Code Sec. 6751(b)(1) was applicable because the 10 percent exaction is either a penalty or an additional amount under Code Sec. 6751(c). Grajales argued that the Tax Court should reconsider its previous decisions characterizing the Code Sec. 72(t) exaction as a tax, citing the Supreme Court's opinion in Nat'l Fed'n of Indep. Bus. V. Sebelius (NFIB), 2012 PTC 167 (S. Ct. 2012). In NFIB, the Supreme Court held that the individual mandate under the Affordable Care Act (ACA) is a penalty for purposes of the Anti-Injunction Act but is a tax for purposes of constitutional analysis. Grajales contended that the Tax Court should follow the "functional approach" of NFIB (i.e., the approach the Court used in its constitutional analysis) and conclude that the Code Sec. 72(t) exaction is a penalty rather than a tax. Grajales also relied on various bankruptcy court cases, including In re Daley, 315 F.Supp. 3d 679 (D. Mass. 2018), which followed In re Cassidy, 983 F.2d 161 (10th Cir. 1992), in holding that the Code Sec. 72(t) exaction is a penalty for bankruptcy purposes.

Analysis

The Tax Court rejected Grajales' arguments and held that the Code Sec. 72(t) exaction is a tax, rather than a penalty, addition to tax, or additional amount, and is therefore not subject to the written supervisory approval requirement under Code Sec. 6751(b)(1).

The Tax Court noted that in contexts other than the application of Code Sec. 6751(b)(1), it has held repeatedly that the Code Sec. 72(t) exaction is a tax, and the court saw no reason to characterize it differently for this purpose and for other purposes under the Code. The Tax Court recalled that, in El v. Comm'r, 144 T.C. 140 (2015), it found that the text of Code Sec. 72(t) as well as the larger statutory structure supports the conclusion that the exaction is a tax. In El, the court found that Code Sec. 72(t) calls the exaction a tax, not a penalty, and that several provisions of the Code, including Code Sec. 26(b)(2) and Code Sec. 401(k)(8)(D), refer to the additional tax under Code Sec. 72(t) using the unmodified term "tax." The court also rejected Grajales' contention that the Code Sec. 72(t) exaction is an "additional amount," noting that it has consistently held that "additional amounts," particularly when that term appears in a series that also includes "tax" and "additions to tax," refers exclusively to civil penalties enumerated in Code Secs. 6651 - 6665.

The Tax Court also found that the NFIB decision supports the Tax Court's previous decisions characterizing the Code Sec. 72(t) exaction as a tax. The court observed in NFIB, when considering whether the ACA individual mandate is a tax within the meaning of the Anti-Injunction Act so as to bar the suit before it, the Supreme Court focused on the text of the relevant statutes as the best evidence of Congress's intent. Noting that the ACA labels the individual mandate a penalty rather than a tax, the Supreme Court treated it as a penalty for purposes of the Anti-Injunction Act. However, for purposes of its constitutional analysis, the Court explained that "every reasonable construction must be resorted to, in order to save a statute from unconstitutionality." For this purpose the Court applied a "functional approach" whereby it examined various characteristics of the individual mandate and concluded that it could reasonably be characterized as a tax. The Court therefore held that the individual mandate was a constitutional exercise of Congress's taxing power.

The Tax Court declined to apply the Supreme Court's "functional approach" in this case because it found that this case presented no constitutional issue. Rather, because the issue was one of statutory construction, the court found that NFIB directed it to look at the statutory text as the best evidence of Congress's intent, and the court found that, as noted above, Code Sec. 72(t) expressly labels its exaction a tax consistent with the larger statutory structure.

The Tax Court also rejected Grajales' reliance on the holdings of bankruptcy cases. The court noted its previous holding in Ross v. Comm'r, 1995 WL 750102, in which In re Cassidy is not controlling in characterizing the Code Sec. 72(t) exaction for tax purposes because its holding was based on the application of bankruptcy policy and was limited to determining the priority of claims in bankruptcy proceedings. The court found that, for the same reason, In re Daley and the various other bankruptcy cases which Grajales cited were not controlling. The court concluded that, as the Supreme Court explained in NFIB, an exaction may be a tax for one purpose and a penalty for another purpose, depending on the context.

For a discussion of the written supervisory approval requirement, see Parker Tax ¶262,195.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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