Lesson From The Tax Court: The Tax Court Is Not Your Advocate

Today I present two lessons.  First, we learn why diabetes is not a per se disability sufficient to avoid penalties for early 401(k) distributions.  Second, we learn that pro se litigants cannot rely on the Tax Court to consider potential arguments they could have raised, but did not.

Diabetes is a well-known and widespread disease, afflicting some 37.3 million people in the U.S., according to the CDC’s 2022 National Diabetes Statistics Report.  That’s just over 11% of the US population.  Medical complications abound, as detailed in this report from the Diabetes Institute Research Foundation.

Managing diabetes and its attendant complications can be difficult and expensive.  In recognition of that, Canada gives this tax credit to Canadians who must manage the disease.  And in the U.S., many of the costs associated with diabetes qualify for the medical expense deduction under §213.  See e.g. IRS Publication 502 (2021) at p. 7 (explaining that cost of blood sugar test kit for diabetes is a qualifying medical expense).

In Robert B. Lucas v. Commissioner, T.C. Memo. 2023-9 (Jan. 17, 2023) (Judge Urda), the unemployed taxpayer took an early distribution from his 401(k) plan to help make ends meet, which included helping to manage his diabetes.  The issue was whether he had to pay the §72(t) 10% penalty for early distributions.  He could avoid the entire penalty if his diabetes qualified as a disability, and he could avoid some of it if the distribution was used for expenses allowable as a §213 deduction.  As to the first, Judge Urda teaches us why diabetes is not, in and of itself, a disability sufficient to escape the 10% penalty.  As to the second, Judge Urda notes the issue but, because the taxpayer did not raise it, “[w]e accordingly deem the issue forfeited.”  Op. at 4.  In doing that, Judge Urda teaches an important lesson on the role of the Tax Court.

Details below the fold.

Law: The Hot Mess of §72(t) Penalties
In 1978, Congress enabled the modern defined contribution plans by creating a new subsection (k) in §401.  Revenue Act of 1978, Pub.L. 95–600, 92 Stat. 2763.  You can find a nice short history of §401(k) and its unexpected consequences in this CNBC article from 2017.

In 1986 Congress created §72(t) as a kind of penalty hub for early distributions from any type of retirement plan.  Tax Reform Act of 1986 P.L. 99-514, 100 Stat. 2085, 2472.  Section 72(t) is now the go-to place to figure out early distribution penalties for all types of retirement accounts, including 401(k) plans and the various flavors of IRAs.

Yes, yes, all you fussbudgets, I know the Tax Court does not view §72(t) as a penalty but instead as a tax.  El v. Commissioner, 144 T.C. 140 (2015) (§72(t), imposes a "tax" and not a "penalty, addition to tax, or additional amount" for purposes of burden of proof shifting rules in §7491(c)).  But common understanding is different, as you see from this explanation from investment mega-firm Fidelity! So without getting into the metaphysical discussion of the distinction between a “tax” and a “penalty” I’m going to stick with the common parlance. Note: even Judge Urda slips up and calls it a penalty.  See Op. at p. 3.

Call it a tax, call it a penalty, call it a banana, the general rule in §72(t)(1) is now as it has been since 1986: taxpayers must pay an extra 10% on any distribution from “a qualified retirement plan (as defined in section 4974(c)).”  That includes §401(k) plans.

Section 72(t)(2) then gives an ever-expanding and confusing bunch of exceptions to the 10% penalty.  For a lesson on one of the big confusions that trip up taxpayers, see Lesson From The Tax Court: Know The Difference Between IRAs And 401(k)s, TaxProf Blog (Aug. 12, 2019).

The main exception to the penalty is, of course, for distributions “made on or after the date on which the employee attains age 59½.”  §72(t)(2)(A)(i).  Please do not ask me why the half-year matters.  Perhaps some knowledgeable reader can tell us why in the comments?

Therefore, taxpayers who take what we call “early” or “premature” distributions (before the sixth month after their 59th birthday) must find refuge from the penalty in one of the other myriad exceptions in §72(t).  Two of those are relevant to today’s lessons.

First is the disability exception.  Subsection (t)(2)(A)(ii) says there is no penalty for distributions “attributable to the employee’s being disabled within the meaning of subsection (m)(7).”  Subsection (m)(7), titled “Meaning of Disabled” says that an employee is disabled when “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.”

The regulations create a facts-and-circumstances test for the (m)(7) disability determination.  The test includes the nature and severity of the impairment, the taxpayer’s education, training, and work experience.  Most importantly, the regulations clarify what the requirement is not.  It is not that the taxpayer cannot engage in any type of paid work.  Rather, the impairment must prevent the taxpayer from working in the same kind of job the taxpayer was engaged in before the impairment.  See Treas. Reg. 1.72-17A(f)(1) (“The substantial gainful activity to which section 72(m)(7) refers is the activity, or a comparable activity, in which the individual customarily engaged prior to the arising of the disability or prior to retirement if the individual was retired at the time the disability arose.”).  The regulation gives the following examples of “impairments which would ordinarily be considered as preventing substantial gainful activity...(ii) Certain progressive diseases which have resulted in the physical loss or atrophy of a limb, such as diabetes, multiple sclerosis...”  But it will always be a facts-and-circumstances test.

Second is the medical expense exception.  Subsection (t)(2)(B) says the 10% penalty will not apply to distributions that “do not exceed the amount allowable as a deduction under section 213 to the employee for amounts paid during the taxable year for medical care (determined without regard to whether the employee itemizes deductions for such taxable year).” I am not well versed in this but it appears to me that this rule applies whether or not the taxpayer has claimed those expenses as an itemized deduction.  That is, say the taxpayer takes an early distribution of $10,000 and also spends $10,000 on medical expenses that qualify for the §213 deduction.  But the taxpayer also has an AGI of $100,000 and so only $2,500 of those medical expenses are actually allowable deductions.  See §213(a) (imposing 7.5% floor).  I read §72(t)(2)(B) as excluding $2,500 of the early withdrawal from the 10% penalty, regardless of whether the taxpayer actually itemizes that $2,500.  That’s because money is fungible and I find no tracing requirement.  Sadly, I really cannot find any authority supporting or negating that understanding so I welcome any comments from more knowledgeable readers correcting my understanding!

Facts
The year at issue is 2017 but the relevant facts go back to 2015.  At that time Mr. Lucas was a software engineer and during that year he was diagnosed with diabetes.  He was able to continue working, however, “effectively treating his diabetes with a mix of insulin shorts and other medications.”  Op. at 5.  He continued to work as a software engineer until 2017 when he was laid off.  During that year, “to make ends meet, he obtained a distribution of $19,365...from a section 401(k) plan account.”  Op. at 2.  His 401(k) administrator sent the IRS a Form 1099-R reporting the distribution and reporting it as one being an early distribution with no known exceptions to being taxable.

While Mr. Lucas disclosed the distribution on his 2017 tax return, he did not (a) report any part of the $19k as gross income, or (b) calculate and pay the 10% penalty.

That’s to its computer matching program, the IRS picked up the error and sent Mr. Lucas an NOD asserting a total deficiency of about $5,000.  It does not appear the IRS asserted a §6662(a) penalty.

Lesson 1: Diabetes Not a Per Se Disability for §72(t) Exceptions
In Tax Court Mr. Lucas represented himself.  That is understandable because the amount in controversy was only about $5,000.  I would guess it would cost him at least half of that to get representation but I’m just an academic so what do I know about fees?  I welcome comments on that.

You could tell that Mr. Lucas was confused about some basic issues.  For example, in trying to explain why he thought he could exclude the entire early distribution from gross income, Mr. Lucas pointed to a website he had relied on for advice.  Judge Urda had to explain that the website was just addressing “the applicability of the early withdrawal penalty in cases of disability.”  Op. at p. 3 (Emphasis supplied and not simply to point out that Judge Urda also calls the §72(t) amount a “penalty”!).  The applicability of the extra 10% “is a distinct subject from whether the distribution counts as income” in the first place, explains the Judge.  Id.  The early distribution was income because, as we saw in this year's first Lesson, everything is income.

Judge Urda then turned to the question of whether Mr. Lucas was disabled in 2017 because of his diabetes.  Recall this is a facts-and-circumstances test on whether the impairment prevents the taxpayer from engaging is the same kind of job he had been doing.  Even though the regulation lists diabetes as a potential impairment, whether it is actually an impairment just....depends.  In this case, Judge Urda found that since Mr. Lucas was able to be gainfully employed as a software engineer after his diabetes diagnoses in 2015, he was not disabled for purposes of this exception.  It was important to Judge Urda that Mr. Lucas was successful in managing his disease.  See Op. at p. 2, p. (he had “effectively ... treated” it); p. 5 (same).

Bottom line: When evaluating the applicability of the §71(t) 10% penalty, the question is not whether a client has diabetes (or any other disease), the questions are (a) how controlled is it and (b) does it prevent the taxpayer from engaging in their normal type of work?

Lesson 2: Don’t Count on The Tax Court to Help You
Mr. Lucas was not only confused about basic ideas of income, he also appears to have totally missed the medical expense exception to the §71(t) penalty.  That is, treating his diabetes was not costless.  Mr. Lucas could avoid the 10% penalty on whatever amount of his early distribution matched his diabetes expenses.  §71(t)(2)(B).  I'm no expert on this but I did not find any tracing requirement.  That would make sense because money is fungible.

According to this American Diabetes Association webpage, folks with diabetes spend about $16,000 per year managing it. Assume Mr. Lucas spent that amount in 2017.  Assume his AGI was $100k.  In that case I think §71(t)(2)(B) would exclude $9,500 ($16,000 - $7,500) from the penalty whether or not he also deducted that amount as part of itemizing.  At least that’s my admittedly neophyte reading of that provision.

Judge Urda notes this possibility in footnote 3 of the opinion.  But he refuses to consider it because Mr. Lucas—proceeding pro se remember—“did not claim he qualified for it.”  Op. at 4 (note 3).

One surely cannot fault Judge Urda for this approach.  Tax Court litigation is—as a formal matter— an adversarial process and the hallmark of adversarial process is that each party is responsible for its own arguments.  The Court exists to referee and judge the merits of the arguments each side raises.  In an adversarial system it is simply not the job of the Court to go beyond the arguments raised by the parties.

That said, Tax Court judges do sometimes take a more inquisitorial approach.  That is, regardless of what the parties argue, the Tax Court will sometimes exercise discretion to look more closely at an issue, as part of its job to “redetermine.”  Two recent cases illustrate my point.

First, in Patacsil v. Commissioner, T.C. Memo. 2023-8 (Jan. 17, 2023), Judge Holmes went beyond arguments raised by the taxpayers to act on information in the record.  In that case, the NOD asserted a deficiency based, in part, on unreported income of $7,000 from the Discharge of Indebtedness (DOI).  The pro-se taxpayers argued they were insolvent in the year of the DOI but could not prove it.  The pro-se taxpayers did not raise any argument about the sufficiency of the NOD.  However, Judge Holmes took a very close look at the data in the record to conclude that “a transcript of all the third-party reports of income” provided by the IRS did not reflect any Form 1099 for the DOI for the year at issue.  Op. at 9.  Accordingly, Judge Holmes decided that part of the NOD was defective.  But this was not because of any argument the taxpayers made; it was because the Tax Court Judge made his own deep dive inquiry beyond the face of the NOD.

Second, in Belton v. Commissioner, T.C. Memo. 2023-13 (Jan. 24, 2023), Judge Toro also went beyond arguments raised by the taxpayers to act on information in the record.  There, the IRS had certified the taxpayers to the Department of State as having “seriously delinquent tax debt” as part of the passport revocation procedure.  For a description of the passport revocation process see Lesson From The Tax Court: Cheshire Cat Jurisdiction Over Passport Revocation Petitions, TaxProf Blog (June 29, 2020).

One issue in Belton was whether the taxpayers—again proceeding pro se—had a “seriously delinquent tax debt” at the time the IRS made the certification.  To show they did, the IRS produced a transcript of the taxpayers’ account, showing the various events that happened.  The taxpayers appeared to make no argument about the validity of the account transcript.  I mean, come on.  Why on earth would you expect a pro-se taxpayer to know how to read a transcript or to even know there are different types of transcripts?

Judge Toro made a careful inquisition into the transcripts—independent of any taxpayer argument.  He read them critically to conclude that “the Belton’s...transcript and literal account transcript contain entries that raise questions about the validity” of the amount certified to the State Department.  Op. at 22.  While that does not end the case—Judge Toro was simply denied the IRS motion for Summary Judgment—it does show that sometimes the Tax Court sees its job as more than just a passive receptor of arguments from the parties—the quintessential role of a Court in an adversarial system.  Sometimes the Tax Court will take a more active role, acting as a Court of Inquisition to ensure a proper result.

But you cannot count on it.

Bottom Line:  alert readers will see distinctions between today’s case and the two I just mentioned and we could have a lovely discussion about just when and how the Tax Court might depart from a strictly adversarial model of judging.  For today’s purposes, however, I just wanted to alert readers that you simply cannot expect the Tax Court to rescue you from arguments or issues that you may miss. 

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.  He invites readers to return each Monday (or Tuesday if Monday is a federal holiday) to TaxProf blog for another Lesson From The Tax Court.