Thursday, December 1, 2016

Someone Fought Back Against Ohio – And Won

I admit it will be a challenge to make this topic interesting.

Let’s give it a shot.

Imagine that you are an owner of a business. The business is a LLC, meaning that it “passes-through” its income to its owners, who in turn take their share of the business income, include it with their own income, and pay tax on the agglomeration.

You own 79.29% of the business. It has headquarters in Perrysville, Ohio, owns plants in Texas and California, and does business in all states.

The business has made a couple of bucks. It has allowed you a life of leisure. You fly-in for occasional Board meetings in northern Ohio, but you otherwise hire people to run the business for you. You have golf elsewhere to attend to.

You sold the business. More specifically, you sold the stock in the business. Your gain was over $27 million.

Then you received a notice from Ohio. They congratulated you on your good fortune and … oh, by the way … would you send them approximately $675,000?

Here is a key fact: you do not live in Ohio. You are not a resident. You fly in and fly out for the meetings.

Why does Ohio think it should receive a vig?

Because the business did business in Ohio. Some of its sales, its payroll and its assets were in Ohio.

Cannot argue with that.

Except “the business” did not sell anything. It still has its sales, its payroll and its assets. What you sold were your shares in the business, which is not the same as the business itself.

Seems to you that Ohio should test at your level and not at the business level: are you an Ohio resident? Are you not? Is there yet another way that Ohio can get to you personally?

You bet, said Ohio. Try this remarkable stretch of the English language on for size:
ORC 5747.212 (B) A taxpayer, directly or indirectly, owning at any time during the three-year period ending on the last day of the taxpayer's taxable year at least twenty per cent of the equity voting rights of a section 5747.212 entity shall apportion any income, including gain or loss, realized from each sale, exchange, or other disposition of a debt or equity interest in that entity as prescribed in this section. For such purposes, in lieu of using the method prescribed by sections 5747.20 and5747.21 of the Revised Code, the investor shall apportion the income using the average of the section 5747.212 entity's apportionment fractions otherwise applicable under section 5733.055733.056, or 5747.21 of the Revised Code for the current and two preceding taxable years. If the section 5747.212 entity was not in business for one or more of those years, each year that the entity was not in business shall be excluded in determining the average.
Ohio is saying that it will substitute the business apportionment factors (sales, payroll and property) for yours. It will do this for the immediately preceding three years, take the average and drag you down with it.

Begone with thy spurious nonresidency, ye festering cur!

To be fair, I get it. If the business itself had sold the assets, there is no question that Ohio would have gotten its share. Why then is it a different result if one sells shares in the business rather than the underlying assets themselves? That is just smoke and mirrors, form over substance, putting jelly on bread before the peanut butter.

Well, for one reason: because form matters all over the place in the tax Code. Try claiming a $1,000 charitable deduction without getting a “magic letter” from the charity; or deducting auto expenses without keeping a mileage log; or claiming a child as a dependent when you paid everything for the child – but the divorce agreement says your spouse gets the deduction this year. Yeah, try arguing smoke and mirrors, form and substance and see how far it gets you.

But it’s not fair ….

Which can join the list of everything that is not fair: it’s not fair that Firefly was cancelled after one season; it’s not fair that there aren’t microwave fireplaces; it’s not fair that we cannot wear capes at work.

Take a number.

Our protagonist had a couple of nickels ($27 million worth, if I recall) to protest. He paid a portion of the tax and immediately filed a refund claim for the same amount. 

The Ohio tax commissioner denied the claim.
COMMENT: No one could have seen that coming.
The taxpayer appealed to the Ohio Board of Tax Appeals, which ruled in favor of the Tax Commissioner.

The taxpayer then appealed to the Ohio Supreme Court.

He presented a Due Process argument under the U.S. Constitution.

And the Ohio Supreme Court decided that Ohio had violated Due Process by conflating our protagonist with a company he owned shares in. One was a human being. The other was a piece of paper filed in Columbus.

The taxpayer won.

But the Court backed-off immediately, making the following points:

(1)  The decision applied only to this specific taxpayer; one was not to extrapolate the Court’s decision;
(2)  The Court night have decided differently if the taxpayer had enough activity in his own name to find a “unitary relationship” with the business being sold; and
(3)  The statute could still be valid if applied to another taxpayer with different facts.

Points (1) and (3) can apply to just about any tax case.

Point (2) is interesting. The phrase “unitary relationship” simply means that our protagonist did not do enough in Ohio to take-on the tax aroma of the company itself. Make him an officer and I suspect you have a different answer. Heck, I suspect that one Board meeting a year would save him but five would doom him. Who knows until a Court tells us?

With that you see tax law in the making.

By the way, if this is you – or someone you know – you may want to check-out the case for yourself: Corrigan v Tesla. Someone may have a few tax dollars coming back.

No, not that kind of Tesla.


Friday, November 25, 2016

Can A Coffee Shop Be Tax-Exempt?

I have been spending quite a bit of time over the last few days working on or reviewing not-for-profit returns.

It may surprise you, but – with a few exceptions – not-for-profit organizations are required to file paperwork annually with the IRS.

There is a reason for this: the tax Code recognizes some organizations as “per se” not-for-profit – churches are the classic example. Churches do not need to be told by the IRS that they are tax-exempt; they simply are. A large part of this is church:state separation, although church programs that begin to look uncannily similar to for-profit businesses are supposed to file an income tax return (known as Form 990-T) and pay tax.

Then we have the next tier: the education, charitable, scientific, etc. entities that also comprise not-for-profits. These are not “per se” and have to apply with the IRS to have their exempt status recognized. The application is done via either Form 1023 or Form 1024, depending upon the type of exempt status desired.

We talking about the March of Dimes, Doctors Without Borders or your local high school boosters club.

One thing this tier has in common is that they have to explain to the IRS what their exempt purpose is.

And there are tax subtleties at play. For example, can your exempt purpose be less than 50% of what you do? What if it is more than 50% but you have a significant (but less than 50%) non-exempt purpose? What if you start out at a more-than-50% exempt purpose but – over time – your non-exempt purpose goes over 50%?

This becomes its own field of specialization. I have met practitioners over the years whose only practice is tax exempts.

I am looking at the IRS response to a recent exempt application. I will give you a few facts and flavor, and let’s see if you can anticipate the IRS decision on the matter.

(1)  A minister had an idea for a coffee shop. The shop would be separate from the church (hence the exempt application). Being separate however would allow (and maybe encourage) other churches and religious groups to participate.
(2)  The coffee shop would allow believers and non-believers to interact. There would be religious activities, but the activities would not be organized by the shop. They would instead be organized by the patrons. By the way, the shop could also be used for non-religious activities. One could leave a donation for the use of the space.
(3)  There are no similar businesses where the shop is located, hence it is not taking commercial opportunity from a profit-seeking business.
(4)  The shop affords a gathering space that is open late, as well as provide safe space for residents to gather.
(5)  The shop takes part in a job-skills training program to help underserved youth by placing them in an actual job for a six-week internship.
(6)  The shop participates in a project for the children of incarcerated parents. Patrons can share gifts with the kids, such as for their birthdays and Christmas.
(7)  The shop does not want to turn away anyone for inability to pay. There is a program where a customer can pay for a certain amount of coffee in advance. When a not-able-to-pay patron enters, he/she is served from those advance payments.
(8)  The shop sells coffee, teas, smoothies and so forth. There are also baked goods, as well as salads and desserts.
(9)  The shop roasts its own coffee, which is sourced directly from coffee farmers. This allows the farmers to earn more than other conventional means of distribution. The coffee is also available for sale, and there are plans to sell the coffee online in the future
(10)        The shop uses some volunteers, but its largest expense is (understandably) wages and related payroll costs.
(11)        The shop intends to give away its profits - that is, when it finally becomes profitable.

What do you think? Would you give this shop exempt status?

Here goes the IRS:

(1)  To be exempt, an organization must be both organized and operated exclusively for an exempt purpose. The test has two parts: the paperwork and what is actually going on.
(2)  The IRS has defined the word “exclusively” to mean “primarily.”
(3)  Hot on the heels of that definition, the IRS has also said that non-exempt activities must not be “more than an insubstantial part” of activities.

OBSERVATION: You can see the evolution of law here. A non-tax specialist would anticipate that an activity is exempt if the exempt activity is 51% or more of all activities. The flip side is that a non-exempt activity should be as much as 49%.

The IRS however states that a non-exempt activity cannot be “more than an insubstantial part” of all activities.

Does “insubstantial” mean as much as 49%?

If not, then the IRS is changing definitions all over the place.

(4)  The IRS has previously decided that the operation of a grocery store to provide on-the-job training to hardcore unemployed represented two purposes, not one. Each purpose has to be reviewed to determine whether it is exempt or not.

(a)  And now it gets tricky. If the store is staffed principally by a target group (or volunteers) AND the store is no larger than reasonably necessary for achieving the exempt purpose, the IRS has said that the store is exempt.
(b)  Conversely, if the store is not staffed by the target group (or volunteers) or larger than necessary, the IRS has said that the store is non-exempt.

(5)  While the coffee shop intends to donate its profits, its main activity is the operation of a coffee shop in a commercial manner.
(6)  And that activity is “more than insubstantial.”

The IRS rejected the application. The coffee shop will have to pay taxes.

Doesn’t it matter that they are giving away all profits? Isn’t there a vow-of-poverty-thing that one can point to?

And there is a key point about tax law in the world of exempts. Giving away money will not transform a for-profit activity into a not-for-profit activity. Granted, you may get a charitable deduction, but you will be taxable. The IRS has been steadfast on this point for many years. The activity itself has to be exempt, not just the monies derived from said activity. To phrase it differently, gigantic donations will not make Microsoft a tax-exempt entity.

The IRS decided the shop was too similar to a Starbucks or Caribou.    
And giving away any profits wasn’t enough to change the answer.

Does the shop do great work?

Yes.

Is it tax exempt?

Nope.

Saturday, November 19, 2016

A Mom Taking Care Of A Disabled Child And Payroll Taxes


We have a responsible person payroll tax story to tell.
You may know that I sardonically refer to this penalty as the “big-boy” penalty. It applies when you have some authority and control over the deposit of payroll withholding taxes but do not remit them to the IRS. The IRS views this as theft, and they can be quite unforgiving. The penalty alone is equal to 100% of the tax; in addition, the IRS will come after you personally, if necessary.
You do not want this penalty – for any reason.
How do people get into this situation? In many – if not most cases – it is because the business is failing. There isn’t enough cash, and it is easier to “delay” paying the IRS rather than a vendor who has you on COD. You wind up using the IRS as a bank. Now, you might be able to survive this predicament if we were talking about personal or business income taxes. Introduce payroll – and payroll withholding – and you have a different answer altogether.
Our story involves Christina Fitzpatrick (Christina). Her husband made the decision to start a restaurant in Jacksonville with James Stamps (Stamps). They would be equal partners, and Stamps would run the show. Fitzpatrick would be the silent wallet.
They formed Dey Corp., Inc to hold the franchise. The franchise was, of course, the restaurant itself.  
Sure enough, shortly after formation and before opening, Stamps was pulled to Puerto Rico for business. This left Fitzpatrick, who in turn passed on some of the pre-opening duties to his wife, Christina.
Fortunately, Stamps got back in town before the place opened. He hired a general manager, a chef and other employees. He then went off to franchise training school. Meanwhile, the employees wanted to be paid, so Stamps had Christina contact Paychex and engage their services. They would run the payroll, cut checks and make the tax deposits.
            OBSERVATION: Let’s call this IRS point (1)
He also had Christina open a business bank account and include herself as a signatory.
            OBSERVATION: IRS point (2) and (3)
Stamps and the general manager (Chislett) pretty much ran the place. Whether he was in or out of town, Stamps was in daily contact with Chislett. Chislett managed, hired and fired, oversaw purchases and so on. He was also the main contact with Paychex.
Except that …
Paychex started off by delivering paychecks weekly to the restaurant. There was a problem, though: the restaurant wasn’t open when they went by. Paychex then starting going to Christina’s house. Chislett told her to sign and drop-off the paychecks at the restaurant. Chislett could not do it because it was his day off.
            OBSERVATION: IRS point (4) and (5).
You can anticipate how the story goes from here. The restaurant lost money. Chislett was spending like a wild man, to the extent that the vendors put him on COD. Somewhen in there Paychex drew on the bank account and the check bounced. Paychex stopped making tax deposits for the restaurants because – well, they were not going to make deposits with rubber checks.
By the way, neither Stamps nor Chislett bothered to tell the Fitzpatricks that Paychex was no longer making tax deposits.
Sure enough, the IRS Revenue Officer (RO) showed up. She clued the Fitzpatricks that the restaurant was over two years behind on tax deposits.
Remember that the restaurant was short on cash. Who could the IRS chase for its money in its stead?  Let me think ….
The RO decided Christina was a responsible person and assessed big bucks (approximately $140,000) against her personally.
Off to Tax Court they went.
The Court introduces us to Christina.
·       She spent her time taking care of her disabled son, who suffered from a rare metabolic disorder. As a consequence, he had severe autism, cerebral palsy and limited mobility. He needed assistance for many basic functions, such as eating and going to the bathroom. He could not be left alone for any significant amount of time.
·       Taking care of him took its toll on her. She developed spinal stenosis from constantly having to lift him. She herself took regular injections and epidurals.
·       She truly did not have a ton of time to put into her husband’s money-losing restaurant. At start-up she had a flurry of sorts, but after that she visited maybe once a week, and that for less than an hour.
·       She could not hire or fire. She was not the bookkeeper or accountant. She did not see the bank statements.
She did, unfortunately, sign a few of the checks.
The IRS looks very closely at who has signatory authority on the bank account. As far as they are concerned, one could write a check to them as easily as a check to a vendor. Christina appears to be behind the eight ball.
The Court noted that the IRS was relying heavily on the testimony of Stamps and Chislett.
The Court did not like them:
Petitioner’s cross-examination of Mr. Stamps and Mr. Chislett revealed that their testimony was unreliable and unbelievable."
That is Court-speak to say they lied.
Mr. Stamps evaded many of the petitioner’s questions during cross-examination by repeatedly responding ‘I don’t remember.’”
Sounds like a possible presidential run in there for Stamps.
The Court was not amused with the IRS Revenue Officer either:
However, we believe that RO Wells did not conduct a thorough investigation. For instance, RO Wells made her determination before she received and reviewed the relevant bank records. She also failed to interview (or summon) Mr. Stamps, the president of the corporation.”
The IRS is supposed to interview all the corporate officers. Sounds like this RO did not.
The Court continued:
We are in fact puzzled that Mr. Stamps, the president of the corporation and a hands-on owner, an Mr. Chislett, the day-to-day manager, successfully evaded in the administrative phase any personal liability for these TFRPs.”
My, that is curious, considering they RAN the place. The use of the word “evaded” clarifies what the Court thought of these two.
But there is more required to big-boy pants than just signing a check. The Court reminded the IRS that a responsible person must have some control:
The inquiry must focus on actual authority to control, not on trivial duties.”
Here is the hammer:
Notwithstanding petitioner’s signatory authority and her spousal relationship to one of the corporation’s owners, the substance of petitioner’s position was largely ministerial and she lacked actual authority.”
The Court liked Christina. The Court did not like Stamps and Chislett. They especially did not like the IRS wasting their time. She was a responsible person they way I am a deep-sea diver because I have previously been on a boat.
The Court dismissed the case.
But we see several points about this penalty:
(1)  The IRS will chase you like Khan chased Kirk.


(2)  Note that the IRS did not chase Stamps or Chislett. This tells me those two had no money, and the IRS was chasing the wallet.
(3)  Following on the heels of (2), do not count on the IRS being “fair.” They IRS can cull one person from the herd and assess the penalty in full. There is no requirement to assess everyone involved or keep the liability proportional among the responsible parties.
We have a success story, but look at the facts that it took.


Saturday, November 12, 2016

You Got Repossessed And The Bank Says You Have HOW MUCH Income?


I ran into a cancellation-of-debt issue recently.

You may know that – should the bank or finance company cancel or agree to reduce your debt – you will receive a Form 1099. The tax Code considers forgiveness of debt to be taxable income, as your “wealth” has increased - supposedly by an amount equal to the debt forgiven. There are exceptions to recognizing income if you are insolvent, file for bankruptcy and several other situations.

Let me give you a situation here at galactic headquarters:

Married couple. Husband is a doctor. Husband buys a boat. He puts both the boat and the promissory note in the wife’s name, presumably in case something happens and he gets sued. They divorce. It is understood that he will keep the boat and make the bank payment. He does not. The boat is repossessed and then sold for nickels on the dollar. Wife (who was never taken off the note) receives a Form 1099-C. She has cancellation-of-debt income, which is bad enough. To make it worse, income is inflated as the bank appears to have sold the boat at a fire-sale price.

Our client is – of course – the wife.

The person who signs on the note receives the 1099 and reports any cancellation-of-debt income. If the debt “belongs” to your spouse and not to you, you better have your name removed from the debt before you get out of divorce court. The IRS argues that – if you receive a 1099 that “belongs” to your ex-spouse - you should seek restitution by repetitioning the court. This makes it a divorce and not a tax issue. The IRS is not interested in a divorce issue.

It all sounds fine until real life.

The wife received a $100,000-plus Form 1099-C from that boat.

Let’s reflect on how she there:

(1)  The wife doesn’t have a boat and never did. Hubby wanted a boat. She signed on the note to keep hubby happy.
(2)  The wife’s divorce attorney forgot to get that note out of her name. Alternatively, the attorney could have seen to it that wife also wound up with the boat.
(3)  For whatever reason, husband let the boat be repossessed.
(4)  The bank issued a Form 1099-C to the wife. The income amount was simple math: the debt less whatever the bank received for the boat.

Let’s introduce real life:
  • What if the bank makes a mistake?
  • What if the bank virtually gives the boat away?

The IRS has traditionally been quite inflexible when it comes to these 1099s. If the bank reports a number, the IRS will run with it.

You can see the recipe for tragedy.

Fortunately, the IRS pressed too far with the 2009 Martin case.

In 1999 Martin bought a Toyota 4-Runner. He financed over $12 thousand, but stopped making payments when the loan amount was about $6,700. The Toyota was repossessed. He received a Form 1099-C for the $6,700.
… which meant that the bank received zero … zip… zilch… on the sale of the 4-Runner.
Doesn’t make sense, does it?

The IRS did not care. Go back to the lender and have them change the 1099, they said.
COMMENT: Sure. I am certain the lender will jump right on this.
Martin did care. He told the Court that the Toyota was worth roughly what he owed on it when repossessed, and that the 1099-C was incorrect.

Enter Code section 6201(d):
(d) Required reasonable verification of information returns In any court proceeding, if a taxpayer asserts a reasonable dispute with respect to any item of income reported on an information return filed with the Secretary under subpart B or C of part III of subchapter A of chapter 61 by a third party and the taxpayer has fully cooperated with the Secretary (including providing, within a reasonable period of time, access to and inspection of all witnesses, information, and documents within the control of the taxpayer as reasonably requested by the Secretary), the Secretary shall have the burden of producing reasonable and probative information concerning such deficiency in addition to such information return. 

Normally, the IRS has the advantage in a tax controversy and the taxpayer has the burden of proof. 

Code section 6201(d) provides that – if you can assert a reasonable dispute with respect to an item of income reported on an information return (such as a 1099-C), you can shift the burden of proof back to the IRS.

The Tax Court decided that Martin had shifted the burden of proof. The 4-Runner had to be worth something. The ball was back in the IRS’ court.

Granted, Martin was low-hanging fruit, as the bank reported no proceeds. The IRS should have known better than to take this case to court, but they did and we now have a way to challenge an erroneous 1099-C.  

In our wife’s case, I am thinking of getting a soft appraisal on the value of the boat when repossessed. If it is materially different from the bank’s calculation (which I expect), I am considering a Section 6201(d) challenge.

Why? Because my client should not have to report excess income if the bank gave the boat away. That was a bank decision, not hers. She had every reasonable expectation that the bank would demand and receive fair market value upon sale. Their failure to do so should not be my client’s problem. 

Which will be like poking the IRS bear.


But she has received a questionable $100,000-plus Form 1099-C. That bear is already chasing her.

Sunday, November 6, 2016

The Mary And Brad Story


"With respect to petitioner wife’s Federal income tax for 2008, the Internal Revenue Service … determined a deficiency of $106,733 and an accuracy-related penalty of $21,347 under section 6662(a). With respect to petitioners’ joint federal tax for 2010, the IRS determined a deficiency of $100,924 and a section 6662(a) penalty of $20,185.”
Someone went into Tax Court for a quarter of a million dollars. Let’s check it out.

Oh, oh. The issue was whether the taxpayers had a business or nonbusiness bad debt. If they did not, then other tax dominoes would tumble, such as whether a net operating loss existed.

We have Mary Bell. She was single in 2008. She married in 2010. They lived in Texas.

Mary had an MBA, and through 2010 she worked at Blockbuster Corp. You may recall how that turned out, and since 2011 Mary had been a partner with a private equity 
firm.


Her husband also brought some financial chops to the relationship. He was involved with real estate loans, but he lost his job with the 2009 crash. His health thereafter became an issue, but he hoped to get back into the business. His previous clients would eventually have their loans mature, and he wanted to be there when they refinanced.

Our story involves Mary.

Before marrying, Mary dated Brad. Brad was unemployed but full of hope and hype. He was working on a comic strip called “In the Rough,” involving golf.

Mary was making a couple of nickles, and she loaned Brad $75,000. Mary did not go through the due diligence a bank would do, though: investigate his credit rating, request tax returns, obtain other financial information.

She loaned him another $50,000. Brad, being a mature and responsible guy, bought a Hummer with it. He clearly was a keeper.

In all she loaned $430,500 to Brad.

She obtained a written note. It had interest at 5% and matured on December 31, 2007.

How did our tale turn out?

Yep. Our protagonist – the enigmatic, charismatic, problematic Brad – defaulted.

To be fair, he did repay $7,000, so it wasn’t a complete loss.

In 2010 Mary sent an e-mail demanding payment. Brad replied:
"I have no money.”
She continued trying.

In 2011 she filed suit for performance.

In 2012 she received a judgement against Brad.

In 2014 she reasoned that if Brad could get his comic strip syndicated, then he might have enough money to pay her back. She introduced Brad to people. She did not however get any interest, ride or other participation should Brad ever get the comic published.

In 2010 Mary set up an LLC to take-over the note. She then claimed it as a business bad debt on her/their 2010 joint tax return. The note, including interest, was over $600,000 at that time. Not surprisingly, this created a net operating loss, which she carried-back to 2008 for a refund.

We already know that they went to Tax Court.

While there were several issues in the case, we are concerned with only one today 

There are two pieces here:
You made a loan that went south, and
You are in the trade or business of making loans
The IRS quite agreed that Mary made a loan, but they argued that she did not meet the second requirement.

You do not need a building and employees to be in the trade or business of making loans, but you do need to make loans repetitively. That is what “trade or business” means: Jimmy John's does not make one sandwich and call it a day. One loan does not rise to the level of “repetitively.” It also helps to meet the routine requirements that banks and other lenders observe: perform credit checks, obtain financial information, obtain security for the loan, etc.

Mary in turn argued that she worked on content deals all the time at Blockbuster, and Brad’s comic strip was “content” by another name. She was in a “trade or business” because she had done something similar at work.

Not a bad argument, but it had two holes:

Mary did not loan money to Brad in the context of her job at Blockbuster. As a consequence, what she did at Blockbuster was not particularly relevant to the tax outcome of her loan.

Even allowing for that, she did not have an interest, royalty, or other equity participation in the comic strip. She could have demanded it from Brad, but she did not. The only thing she had was a creditor interest, the same as Fifth Third or SunTrust have when they lend money. We are still talking about a loan.

The Court decided that Mary had a nonbusiness bad debt.

The tax difference is huge.

If you have a business bad debt, you can deduct the loan the same way you would deduct your rent, payroll or any other expense. If the sum goes negative, you might have a net operating loss that you can carryback and/or carryforward, offsetting taxable income in other years. If you can carryback, you might even get a refund of taxes previously paid.

If you have a nonbusiness bad debt, the most you can do is offset your capital gains plus $3,000. That’s it. The biggest net subtraction you get can on your tax return is $3 grand. And there is no carryback. Mind you, you can carryforward indefinitely, but at $600 grand Mary would be carrying-forward until the cows came home.

Which is why Mary wanted the business bad debt so badly.

But she was not in the business of making loans. The best she could do was the $3,000. 

She owed the tax. She owed the penalty. It was a loser for her all around.

Sunday, October 30, 2016

When Hardship Is Not Enough



Let’s talk a bit about hardship distributions from your retirement plan – perhaps your 401(k).

You may know that you are not supposed to touch this money before a certain age. If you do, not only will there be income taxes to pay, but also a 10% early withdrawal penalty. These are two moving pieces here: one is the income tax on the distribution and another for the 10% penalty.

Here is a question for you:

Let’s say you can withdraw money from your plan for hardship reasons. Does that mean that the penalty does not apply?

The answer is no. One would think that the two Code sections move in tandem, but they do not.

Candace Elaine ran into this in a recent Tax Court decision.

Candace lived in California, and in 2012 she withdrew $84,000 from her retirement plan. She had lost her job in 2009, and she was trying to support herself and family.

The tax Code applies two requirements to the income taxation of hardship withdrawals:

·        On account of an immediate and heavy financial need, and
·        Any amount withdrawn is limited to actual need

An “immediate and heavy financial need” would include monies needed for medical expenses or to avoid foreclosure. In addition, one is not allowed to withdraw $20,000 if the need is only $12,000, with the intention of using the excess for other purposes. 

The plan custodian is the watchman for these two requirements. The custodian is to obtain reasonable assurance of need and inquire whether other financial resources exist. This is a role above and beyond routine administration, and consequently many plans simply do not offer hardship withdrawals.

Candace met those requirements and her plan allowed withdrawals. She reported and paid income tax on the $84,000, but she did not pay the 10% penalty.

The IRS bounced her return. Off to Tax Court they went, where Candace represented herself.

Her argument was simple: I received a hardship distribution. There is an exemption for hardship.

The IRS said that there was not. And in the spirit of unemployed taxpayers trying to support their family, the IRS assessed a penalty on top of the 10% chop.

The Court pointed several exceptions to the 10% early withdrawal penalty, including:

·        Separation from service
·        Disability
·        Deductible medical expenses
·        Health insurance premiums while unemployed
·        Higher education
·        First time purchase of a principal residence

There isn’t one for hardship, though.

Meaning that Candace owed the 10% penalty.

The Court did note that the misunderstanding on the 10% is widespread and refused to assess the IRS’ second penalty.

Why did Candace not just borrow the money from her 401(k) and avoid the issue? Because she had been let go, and you have to be employed in order to take a plan loan.

What if she had rolled the money into an IRA?

IRAs are not allowed to make loans, even to you. The only way you can get money out of an IRA is to take a distribution. This is what sets up the ROBs (Roll-Over as Business Start-Up) as a tax issue, for example.

Candace was stuck with the penalty.