Exceptions to Early Distribution Penalties

 

What caught my eye about the case was the reference to an “oral opinion.”

Something new, methought.

Better known as a “bench opinion.’

Nothing new, methinks.

What happened is that the Tax Court judge rendered his/her opinion orally at the close of the trial.

Consider that a tax case will almost certainly include Code section and case citations, and I find the feat impressive.

Let’s talk about the case, though, as there is a tax gotcha worth discussing.

Molly Wold is a licensed attorney. She was laid-off in 2017. Upon separation, she pulled approximately $86 grand from her 401(k) for the following reasons:

(1)  Pay back a 401(k) loan

(2)  Medical expenses

(3)  Student loans

(4)  Mortgage and other household expenses

You probably know that pulling money from a 401(k) is a taxable event (set aside a Roth 401(k), or we are going to drive ourselves nuts with the “except-fors”).

Alright, she will have income tax.

Here is the question: will she have an early distribution penalty?

This is the 10% penalty for taking money out from a retirement account, whether a company plan (401(k), 403(b), etc) or IRA and IRA-based plans (SIMPLE, SEP, etc). Following are some exceptions to the penalty:

·      Total and permanent disability

·      Death of the account owner

·      Payments over life expectancy; these are sometimes referred to as “Section 72(t)” payments.

·      Unreimbursed medical expenses (up to a point)

·      IRS levy

·      Reservist on active duty

Then it gets messy, as some exceptions apply only to company-based plans:

·      Leaving your job on reaching age 55 (age 50 if a public safety employee)

Is there a similar rule for an IRA?

·      Withdrawals after attaining age 59 ½.

Why age 55 for a 401(k) but 59 ½ for an IRA?

Who knows.

Molly was, by the way, younger than age 55.

There are exceptions that apply only to a company-based plan:

·      A qualified domestic relations order (that is, a divorce)

·      Dividends from an ESOP

There are exceptions that apply only to an IRA and IRA-based plans:

·      Higher education expenses

·      First-time homebuyer (with a maximum of $10,000)

Yes, Congress should align the rules for both company, IRA and IRA-based plans, as this is a disaster waiting to happen.

However, there is one category that all of them exclude.

Ms Wold might have gotten some pop out of the exception for medical expenses, but that exclusion is lame. The excluded amount is one’s medical expenses exceeding 7.5% of adjusted gross income (AGI). I suppose it might amount to something if you are hit by the proverbial bus.

The rest of the $86 grand would have been for general hardship.

Someone falls on hard times. They turn to their retirement account to help them out. They take a distribution. The plan issues a 1099-R at year-end. Said someone says to himself/herself: “surely, there is an exception.”

Nope.

There is no exception for general hardship.

10% penalty.

Let’s go next to the bayonet-the-dead substantial underpayment penalty. This penalty kicks-in when the additional tax is the greater of $5,000 or 10% of the tax that should have been shown on the return.

Folks, considering the years that penalty has been around, you would think Congress could cut us some slack and at least increase the $5 grand to $10 grand, or whatever the inflation-adjusted equivalent would be.

Ms Wold requested abatement of the penalty for reasonable cause.

Reasonable cause would be that this area of the Code is a mess.

You know who doesn’t get reasonable cause?

An attorney.

Here is the Court:

So I will hold her as a lawyer and as a highly intelligent person with a good education to what IRS instructions that year showed.”

Our case this time was Woll v Commissioner, TC Oral Order.

Marijuana And Tax-Exempt Status

I am not surprised.

I am looking at a Private Letter Ruling on a tax -exempt application for an entity involved with marijuana and CBD.

I doubt the CBD plays any role here. It is all about marijuana.

I have become sensitive to the issue as I have two friends who are dealing with chronic pain. The pain has risen to the level that it is injuring both their careers. The two have chosen different ways to manage: one does so through prescriptions and the other through marijuana.

Through one I have seen the debilitating effect of prescription painkillers.

The other friend wants me to establish a marijuana specialization here at Command Center.

I am not. I am looking to reduce, not expand, my work load.

What sets up the tax issue?

Federal tax law. More specifically, this Code section:

        § 280E Expenditures in connection with the illegal sale of drugs.

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.

Marijuana is a Schedule I substance, so it runs full-face into Section 280E. There is “no deduction or credit” allowed on that tax return.

There is one exception, and that has to do with the cost of the marijuana itself. Accountants refer to this as “cost of sales,” and it would include more than just the cost of the product. It would include costs associated with buying the product or storing it, for example. Still, the big bucks would be with the cost of the product itself.

There is a Court decision which defines taxable revenues as revenues after deduction for cost of goods sold. The decision applies to all businesses, not just marijuana.

What it leaves out is everything other than cost of sales, such as rent, utilities or the wages required to staff and run the business.

That gets expensive. One is paying taxes on business profit, without being allowed to deduct all the costs and expenses normally allowed in calculating business profit. That is not really “profit” in the common usage of the word.

I am reading that someone applied for tax exempt status. They argued that their exempt purpose was:

·      To aid financially disadvantaged patients and families affected by the cost of THC and CBD medical treatment

·      To educate health providers about THC and CBD medical treatments

·      To support research into said THC and CBD medical treatments

The entity anticipated the usual stuff:

·      It will be supported by contributions and gifts

·      It will develop a website, which will give it another venue to educate about its mission as well as fundraise

·      It will develop relevant medical and treatment literature

·      It will conduct relevant seminars and classes

·      It will organize support groups for patients and their families

·      It will track and publish relevant medical data

The IRS led with:

You were formed to aid financially disadvantaged patients and patient’s families who are affected by the costs of THC and CBD medical treatment by providing financial support to cover costs of living and other expenses that the patients may incur.”

It continued:

… you are providing funding to the users of these substances who may be struggling to pay living and/or travel expenses because of their use of these illegal substances. Furthermore, your financial assistance is only available to users of these substances.”

In response the entity argued that it did not directly provide THC or CBD to individuals nor did it provide direct funding for the same.

The IRS was unmoved:

You were formed for the purpose of providing financial assistance to individuals who are engaged [in] an illegal activity which is contrary to public policy.”

The IRS rejected the tax-exempt application.

There are numerous tax-exempts throughout the nation that counsel, research, educate and proselytize concerning their mission. A substance abuse clinic can provide methadone, for example. What it cannot do is provide the heroin.

The entity could, I suppose, withdraw the financial support platform from its mission statement, greatly increasing the likelihood for tax-exempt status.

If its core mission was to provide such financial support, however, this alternative might be unacceptable.

If I were advising, I might consider qualifying the entity as a supporting organization for a pain clinic. The clinic would likely address more than marijuana therapy (it would have to, otherwise we are just circling the block), which represents a dilution of the original mission. In addition, a supporting organization transfers some of its governance and authority to the supported organization. It may be that either or both of these factors could be deal-breakers.

It has been interesting to see the continuing push on this area of tax law.

Do You Have To Register To Be Considered A College Student?

I cannot believe this case made it to the Tax Court.

Granted, it is a "pro se" decision, which means that the taxpayer represented himself/herself. It sometimes is the professional wrestling of tax literature.

I will give you the facts, and you can tell me how the case was decided.

Through 2012 Brittany was a student at Saddleback College (Saddleback) in Mission Viejo, California. Our story takes place in the spring, when Brittany registered for a five-hour physiology course.  She also attended (for eight weeks, at least) a contemporary health course, although she never registered or enrolled in the course.

She filed her 2012 tax return and claimed a $2,500 American Opportunity tax credit. This is the credit for the first four years of college.

The IRS bounced the return. It pointed out the following from Code section 25A:

(B) Credit allowed for year only if individual is at least 1/2 time student for portion of year

The Hope Scholarship Credit under subsection (a)(1) shall not be allowed for a taxable year with respect to the qualifies tuition and related expenses of an individual unless such individual is an eligible student for at least one academic period which begins during such year.

The term "eligible student" in turn is defined as one carrying at least half the normal full-time workload at school.

The IRS saw a five-hour load and did not see an eligible student.

Brittany did not see it that way. She saw a five-hour load and her sitting-in on a three-hour course. That added up to eight hours, which was more than half-time.

What did the Tax Court decide?

We do not need Apple's tax department for this one.

The Regulations require that a student enroll at the school. And the course. Each course.

Five hours was not enough to be half-time. She did not qualify for the credit.

You Can Start Filing Tax Returns Today

Today the IRS finally starts accepting 2012 individual tax return filings.  It is January 30, 2013.

Why so late? You recall that Congress passed, and the President signed, a tax bill on January 1, 2013. This tax bill was retroactive to 2012. While the IRS tried to anticipate what would be in the bill, to do so exactly is nearly impossible. The IRS in turn separated the tax changes into two categories: those affecting the most people and the balance of the changes. It has programmed those changes with the widest effect, and this first category of taxpayers can begin filing today.

So if you claim state sales tax (because your state does not have an income tax), claim an education deduction or claim schoolteacher expenses, you can begin filing today.

What if you claim depreciation, own and rent a duplex or have a kid in college and claim an education tax credit (rather than a deduction)? You are in the second group and have to wait until late February or March. Your tax preparer can prepare your tax return, but he/she cannot send it to the IRS until then.

Here is the list of tax changes and forms included in the second category, if you wish to labor through them:

• Form 3800 General Business Credit
• Form 4136 Credit for Federal Tax Paid on Fuels
• Form 4562 Depreciation and Amortization (Including Information on Listed Property)
• Form 5074 Allocation of Individual Income Tax to Guam or the Commonwealth of the Northern Mariana Islands
• Form 5471 Information Return of U.S. Persons With Respect to Certain Foreign Corporations
• Form 5695 Residential Energy Credits
• Form 5735 American Samoa Economic Development Credit 
• Form 5884 Work Opportunity Credit
• Form 6478 Credit for Alcohol Used as Fuel
• Form 6765 Credit for Increasing Research Activities
• Form 8396 Mortgage Interest Credit
• Form 8582 Passive Activity Loss Limitations
• Form 8820 Orphan Drug Credit
• Form 8834 Qualified Plug-in Electric and Electric Vehicle Credit
• Form 8839 Qualified Adoption Expenses
• Form 8844 Empowerment Zone and Renewal Community Employment Credit
• Form 8845 Indian Employment Credit
• Form 8859 District of Columbia First-Time Homebuyer Credit
• Form 8864 Biodiesel and Renewable Diesel Fuels Credit
• Form 8874 New Markets Credits
• Form 8900 Qualified Railroad Track Maintenance Credit
• Form 8903 Domestic Production Activities Deduction
• Form 8908 Energy Efficient Home Credit
• Form 8909 Energy Efficient Appliance Credit
• Form 8910 Alternative Motor Vehicle Credit
• Form 8911 Alternative Fuel Vehicle Refueling Property Credit
• Form 8912 Credit to Holders of Tax Credit Bonds
• Form 8923 Mine Rescue Team Training Credit
• Form 8932 Credit for Employer Differential Wage Payments
• Form 8936 Qualified Plug-in Electric Drive Motor Vehicle Credit

There is some rhyme or reason to what the IRS is doing. Category two changes require more extensive programming. In addition, those tax attributes tend to appear on more complicated returns. These returns – as a rule of thumb – are prepared later in the filing season or are extended.