Tax-Court
As a general rule, when you withdraw money from your individual retirement account before age 59 1/2 you will have to pay a 10 percent early withdrawal penalty in addition to income tax on the amount withdrawn [IRC Sec. 72(t)(1)]. This means a $10,000 early withdrawal by a taxpayer in the 25 percent tax bracket would result in $3,500 in taxes and penalties. However,   section 72(t)(2)(A)(iii) provides an exemption for distributions which are attributable to the taxpayer’s being disabled. Disability for purposes for this exemption is defined in section 72(m)(7), which states that a taxpayer is considered disabled if he is “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.”

In a recent US Tax Court decision [Trainito v. Commissioner] the definition disability was tested again.  This time the taxpayer was diagnosed with type 2 diabetes in 2005. In April 2011 Trainito received an early distribution from his qualified retirement savings account. In June 2011 he suffered a diabetic coma and was hospitalized until the end of July, and the coma resulted in muscle atrophy and the reduced use of an arm and a leg. When he filed his 2011 tax return he attached Form 5329 (Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts) claiming the distribution in April 2011 was exempt from the 10 percent penalty tax on early distributions. The IRS rejected taxpayer’s claimed exemption and imposed the penalty.

The US Tax Court ruled in favor of the IRS. In making the determination, the following was taken into consideration:

1.For a taxpayer to be considered disabled the impairment must be expected to continue for a long and indefinite period or result in the death of the individual.

2. An impairment is not considered a disability if it is remediable or if it can be diminished by the individual with reasonable effort and safety to the extent that the individual will not be prevented by the impairment from engaging in his customary or any comparable substantial activity.

3. Examples of impairments that are normally considered to prevent substantial gainful activity include progressive physical diseases, such as diabetes, that have resulted in the physical loss or atrophy of a limb as well as mental diseases, such as psychosis or severe psychoneurosis, that require continued institutionalization or constant supervision of the afflicted individual.

You will notice that the distribution from his retirement account was in April 2011 and Trainito suffered the diabetic coma he suffered in June 2011. He could not prove disability before the distribution of his retirement funds (April 2011). While Trainito testified at trial that, following his diagnosis with diabetes in 2005, he saw a primary care doctor twice per month until his resignation from his job, he was not able to produce any medical records relating to these visits, nor did his primary care doctor testify on his behalf, nor was he able to prove disability during the period from 2005 to 2011. Instead, he continued working until 2010 when he quit his job.

While his condition is one of the examples provided under section 72(m)(7), the court focused on the date of the distribution (April 22, 2011) and concluded that section 72(t)(2)(A)(iii) requires that the distribution be attributable to the taxpayer’s being disabled. Also, the court concluded that a taxpayer may not escape the 10% early withdrawal penalty by suffering a disability at just any point during the tax year; rather the disability must be present at the time the distribution is made. [Kopty v. Commissioner, T.C. Memo. 2007-343 (finding that distributions were not attributable to disability where diagnosis of heart condition was not made until after taxpayer received distributions from his retirement fund].

Therefore, the fact that petitioner suffered a diabetic coma on June 12, 2011, does not indicate whether he was disabled on April 22, 2011. Trainito undoubtedly suffered from diabetes on April 22, 2011, but was not able to provided sufficient evidence to show that his diabetes caused him to be disabled within the meaning of section 72(m)(7) at April 22, 2011 or before.

This case is a good reminder of the importance of organization, specially when it comes to health issues. When it comes to tax courts, the IRS Commissioner’s determination as to the taxpayer’s tax liability is presumed correct, and the taxpayer bears the burden of proving otherwise [US Tax Court Rule 142(a)]. The way to overcome this hurdle, the taxpayer must introduces credible evidence with respect to any relevant factual issue and meets other conditions, including maintaining required records.