Taxing Lessons Case Summaries

Case — Reasonable Cause for Penalty Abatement

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TL Case Summ

THE QUESTION

Is depression a qualifying disability for penalty abatement?

THE DISPUTE

Taxpayer Says: Depression suffered due to the death of a spouse in June 2001 and the loss of friends and neighbors in the September 11, 2001 attacks qualifies as total disability, providing reasonable cause for penalties to be abated.

Internal Revenue Service Says: Disability for insurance purposes does not establish disability under the tax code. Taxpayer does not have reasonable cause for abatement, and penalties should be assessed.

THE LAW

From Internal Revenue Code Section 72(t)(1): Imposes a 10% additional tax on early distributions from qualified retirement accounts.

From Internal Revenue Code Section 72(t)(2)(A)(iii): Provides for an exception to the imposition of the 10% additional tax if the distribution is attributable to an individual’s being “disabled.”

From Internal Revenue Code Section 72(m)(7): An individual is “disabled” for this purpose if he or she “is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment that can be expected to result in death or to be of long-continued and indefinite duration.” An individual seeking to benefit from the exception must provide proof of his or her disability.

From Internal Revenue Code Section 6651(a)(1): Provides for an addition to tax for failure to timely file a tax return on or before the specified filing date.

From Internal Revenue Code Section 6651(a)(2): Provides for an addition to tax for failure to timely pay the tax due.

From United States v. Boyle, 469 U.S. 241, 245 (1985): The additions to tax under section 6651 do not apply if the failure to timely file or timely pay is due to reasonable cause and not to willful neglect.

THE CAUSE OF THE DISPUTE

Taxable distributions taken from your retirement accounts before you reach age 59-1/2 are generally subject to a 10% federal early withdrawal penalty tax. If you have evidence supporting your claim, you may qualify for an exception to the penalty, such as disability. Disability is typically defined as a physical or mental condition that prevents you from engaging in gainful employment and is of long and indefinite duration or is expected to lead to death.

Penalties can also be assessed for failing to file a tax return on time, unless you can show reasonable cause for your failure to file.

In this case, the taxpayer’s depression left him unable to work. He received medication for depression, and applied for, and received, payments under a disability insurance policy. Though providing no substantiation from doctors, the taxpayer believes these facts prove he suffered a disability that qualifies for the exception to the 10% early withdrawal penalty, as well as the failure to file penalty.

The IRS says that without substantiation, the receipt of insurance proceeds is not sufficient to meet the definition of disability under the tax code. In addition, the taxpayer’s depression was not reasonable cause for the lengthy delay in filing required tax returns.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 14KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Right answer!
For the IRS. Taxpayer did not establish disability as defined in the tax code. In addition, the depression did not incapacitate him to such an extent that he was unable to file his return and pay the tax due. Taxpayer is liable for the penalties.
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