District Court Holds That Premature Withdrawal from Retirement Account Under Threat of Levy Subject to 10 Percent Additional Tax

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In this post I will discuss Thompson v US, an opinion from the Northern District of California that explores the limits to an exception to the 10% penalty on early withdrawals from tax favored retirement plans when the distribution is used to pay an assessed federal tax liability on account of a levy.

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The facts of Thompson are straightforward. Facing a significant tax liability and “under imminent threat of levy and lien collection by Field Collections,” the Thompsons withdrew over a million dollars from a retirement account.  There are a number of exceptions to the additional 10% tax on levied on the gross distributions from a retirement plan. The most commonly known is the exception for distributions after an employee turns 59 1/2; another is found in Section 72(t)(2)(A)(vii), which provides that the 10% additional tax does not apply if the distribution is “on account of a levy under Section 6331.”

The Thompons paid the tax and filed a claim for refund, arguing that they were not subject to the early distribution additional tax under the Section 72(t)(2)(A)(vii) “on account of a levy” exception.

After IRS rejected the claim and the Thompsons sued for a refund in federal court, the government filed a motion to dismiss, arguing that the Thompsons’ withdrawal was voluntarily made and thus not “on account” of a levy and thus outside the exception in 72(t)(2)(A)(vii). The Thompsons in response did not deny that there was no actual levy, but instead argued that the government “took all the legally required steps to set in motion a levy, issuing Final Notices/Notices of Intent to Levy on December 12, 2012.” In addition, facing the threat of a Notice of Federal Tax Lien, which posed a “threat to Mr. Thompson’s business, his livelihood and his ability to generate funds sufficient to pay the balance of the liability over time,” meant that the withdrawal was not truly voluntary and and therefore should not be subject to the penalty.

For support, the Thompsons pointed to Murillo v Comm’r, where there was a distribution from a retirement plan that arose due to a forfeiture order and the Tax Court held that the taxpayer was not subject to the penalty, and to an earlier case, Laratonda v Comm’r, where the Tax Court, prior to the statutory exemption for levies now found in Section 72(t)(2)(A)(vii), found that a taxpayer whose funds from a retirement account were withdrawn pursuant to an IRS levy was not subject to the penalty.

The district court distinguished the Thompsons’ facts from the exception the Tax Court fashioned in Murillo and Laratonda:

Plaintiffs rely on the court’s emphasis on the involuntary nature of the withdrawals in Murillo and Laratonda in support of their assertion that they have stated a valid claim. Yet the limited facts alleged here are distinguishable from both Murillo and Laratonda in a crucial respect. Here, Plaintiffs’ retirement account was not, in fact, levied and the distribution was triggered not by any act of the IRS but by Plaintiffs’ own acts. In other words, Plaintiffs were actively involved in the distribution.

For good measure the district court noted that the legislative history to Section 72(t)(2)(A)(vii) explicitly referred to the exception as not applying to voluntary withdrawals to pay in the absence of an actual levy, as well as a 2009 Tax Court case, Willhite v Comm’r, which held that a taxpayer who had withdrawn funds from a retirement account following receipt of a notice of intent to levy was subject to the 10 % penalty.

Conclusion

In finding for the government and granting dismissal of the complaint, the district court did, however, throw a lifeline to the Thompsons. It noted that cases like Murillo suggest that there “may be circumstances other than a levy (for instance, a forfeiture) where a withdrawal is involuntary and therefore does not trigger the 10% penalty under § 72(t).” While noting that the Thompsons did not allege facts to support a plausible inference that the exception applies, it dismissed the complaint without prejudice, meaning that the Thompsons can file an amended complaint, which could include facts that would support such an inference.

In dismissing the complaint the district court held that it “need not decide at this juncture whether Plaintiffs might be able to state a claim based on allegations that the withdrawal was involuntary and coerced for reasons other than the fact that the IRS had set in motion a levy.”

I suspect that the Thompsons may have a difficult time navigating the narrow exception that Murillo supports. The issue of avoiding the 10% additional tax based on the levy exception is one Keith discussed most recently here, when he updated readers on Dang v Commissioner, involving a taxpayer who requested that IRS levy on his retirement account to ensure that the 10% tax did not apply. That post generated thoughtful comments, and Joe Schimmel suggested that perhaps IRS should draft a revenue procedure that allows the taxpayer to elect a levy on a retirement account. If the IRS listened to Joe that would have allowed the Thompsons to avoid what seems like a fairly punitive result of paying what amounts to an additional fairly harsh penalty for their tax troubles–admittedly of their own doing.

One other issue that the Thompons apparently did not raise is whether Section 72(t) is a penalty for purposes of Section 6751(b). As one might expect, another of our longtime readers and pioneer on this issue, Frank Agostino (joined by Malinda Sederquist) has weighed in on this in the latest issue of the Monthly Journal of Tax Controversy. Frank and Malinda point to analogous authority in the bankruptcy context, which has held that Section 72(t) is a penalty for purposes of determining priority status, and they recommend that taxpayers challenge the Section 72(t) 10% addition under Section 6751(b). Frank and Malinda do note that there is a summary non precedential Tax Court opinion holding that Section 72(t) is not a penalty for purposes of Section 6751(b) and they also acknowledge El v Commissioner, a 2015 opinion that held that Section 72(t) is not a penalty for purposes of Section 7491(c).

Whether this can be raised by the Thompsons in an amended complaint is unclear, as they would run into a likely variance challenge if they had not raised the 6751(b) issue in their original claim. I have no doubt, however, that Frank and friends and others will be pressing this issue.

 

 

 

Leslie Book About Leslie Book

Professor Book is a Professor of Law at the Villanova University Charles Widger School of Law.

Comments

  1. Good explanation.

    Had they worked with a competent EA or CPA, they would have known to insist on having the IRS levy those accounts.

    But, once having done it incorrectly, they had nothing to lose by trying to fight the penalties. Alas, the outcome was obvious.

    • As the opinion states, ” Plaintiffs contend the IRS intended to file a potentially ruinous Notice of Federal Tax Lien at an early time and that this posed a threat to Mr. Thompson‘s business, his livelihood and his ability to generate funds sufficient to pay the balance of the liability over time. ”

      I am not sure what a competent EA or CPA would have done, but I think a competent lawyer would have advised these taxpayers that IRS could file a potentially ruinous Notice of Federal Tax Lien, threatening their livelihood and ability to generate funds sufficient to pay the balance of the liability over time. Some of the tax debt went back to 2002, so there may have been statute expiration issues that would have made this more likely. The funds were withdrawn in December 2012.

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