Attorney Liable for Penalty, Additional Tax on Early Distribution

MARY WALSH WOLL & JONATHAN WOLL,
Petitioners,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent.

UNITED STATES TAX COURT
WASHINGTON, DC 20217

ORDER

Pursuant to Rule 152(b), Tax Court Rules of Practice and Procedure, it is

ORDERED that the Clerk of the Court shall transmit herewith to petitioner and to respondent a copy of the pages of the of the trial of the above case before Judge Mark V. Holmes at Saint Paul, Minnesota on March 18, 2021, containing his oral findings of fact and opinion rendered after the conclusion of trial.

In accordance with the oral findings of fact and opinion, a decision for Respondent will be entered.

(Signed) Mark V. Holmes
Judge

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Bench Opinion by Judge Mark V. Holmes

March 18, 2021

 

THE COURT: The Court has decided to render oral findings of fact and opinion in this case, and the following represents the Court's Oral Findings of Fact and Opinion.

This bench opinion is made pursuant to the authority granted by section 7459(b) of the Internal Revenue Code of 1986 as amended, and Rule 152 of the Tax Court Rules of Practice and Procedure. This case is about an increase in tax of approximately $8,600 plus an associated penalty caused by the withdrawal of money from a 401K plan.

BACKGROUND

Petitioner Molly Woll is a licensed attorney who lived with her husband and co-petitioner, her husband Jonathan Woll, in Minnesota when the petition was filed. In 2017 Ms. Woll was laid off by her employer Thompson-Reuters. This resulted in a termination of her 401K savings plan, which at the time had more than $86,000 in it. At that time and continuing to this day, Ms. Woll is younger than 55 years of age. Of the $86,000 pulled out of the 401K plan, the Wolls spent $39,000 to immediately pay back borrowed money in accordance with the terms of a loan they had made to get some of that money out beforehand. Some of the money went to pay their medical expenses, including health insurance premiums in 2017, a year in which they reported that they had $9,462 in medical expenses.

They spent some of the money on student loans from Ms. Woll's law school days of years before, used some to pay their mortgage bills and house expenses, and the other bills that come due whether or not one has been laid off or not. As so often happens this triggered a distribution that had to be reported on their tax bill, increasing their taxes at a time when their expenses were remaining the same or even increasing, and their taxable income was otherwise going down. This is a hardship for a lot of people.

Ms. Woll did prepare the couple's tax returns for 2017 and she did report the distribution on the 1040 form, but she did not add an extra 10 percent tax on the amount withdrawn and that was not rolled over to another retirement savings plan. This tax is imposed by Internal Revenue Code section 72(t) on line 59 of the Form 1040. This then triggered an audit by the IRS's own computers. They increased the tax by that extra 10 percent of the withdrawn amount from the 401K and added a penalty for a substantial understatement.

The Woll's filed their petition in a timely manner, and their reason stated in their petition was "the family was in hardship due to unemployment. Remaining funds used for household necessities and educational expense owing (loans), mortgage, medical, dental insurance premiums and other."

DISCUSSION

I found Ms. Woll, the only witness in the case to be generally credible and honest. The parties agreed to a stipulation, and that together with her testimony constituted the evidence in this case. The facts were not much disagreed on by the parties. It's the law that is at issue here. And the law is clear that section 72(t) imposes a tax of 10 percent on early withdrawals unless an exception applies. Ms. Woll pointed to no exceptions that could apply here. So I do have to enforce the deficiency and sustain the IRS's determination that an extra 10 percent on the withdrawn amount applies.

The question of the penalty in this case is somewhat more difficult. The burden of production for penalties when an individual is involved is on the Commissioner. This typically has two parts, one part is what one can think of as a procedural part. Section 6751 of the code requires the immediate supervisor's approval in writing of any penalties. However, we have held very recently that the increase in tax on withdrawn amounts from retirement accounts imposed by section 72(t) of the code is not in fact a penalty, but an increase in tax. See Grajales v. Commissioner, 156 T.C. 3 (January 25, 2021), where we held "that for purposes of 6751(b) and (c), the section 72(t) exaction is a tax, and not a penalty addition to tax or additional amount. Consequently, the written supervisory approval requirement of section 6751(b) is inapplicable to the section 72(t) exaction.

The penalty under 6662 for substantial understatement typically does require supervisory approval. However, where the understatement of income tax is calculated by the IRS' computer program, and that additional tax exceeds the greater of $5,000 or 10 percent of the tax required to be shown on the return, the program systematically includes in the Notice of Deficiency a substantial understatement penalty. 

In another recent case we held that the penalty determined mathematically by computer software without the involvement of a human IRS examiner is one that is "automatically calculated through electronic means", section 6751(b)(2)(B) is the plain text that the statutory exception requires. See Walquist v. Commissioner, 152 T.C. 3 (February 25, 2019) at page 15. So the IRS didn't have to get supervisory approval, and it has met its burden of production on the 6662 penalty through math that was done by an IRS computer. That leads the burden to shift to the Wolls to show that they had reasonable cause in good faith for not reporting the additional tax under section 72(t) on their return.

Ms. Woll was the preparer here, so I'm looking at her good faith. She said, however, that she relied on a computer program and I do note that she didn't bring that program here or show how she might have been misled by the program. So I will hold her as a lawyer and as a highly intelligent person with a good education to what the IRS instructions that year showed.

And here's where things might have gotten a little bit complicated. If one looks at the stipulation of facts here, we have a copy of the Form 1099-R for 2017 on that withdrawal. One of the boxes, box number 7, has a code in it that says code number 2. This was apparently done by the trust company that held the 401K at Ms. Woll's former employer. Code number 2, in 2017 at least, meant according to the instructions for that form that the IRS itself posts, "Use code 2 only if the participant has not reached age 59-1/2 and you know the distribution is the following" and it includes a long line of exceptions to the 72(t) 10 percent penalty, including a distribution from a qualified retirement plan after separation from service, or after the year the participant has reached age 55.

It is conceivable that if Ms. Woll had relied on this erroneous code, exempting her from the 72(t) 10 percent tax, her reliance might have been reasonable. However, the instructions for line 59, the line on the 1040 form that requires reporting this 10 percent tax as applicable is very clear. It said in tax returns for 2017 "You must file Form 5329 if distribution code 1 is incorrectly shown in box 7 of Form 1099-R or you qualify for an exception. Such as the exceptions for qualified medical expenses or qualified higher education expenses." We know that none of those exceptions apply. However, the poor distribution code might have given a rise to a reasonable reliance defense.

Unfortunately for Ms. Woll, she did not follow the instructions on the 1040 and did not attach a Form 5329 to her return on which she took such a position. I have to conclude that to show a reasonable cause here, I can look at the regulations for 26 CFR, section 1.6666-4(e)(1), "The determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all the pertinent facts and circumstances. . . .generally the most important factor is the extent of the taxpayer's effort to assess the taxpayer's proper tax liability. Circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of all the facts and circumstances, including the experience, knowledge, and education of the taxpayer. . . .reliance on an information return constitutes reasonable cause and good faith if under all the circumstances such reliance was reasonable and the taxpayer acted in good faith." Here, however, I can't find that Ms. Woll relied on the erroneous distribution code on the 1099-R. She didn't refer to it, and she didn't attach the 5329 form to her return, as required, if she was claiming that erroneous distribution code as justification for not including the premature withdrawal of retirement savings in her gross income.

So I conclude that for a person of Ms. Woll's education and high intelligence this failure was not objectively reasonable and sustain the penalty as well. 

A decision will be entered for respondent. 

And this concludes the Court's oral findings of fact and opinion in this case. 

(Whereupon, at 3:15 p.m., the above-entitled matter was concluded.)