IRS Collection and Retirement Accounts
Pursuant to IRC Section 72(t)(1), if a taxpayer receives a distribution from a qualified retirement account, the taxpayer not only faces potential taxes on the distribution amount itself, but also an additional tax equal to 10% of the amount of the distribution that is includible in gross income. There are a number of exceptions to the 10% rule, most notably distributions made after the taxpayer has reached the age of 59 ½.
Another, much less known, exception to the 10% rule is in Section 72(t)(2)(A)(vii) for a distribution made on account of an IRS levy on the retirement plan. Two recent court cases address the IRS levy exception to the 10% rule and how it should and should not be handled by a taxpayer.
In Thompson v. US (here), the taxpayers had a significant tax liability for the years 2002, 2003 and 2004. The Thompsons paid the IRS by withdrawing over one million dollars from a retirement account which was subject to the 10% penalty for early withdrawal. The Thompsons paid the $122,784 penalty and filed a claim for refund arguing that the IRS levy exception applied to the withdrawal because they were under imminent threat of levy and lien collection by Field Collections and the withdrawal was involuntary and coerced. The Thompsons also claimed that the IRS “took all the legally required steps to set in motion a levy.” The IRS denied the claim for refund and the Thompsons filed an lawsuit in U.S. District Court for the Northern District of California. The court granted the Government’s motion for summary judgement denying the refund claim because there was no IRS levy on the Thompsons’ retirement account and the Thompsons themselves initiated the withdrawal to pay their taxes.
Dang v. Commissioner (here), was a Collection Due Process (CDP) case that was remanded back to IRS Appeals for further consideration of a collection alternative requested by the Mr. Dang. Mr. Dang owed the IRS $100,000 and had an IRA available to pay the liability. Mr. Dang asked the IRS Revenue Officer handling his case to levy on his IRA so that he could avoid the 10% early withdrawal penalty. The Revenue Officer refused to levy on the IRA and instead asked Mr. Dang to withdraw the money from the IRA and pay the IRS. Mr. Dang filed a CDP request and asked for a hearing before IRS Appeals reiterating his request for the IRS to levy on his IRA. The IRS Appeals Office refused to consider the levy on the IRA as a collection alternative and Mr. Dang filed a petition in U.S. Tax Court. In its answer, IRS Chief Counsel agreed that the Appeals office should have considered Mr. Dang’s collection alternative. After the matter was remanded to IRS Appeals, they agreed to levy the IRA to pay the liability, allowing Mr. Dang to avoid the 10% early withdrawal penalty.