Negative Financial Consequences may be Circumvented with Annuities and Certain Cases of Early Disability Distribution
A retirement plan participant who received a distribution before age 59½ avoided the 10% premature distribution tax under Code Sec. 72(t). This decision was despite the fact that he continued to work for over a year after receiving the distribution. (Brown, TC Memo 1996-421) The Tax Court's conclusion that he was exempt was based on the fact that he was disabled before he received the distribution.
Joe Brown was a project engineer for the Maryland State Highway Administration, responsible for supervising bridge construction. Project engineers spend 50% to 75% of their time working on site, and must walk up and down ladders and hillsides, into and out of operating machinery and motor vehicles, on top of building supplies, over obstructions, and be able to lift heavy objects and "walk beams."
Brown had a long history of health problems. He had polio as a child, resulting in severe atrophy of his right leg. As a result, he suffered severe degenerative joint disease of the spine and left knee. He also was overweight and developed severe lower back problems, necessitating a spinal fusion operation in '77. In '78 he was granted a disability retirement allowance but did not accept it, rehabilitated himself, and eventually returned to work. In '88 and '90 he had knee replacement surgery, and had to use crutches for six months following the second operation. On top of these problems, Brown had a "clinically significant" history of hypertension.
In October 1989, Brown took a partial distribution of about $225,000 from his retirement plan, and rolled $150,000 of it over into an IRA. Despite his physical impairment, Brown retained his position as project engineer until December '90 at which time he went on leave and never returned to work. Before that time, he struggled to perform his job. Although he could no longer climb or "walk beams," he attempted to control his job by telephone from home and attempted to work on site by driving or by being driven in a vehicle.
During 1989 and 1990 Brown did not use any sick leave. He used annual leave for his knee replacement surgery and for the following two-week convalescence period. After leaving work on December 26, 1990, Brown exhausted his accumulated annual and sick leave before his retirement. In March 1991, the Maryland Medical Board recommended Brown for disability retirement due to osteo-arthritis of the spine, hypertensive cardiovascular disease, old polio with atrophy of the right leg and obesity. Because of his years of service, however, Brown applied for and received a normal service retirement, effective May 1, 1991. In November 1991, Brown was notified that he was entitled to social security disability benefits retroactive to December 22, 1990.
The IRS determined that Brown's 1989 retirement plan distribution was not eligible for rollover treatment, so that it was fully subject to tax in 1989. In addition, since Brown was only 52 years old in 1989, IRS charged Brown with the 10% premature distribution excise tax. In determining that Brown was not disabled at the time of the distribution in 1989, the IRS relied on the fact that he continued to work for most of 1990, did not use any sick leave in either 1989 or 1990, and received superior job evaluations for 1989 and 1990.
Before 1993, partial distributions from qualified plans could be rolled over to an IRA only if made on account of death, disability, or separation from service. To qualify for this disability exception, the plan participant had to be disabled within the meaning of Code Sec. 72(m)(7), which is the same standard that applies for purposes of the disability exception to the 10% premature distribution tax.
Currently, most qualified plan distributions other than required minimum distributions and annuitized payouts are rollover-eligible, and thus not subject to tax or penalty if transferred by direct (trustee-to-trustee) or regular rollover to an eligible retirement plan within 60 days of the distribution.
A Close Call
The Tax Court disagreed with the IRS, finding that Brown was disabled before he received the distribution in 1989. As a result, the distribution was eligible to be rolled over tax-free into an IRA, and the portion of the distribution that was not rolled over was not subject to the 10% premature distribution tax.
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The court admitted that the issue of Brown's disability was a very close one. Under Code Sec. 72(m)(7), an individual is 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 a long-continued and indefinite duration." The regs emphasize that "substantial gainful activity" refers to the activity that was the individual's customary activity before the impairment, or a comparable activity. The court found that at the time of the distribution Brown was neither mobile nor fit, and was unable to climb, lift heavy objects, or walk beams. In short, he could no longer perform his job, but was mentally not ready to give up, and his subordinates and superiors accommodated him however they could. It found that a superior job evaluation report for 1989 was not incompatible with a disability occurring late in 1989 (when the distribution was received), and it simply dismissed the superior job evaluation for 1990 as contrary to the weight of the evidence. Observation: It is difficult to reconcile Brown with the Tax Court's holding earlier this year in Dwyer ((1996) 106 TC No. 18) that a stock trader suffering from clinical depression wasn't disabled when he received an IRA distribution.
There the court said that Dwyer wasn't considered disabled under Code Sec. 72(m)(7) because his illness didn't prevent him from continuing to work as a stock trader. However, Brown also was able to continue to work despite his impairment. Further, Brown did not address Reg. § 1.72-17A(f), which specifies that a person is not deemed disabled if "with reasonable effort and safety to himself, the impairment can be diminished to the extent that the individual will not be prevented by the impairment from engaging in his customary or any comparable substantial gainful activity." It may be that Brown's physical disability was so severe that the court felt he actually wasn't capable of gainful employment even though he formally stayed on the job after receiving the distribution.
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