Addiction – Not Generally an Exception to Early Withdrawal Penalty
Under the federal tax code, individuals who take an early distribution from a retirement plan or traditional IRA are subject to a 10% tax. There are several exceptions that apply. One of these exceptions is a distribution made to an individual who has suffered a disability prior to such distribution. However, could addiction be considered a disability?
In a 2018 US Tax Court case, an individual suffering from gambling addiction took early distributions from her IRA to fund her gambling addiction. The IRS did not argue that she did not suffer from a real demonstrated addiction. Rather, the IRS argued that her gambling addiction did not constitute a “disability” for purposes of the early withdrawal penalty exception. The Tax Court agreed with the IRS. The Tax Court ruled that “disability” for purposes of the early withdrawal penalty exception required the taxpayer to be “unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which could be expected to result in death or to be of long-continued and indefinite duration,” and found that the taxpayer’s impairment did not prevent her from engaging in substantial gainful activity.
This is not to say that gambling addiction or any other addiction such as drug, alcohol or sex addiction could never amount to a “disability”. But such addiction would need to be of an indefinite duration and rise to the level of preventing the individual from engaging in substantial gainful activity.
“Substantial gainful activity” includes the activity in which the individual customarily engaged before the disability arose or a comparable activity. In determining whether an individual’s impairment makes him or her unable to engage in any substantial gainful activity, primary consideration is given to the nature and severity of the impairment. Consideration is also given to other factors such as the individual’s education, training, and work experience.
An impairment is considered to be of “indefinite duration” if it cannot reasonably be anticipated that the impairment will, in the foreseeable future, be corrected so as to no longer prevent substantial gainful activity. An impairment which is remediable is not a disability. Nor is an individual disabled if with reasonable effort and safety to himself the impairment can be diminished to the extent that the individual could engage in his or her customary or any comparable substantial gainful activity.
The above analysis does not apply to situations where taxpayers are seeking relief from penalties assessed for failure to file returns or pay taxes on time. In such cases, the federal tax code provides penalty exceptions if taxpayers can demonstrate their failure to pay or file on time was the result of reasonable cause. “Reasonable cause” is generally found where a late filing or payment is caused by death or serious illness of the taxpayer or a death or serious illness in his immediate family. Serious illness for this purpose can be based on alcohol, drug, gambling or other addictions.
For example, penalties assessed on a taxpayer who failed to file his 1983 return because he was a patient in a hospital drug and alcohol rehab center were waived for reasonable cause. But where such alcoholism and treatment did not prevent the taxpayer from working in his private practice and attempting to reorient his career toward research and academic pursuits, there was no clear showing that the alcoholism rose to the level of reasonable cause.
If you would like to know more about the exceptions to early withdrawal penalties or reasonable cause for late filing or payment of taxes, please contact one of our tax attorneys at 937-223-1130 or Jeff Senney.