February 1999 Issue


By Peter Barton, JD, CPA, professor of accounting, and Roy Weatherwax, PhD, CPA, Arthur Andersen Professor of Accounting, both at the University of Wisconsin­

In Arnold v. Comm'r, the Tax Court recently ruled that the taxpayer was liable for the 10% early distribution penalty on $220,000 distributed from his IRA because he modified a series of equal distributions within five years, even though the modification occurred after attaining age 59wQ. This case is important because the downsizing of American industry has resulted in many taxpayers needing early distributions from their retirement plans.

Sec. 72(t)(1) imposes a 10% additional tax on distributions from qualified retirement plans, which includes for this purpose virtually all tax-favored retirement arrangements. Sec. 72(t)(2) contains several exceptions to the 10% tax, including distributions that are "part of a series of substantially equal periodic payments" made for the life (or life expectancy) of the employee or joint lives of the employee and designated beneficiary. There is no minimum age requirement, but the distributions cannot begin until the employee separates from service. However, the 10% tax is imposed if the payments are modified (other than by death or disability) either within the five-year period beginning with the first payment, or before the employee attains age 59½. The statute does not define "modified."

Two examples illustrate these provisions. Example 1: An employee, separated from service, begins receiving substantially equal periodic payments on her 56th birthday and modifies the payments prior to attaining age 61. The 10% tax is imposed, but only on the amounts received prior to age 59 ½. Example 2: An employee, separated from service, begins receiving substantially equal periodic payments at age 50 and modifies the payment schedule at age 58. The 10% tax is imposed on all amounts received prior to age 59 ½.

In 1987, Robert Arnold, vice president and 50% owner of ARCO Industries, sold his interest in ARCO, retired, and rolled his ARCO qualified pension plan into an IRA. In December, 1989, Arnold began receiving distributions of $44,000 per year from the IRA as determined by an actuary to avoid the 10% tax. He received the fifth distribution in January, 1993. In November, 1993, after attaining age 59wQ, Arnold received an extra distribution of $6,776. The IRS claimed that this distribution was an impermissible modification and assessed the 10% tax on the total of $220,000. Arnold made the following arguments: he had satisfied the five-year rule because he had received five yearly $44,000 distributions; the $6,776 distribution was due to hardship; and it was a cost-of-living adjustment.

The Tax Court sustained the 10% additional tax, rejecting Arnold's arguments. The court ruled that under the five-year rule, Arnold could not receive additional distributions until December 1994, and that the statute does not allow a hardship exception. Finally, although cost-of-living adjustments are allowed, Arnold did not prove that the $6,776 distribution was a cost-of-living adjustment.

Another Sec. 72(t)(2) exception to the 10% tax not discussed in Arnold allows employees who have separated from service after age 55 to receive distributions without restriction. Returning to work for the same or different employers is permitted. However, IRA distributions do not qualify for this exception. Thus it would not have helped Arnold even if he had retired after age 55. *

Cite: Arnold v. Commissioner, 111 TC No. 12, (September 28, 1998).

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