Injury - and insult - tax laws affecting delinquent payment

Nation's Business, Jan, 1988 by Gerald W. Padwe

Injury--And Insult

Here is a cautionary tale on the dangers of treating lightly IRS efforts to get its hands on taxes owed.

A recent Tax Court case discloses the plight of a self-employed attorney who, for reasons not discussed in the opinion, was delinquent in his federal tax obligations. After efforts to collect the liability proved futile, the IRS looked for assets that could be seized; it settled on the taxpayer's Keogh plan account, from which it collected $22,000.

That was bad enough, you might think, but after collecting the $22,000, IRS sent the taxpayer a notice of deficiency, claiming the seizure was actually a distribution of Keogh funds to the taxpayer followed by a payment from the taxpayer to IRS. Thus, there was a "distribution" of previously tax-deducted amounts to the attorney, and the $22,000 was taxable as income in the year the government took it, to the tune of $11,000 in additional taxes.

Further, because the distribution took place prior to the taxpayer's retirement, it was premature and was subject to a 10 percent penalty tax in addition to the regular tax. Finally, said the IRS, because the taxpayer failed to include the amount on his original return, he is subject to the negligence penalty.

The court held for the government on seizing the Keogh funds but refused to allow the two penalties. It had little trouble concluding that seizure by the IRS was a de facto distribution to the taxpayer followed by an assignment to the government. Since the distribution was from a plan, contributions to which are tax-deductible, the de facto payment is includable as income.

The 10 percent premature-distribution penalty, however, did not apply in this case, although the distribution was made before the taxpayer retired. Looking to congressional intent for the provision, the court concluded that the penalty tax was to prevent use of a retirement plan as a casual bank account, available for voluntary withdrawals. An IRS levy is anything but voluntary, and the 10 percent penalty was inappropriate. Nor was the taxpayer negligent in believing an asset seizure did not produce income.

Nonetheless, it was an expensive lesson for the taxpayer to discover that, in order to settle a tax liability for an earlier year, he incurred an additional $11,000 tax for a subsequent year. Forewarned is still forearmed.