Scott E. Vincent
Vincent, Fontg & Hansen, L.L.C.
Kansas City

The Tax Court recently rejected an IRS effort to impose a penalty on IRA withdrawals for education after the taxpayer’s prior election to receive a series of substantially equal periodic payments from the IRA. Benz v. Commissioner, 132 TC No. 15 (2009). The court held that the distributions for education expenses were not a modification of the taxpayer’s prior election.

Background

In general, amounts distributed from an IRA are includable in gross income pursuant to Code § 72. In addition, distributions from IRAs before age 59½ are typically subject to a 10 percent penalty tax. There are a number of exceptions to this penalty, including an exception for distributions that are part of a series of substantially equal periodic payments (not less frequently than annually) made for the life (or life expectancy) of the IRA owner or the joint lives (or joint life expectancies) of the IRA owner and designated beneficiary. However, if the series of substantially equal periodic payments is modified within five years of the date of the first distribution (other than by reason of death or disability), then the 10 percent additional tax will be imposed retroactively on prior distributions made before the taxpayer attains age 59½ (“recapture tax”), with interest. The recapture tax also applies when a modification occurs after the initial five-year period but before the taxpayer has attained age 59½.

Revenue Ruling 2002-62 provides three methods for determining substantially equal periodic payments for purposes of the exception to the 10 percent penalty tax: a fixed annuitization method; a fixed amortization method; and the required minimum distribution method. This Revenue Ruling also permits an individual who used (or uses in the future) the annuitization or amortization method to compute substantially equal payments to make a one-time switch to the required minimum distribution method without triggering the penalty.

Under another exception, the 10 percent penalty tax does not apply to a distribution from an IRA to the extent it does not exceed the qualified higher education expenses for the taxpayer, the taxpayer’s spouse, and the child or grandchild of the taxpayer or spouse at an eligible educational institution.

Case, Analysis and Holding

In the Benz case, the petitioner separated from employment in January 2002 and then made an election to receive distributions from her IRA in a series of substantially equal periodic payments. This election included an annual fixed distribution of $102,311.50 to be made on January 15 each year for a period based on her life expectancy. On January 15, 2004, she received a $102,311.50 distribution from her IRA in accordance with her election. During 2004, she received two additional distributions from the IRA: a $20,000 distribution in January 2004 and a $2,500 distribution in December 2004. She had not attained age 59 1/2 when she received these additional distributions, which she used for qualified higher education relating to her son’s college expenses. For 2004, she and her joint filing husband spent $35,221.50 in qualified higher education expenses for their son.

The petitioner’s two additional distributions for qualified higher education expenses were made within five years of the first annual periodic payment and before she had attained age 59½. The IRS maintained that the two additional distributions constituted an impermissible modification to the periodic payment election. According to the IRS, the substantially equal periodic payment exception was therefore no longer effective for the 2004 distribution. The IRS conceded that $35,221.50 of the total 2004 distributions satisfied the exception for qualified higher education expenses but considered the remainder of the 2004 distributions subject to the 10% additional tax.

The issue decided by the court was whether a distribution that qualifies for a statutory exception to the 10 percent additional tax constitutes a modification of a series of substantially equal periodic payments triggering the recapture tax. The IRS argued that an employee who elects a series of substantially equal periodic payments is not allowed any further distributions within the first five years of the election irrespective of whether the distributions would qualify for another statutory exception, unless the employee dies or becomes disabled. Petitioners argued that a distribution used for a purpose that qualifies for a statutory exception is not a modification of a series of substantially equal periodic payments that triggers the recapture tax.

The court noted its decision in Arnold v. Commissioner, 111 T.C. 250, 255-256 (1998), where it held that an additional distribution that did not qualify for a statutory exception was an impermissible modification to a series of substantially equal periodic payments: “In order to avoid the section 72(t) tax, petitioners must show that the November 1993 distribution falls within one of the exceptions provided under section 72(t)(2)(A). They have not done so.” Id. at 255. The court further recognized that distributions under § 72(t)(2)(E), enacted in 1997 and after the year in issue in Arnold, do not trigger the § 72(t) additional tax where the taxpayer receives the distribution within five years after the taxpayer begins receiving distributions under a series of substantially equal periodic payments.

Based on the last sentence of § 72(t)(2)(E), which recognizes that an employee may qualify for more than one statutory exception to the 10 percent additional tax, the court went on to conclude that “if a distribution qualifies for more than one statutory exception, the employee is exempt from the 10 percent additional tax on the basis of the applicable exception under subparagraph (A), (B), (C), or (D) and need only rely on the higher education expense exception for the additional amount of the distribution.” The court referenced legislative history that explains the five-year prohibition of modifications to a series of substantially equal periodic payments as follows: “if distributions to an individual are not subject to the tax because of application of the substantially equal payment exception, the tax will nevertheless be imposed if the individual changes the distribution method prior to age 59½ to a method which does not qualify for the exception. . . . For example, if, at age 50, a participant begins receiving payments under a distribution method which provides for substantially equal payments over the individual’s life expectancy, and, at age 58, the individual elects to receive the remaining benefits in a lump sum, the additional tax will apply to the lump sum and to amounts previously distributed.”

The court noted that there is no indication that Congress intended to disallow all additional distributions within the first five years of the election to receive periodic payments, and that Congress’ “legislative purpose is not frustrated where an employee receives distributions for more than one of the purposes that Congress has recognized as deserving special treatment.”

Based on this analysis, the court held that a distribution that satisfies the statutory exception for higher education expenses is not a modification of a series of substantially equal periodic payments. Because the court found that a distribution for higher education expenses is not a modification, the five-year rule prohibiting modifications except in the case of death or disability is not violated.

Conclusions

The Benz case confirms that taxpayers can plan appropriately for IRA distributions before reaching age 59½ without concerns that later needs for IRA funds to cover education expenses or other needs that qualify for statutory exceptions will impose punitive penalties with respect to their distribution planning. Unfortunately, the case also demonstrates the complexity that all taxpayers (and we as practitioners) are faced with in navigating IRA distribution rules in the context of planning, retirement and funding for higher education.