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When is a Penalty Really a Penalty? Section 72(t)(1): Is it a Tax or a Penalty?

Under Internal Revenue Code (IRC) section 6751(b), “No penalty under [the I.R.C.] shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate.” Practically speaking, this penalty authorization memo, must exist in the administrative file of every taxpayer for which the IRS asserts a penalty. And in December 2017, the United States Tax Court held that the IRS must comply with section 6751(b)(1) before asserting a penalty in a deficiency case. See Graev v. Commissioner, 149 T.C. No. 23, 9 (2017). Specifically, the Tax Court held that, in a deficiency case, this written supervisory approval must occur no later than the date the IRS mails the notice of deficiency or files an answer or amended answer asserting penalties.

Tax or Penalty

But when is a penalty really a penalty? Under section 72(t)(1), early withdrawals from qualified retirement plans are subject to a ten percent penalty. Qualified retirement plans include IRAs, 401(k)s, 403(b)s and many types of defined contribution and defined benefit plans. What many taxpayers do not know is that the IRS considers the ten percent early withdrawal penalty a “tax” and not a “penalty.” This distinction is important for purposes of section 6751(b) and the required written supervisory approval. So far, the issue of whether the 72(t)(1) “penalty” requires supervisory approval has not been definitively settled.

In El v. Commissioner, the Tax Court held that section 72(t) exactions are a tax and not a penalty for purposes of the IRS’ burden of production at trial under section 7491(c). El v. Commissioner, 144 T.C. 140, 149 n. 13 (2015). The Tax Court focused at the words of the statute, which specifically calls the 72(t) exaction a “tax” and not a “penalty”, “addition to tax”, or “additional amount”.

But the law is still not settled for purposes of section 6751(b).

Recently, the United States District Court for the District of Massachusetts analyzed whether the ten percent “penalty” under section 72(t)(1) is a tax or a penalty. See In re Daley, No. CV 17-10962-NMG (D. Mass. Aug. 2, 2018). The Court affirmed a bankruptcy court ruling and held that the section 72(t)(1) exaction attributable to the debtors’ early withdrawals was a penalty for determining claim priority status in bankruptcy. The Court noted that for purposes of establishing priority status in a bankruptcy proceeding, the United States Supreme Court has held that courts interpreting the Internal Revenue Code should place no weight on the “tax” label in the statute. Under this reasoning, the fact that the section 72(t)(1) penalty is statutorily labeled a “tax” has no bearing on whether it is really a tax or a penalty. What matters is how the exaction operates in reality. The Court reasoned that the 72(t)(1) “penalty” is truly a penalty because it operates to deter unwanted conduct, even though it generates some revenue.

Because the issue of whether the 72(t)(1) penalty is a penalty for purposes of section 6751(b), i.e., whether the IRS has followed the law and obtained written supervisory approval to assert the penalty in the first place, it is important to challenge it under 6751(b)(1) in any deficiency case.

An experienced tax attorney can help you determine whether you can dispute IRS penalties. Silver Law PLC operates in Arizona and Nevada and all of its lawyers are former trial attorneys for the IRS. A tax lawyer from our team can help you understand how the complex Tax Code applies to your case. We’ll help you ensure that you are meeting your obligations. If you have been audited or are facing collections, we are also in a position to help you navigate that process. We can either find ways to bring down your tax debt or can negotiate a settlement for you. Call us today to talk with a tax lawyer and learn more.

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