Many taxpayers face unexpected challenges in their lives that can make it difficult to meet their tax obligations.
For example, the death of a loved one or the trauma of a major event can have a significant impact on a person’s mental health and their ability to manage their finances. In such cases, individuals may find themselves facing penalties for early retirement distributions and failure to file and pay taxes. But can these penalties be abated in light of such personal circumstances?
This is a question that was addressed in the court case of Kwosh v. Commissioner, T.C. Memo. 2008-204.
The Facts & Procedural History
Mr. Kwosh experienced a great deal of personal hardship in 2001, including the loss of his wife to thyroid cancer and the traumatic impact of the September 11 terrorist attacks. As a result of these events, he was left responsible for caring for his mother-in-law and his two teenage children and lost friends and neighbors in the attack.
His severe depression and anxiety made it impossible for him to continue working, and he sought help through his employer’s employee assistance program and was prescribed medication. As a way to address his financial difficulties, Mr. Kwosh withdrew money from his retirement account to support himself and his family.
This distribution resulted in the IRS assessing penalties for filing his tax return late and for the 10 percent early distribution tax for this withdrawal.
The questions for the court were whether Mr. Kwosh’s depression was caused by his wife’s untimely death at age 53 and the September 11, 2001 terrorist attacks on the World Trade Center:
- Qualifies as a disability for purposes of the 10-percent additional tax on his pension distribution under Section 72(t) and
- Reasonable cause for his failure to file a timely return, timely pay taxes, and pay estimated tax.
Section 72(t) – Exception to the 10% Tax
Section 72(t) of imposes a 10 percent additional tax on early distributions from retirement accounts. There are certain exceptions to this tax.
One such exception is if the taxpayer is considered “disabled.” According to the regulations, an individual is considered disabled if they are unable to participate in substantial gainful activity due to a physical or mental impairment that is expected to result in death or be of long-continued and indefinite duration. There are other cases that consider different ailments that rise to the level of a disability, such as diabetes, that often turns on what occupation the person was in when they were diagnosed and suffered from the condition.
The IRS has interpreted this to require the taxpayer to provide written proof from a qualified medical professional or at least testimony from such a professional. While the taxpayer, in this case, argued that his depression and anxiety resulting from the death of his wife and the September 11 terrorist attacks made him completely “disabled,” he did not present any documentary evidence or testimony from medical professionals to support this claim. As such, the tax court did not find that he was “disabled.”
The Section 72(t) Disability Exception
The disability exception under Section 72(t) has qualified for certain severe illnesses in past cases. For example, patients suffering from end-stage renal disease requiring dialysis have been found to meet the definition. Other cases granted the exception for advanced Parkinson’s disease and terminal cancer.
A key factor is whether the illness renders the taxpayer unable to engage in any substantial gainful work based on their experience, skills, and education level. The impairment must be expected to last indefinitely or result in death.
In Mr. Kwosh’s case, despite his significant depression and anxiety following major life trauma, the court set a high bar for proving he was truly disabled under the tax code definition. The death of a spouse and trauma of 9/11 were not enough on their own.
Substantiating a Disability Claim
To benefit from the disability exception, formal substantiation is key. This involves written proof from a qualified physician, psychiatrist or other medical professional attesting to the taxpayer’s condition and its severity.
Ideal evidence includes documentation of diagnosis, inability to work, prescribed treatments and medications, and ongoing monitoring by doctors. Letters directly addressing the disability criteria in Section 72(t) are most persuasive.
Beyond doctors, assessments by psychologists, social workers and other accredited professionals can bolster claims of disability. Vocational experts may also be used to attest a taxpayer cannot perform gainful work.
Providing only lay statements or self-diagnoses is generally insufficient. The court looks for objective third-party verification to substantiate disabilities for tax purposes.
Late Filing & Payment Penalties
In addition to facing the 10 percent additional tax for early distributions under Section 72(t), Mr. Kwosh also incurred penalties for failing to file and pay his taxes on time.
These penalties can be waived if the taxpayer can demonstrate that he had reasonable cause for his actions. To qualify for this waiver, the taxpayer has to show that he took ordinary and reasonable care but was still unable to file his return or make payments within the prescribed time frame. Illness or incapacity that prevents a taxpayer from fulfilling their tax obligations can be considered reasonable cause.
In the present case, Mr. Kwosh argued that his depression and sleep apnea constitute reasonable cause for his failure to file and pay his taxes. However, the court noted that Mr. Kwosh did not provide any evidence from a medical professional to support this claim and that his failure to pay persisted for an extended period of time.
The court concluded that Mr. Kwosh’s depression did not qualify as a disability under Section 72(t) or as reasonable cause for purposes of the failure to file penalty, failure to pay penalty, or the estimated tax penalty. It is worth noting that Mr. Kwosh did not argue that his inability to keep records or make filings on time was due to the death of his wife or the September 11 terrorist attacks. If this had been the case, the court may have taken into consideration the time and effort he spent caring for his wife during her final days, or the difficulties he faced in making filings due to the events surrounding September 11, as it was likely that he was affected by the attacks as he worked and lived in the vicinity.