While most people know the phrase not everything you read on the internet is true, many don’t know what can actually be relied upon in a legal setting. A reasonable person might think the instructions on an IRS publication or a web article or website published by a credible source, such as an accounting or legal firm, could be used to substantiate a legal or tax position.[1] They would generally be wrong, as illustrated in the recent Lucas case, in which the Tax Court held that a taxpayer’s early withdrawal from his 401(k) plan was gross income subject to the early withdrawal penalty.[2] The taxpayer in question attempted to rely on a web article as his authority for not reporting the withdrawal as taxable income. Shockingly, the Tax Court did not find this argument persuasive.
Facts
Robert B. Lucas worked as a software developer in California until 2017 when he lost his job. Prior to becoming unemployed, Mr. Lucas provided financial support to his children by paying for his daughter to attend nursing school and providing housing for his son. After Mr. Lucas lost his job, he struggled to make ends meet and therefore withdrew $19,365 from his 401(k) plan in 2017. Mr. Lucas was not yet 59 and a half at the time of the distribution, so the plan administrator accordingly reported the withdrawal as an early distribution with no known exception on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.
Mr. Lucas reported the distribution on his 2017 federal income tax return but excluded it from his taxable income. Mr. Lucas had been diagnosed with diabetes in 2015, which he had (effectively) treated with insulin shots and other medications. His return reflected his understanding that the distribution did not constitute income because of his diabetes. Mr. Lucas’s sole basis for this understanding was a web article that discussed the applicability of the early withdrawal penalty in cases of disability.
The IRS subsequently issued Mr. Lucas a notice of deficiency for the 2017 tax year. The notice determined a deficiency of $4,899 based on the inclusion of the retirement plan distribution in his 2017 gross income and the ten-percent additional tax imposed by IRC Section 72(t).
Discussion
The Court began by defining gross income, which includes all income from whatever source derived except as otherwise provided and that gross income includes distributions from employees’ trusts.[3] 401(k) plans are one type of employee trust, whereby a qualified cash or deferred arrangement is established for the benefit of employees who meet certain criteria.[4]
The Court then addressed the web article and Mr. Lucas’s reliance upon it. Although the specific website was not provided in the opinion, the Court stated that the web article in question did not address whether distributions from 401(k) plans were excludable from income for those suffering from a disability. Rather, it contained information related to the applicability of certain exceptions to the early 10% withdrawal penalty under IRC Section 72(t). However, even if Mr. Lucas had correctly understood the substance of the web article, the Court made it abundantly clear that the web article did not constitute legal authority, and therefore could not be relied upon. Accordingly, the Court held that the distribution must be included in Mr. Lucas’s 2017 taxable gross income.
Next, the Court addressed whether Mr. Lucas should be subject to the 10% penalty for the withdrawal under IRC Section 72(t). Generally, distributions from qualified retirement accounts, such as 401(k) plans, to taxpayers under the age of 59 and a half are subject to the 10% penalty unless an exception applies.[5] There is an exception for disabled taxpayers, however it requires the taxpayer to be “unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration.”[6] For the purposes of this analysis, substantial gainful activity means the activity in which the taxpayer customarily engaged prior to the disability, or a comparable activity.[7] This is of course a facts and circumstances analysis, which focuses primarily on the nature and severity of the taxpayer’s impairment, as well as factors such as the taxpayer’s education, training, and work experience.[8]
Diabetes is specifically listed in the regulations as an impairment which would ordinarily prevent substantial gainful activity.[9] Regardless, the Court still determined that Mr. Lucas’s diabetes did not render him unable to engage in gainful activity in light of the fact that Mr. Lucas was diagnosed in 2015 and had continued to work as a software engineer for two years by treating his diabetes with a mix of insulin shots and other medications. As a result, the Court held that the distribution was subject to the 10% penalty and upheld the IRS’s deficiency determination.
Conclusion
This case illustrates the role that secondary authorities play in the legal and tax fields. Secondary authorities are generally materials that summarize or help explain the law, but which are not actually the law themselves, as compared to primary authorities, which are actually the law. As demonstrated by Mr. Lucas, taxpayers cannot rely on secondary authorities to support their legal or tax positions. Rather, they are intended to guide taxpayers to the primary authorities, which are to be relied upon. This general rule certainly has nuance to it beyond the scope of this article. This is especially true with respect to the tax field, where varying levels of authority can be relied upon as substantial authority for certain arguments and purposes (for instance the avoidance of penalties under Section 6662) but cannot be relied upon for others.
Taxpayers should always review the primary authorities and ensure that they correlate with what is stated in the secondary authority or hire a professional to do so for them. The higher quality secondary sources will include citations to primary authorities to make the process of verification easier for the reader. Even if the information in the secondary source was correct when it was published, that doesn’t mean that it is still correct when the taxpayer is reading it. Often such secondary sources can be years old, and the law has changed. Therefore, taxpayers should be extra careful to review the authority related to more dated secondary sources. This is true even for the web articles posted to our website, as we are not exempt from making mistakes or changes in the law due to the passage of time.
While we don’t know the details of the web article Mr. Lucas was attempting to rely upon, we know that he did not understand it, much less the actual law. Taxpayers should learn from the mistakes of Mr. Lucas, and either review and understand the law themselves, or hire a legal or tax professional to do it for them.
[1] See Bobrow, TC Memo 2014-21, in which the taxpayer attempted to rely on the instructions provided in IRS Pub 590 and the Tax Court found that such instructions are not legal authority which taxpayers can rely upon.
[2] Lucas v. Comm’r of Internal Revenue, T.C.M. 2023-009.
[3] IRC Section 61(a).
[4] IRC Section 401(k).
[5] Robertson v. Commissioner, T.C. Memo. 2014-143, at *5.
[6] IRC Section 72(m)(7); Kopty v. Commissioner, T.C. Memo. 2007-343.
[7] Treas. Reg. § 1.72-17A(f)(1).
[8] Id.
[9] Treasury Regulation Section 1.72-17A(f)(2).
