To increase the likelihood that tax-preferred savings actually will be used for retirement, Congress included a 10% penalty tax on IRA and 401(k) distributions before the account owner reaches age 591/2. The penalty applies in addition to the regular income tax on the distribution. For example, someone in the 15% tax bracket who takes a $10,000 premature distribution would owe $1,500 in ordinary tax and $1,000 as an early withdrawal penalty, leaving just $7,500 in after-tax proceeds

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Fortunately, there are exceptions that allow some taxpayers to dodge the penalty (but not the ordinary income tax).

Series of substantially equal periodic payments. A series of payments for the life of the taxpayer or for the joint lives of a taxpayer and a designated beneficiary will avoid the penalty. The payment stream may begin at any age. However, if the payout terms are modified within the later of five years of inception or the taxpayer reaching age 591/2, the penalty will be applied, plus interest, to all the taxable amounts received. An addition to the account balance is considered a modification for this purpose.

Separation from service. A taxpayer who separates from service and is at least 55 years old will not owe a penalty on amounts received from the employer's retirement plans. This provision does not apply to IRAs.

Disability. If one is no longer able to work, the 10% penalty won't apply to retirement plan distributions. However, if the taxpayer is able to engage in any gainful activity, even though diminished, he or she is not considered disabled for purposes of this provision.

Medical expenses. To the extent that the retirement distributions are used to pay deductible medical expenses the penalty is avoided. However, the deduction for medical expenses is limited to amounts in excess of 10% of adjusted gross income.

Medical insurance premiums. Unemployed taxpayers may use retirement plan money to pay for their health insurance without penalty.

Qualified higher education expenses. College costs for the taxpayer, the spouse, or their children or grandchildren may be paid penalty free from retirement accounts. Such costs include tuition, fees, books, supplies, and equipment. If the student has at least half of a normal full-tome course load, reasonable costs for room and board also may be paid.

First-time homebuyers. Up to $10,000 may be withdrawn without penalty for the purchase of a principal residence.

Qualified Domestic Relations Orders (QDRO). Transfers incident to divorce generally won't be penalized.

Other exceptions to the penalty rule include active duty military, ESOP dividends, and distributions due to a tax levy. This is a complicated area of the tax law, so taxpayers should seek professional counsel before making any distribution decisions.

(August 2019)

© 2019 M.A. Co. All rights reserved.

Jeffrey Hyland was the executor and residuary beneficiary of Eva Kollsman's estate. At her death in August 2005, Eva owned two 17th century Old Masters paintings: Village Kermesse, Dance Around the Maypole by Pieter Brueghel the Younger and Orpheus Charming by Jan Brueghel the Elder or Jan Brueghel the Younger or a Brueghel studio. Soon after Eva's death, Hyland was approached by George Wachter of Sotheby's about the possibility of Sotheby's handling the auction of the paintings. Wachter was an expert in Old Masters. In September 2005 Wachter sent Hyland a letter stating that the paintings were worth $500,000 and $100,000 respectively. The valuation was "based upon a firsthand inspection of the property" but gave no other basis for the values. At the same time, a consignment agreement was sent for Hyland's signature, in which the values of the paintings were estimated to range from $600,000 to $800,000 and $100,000 to $150,000.

On Eva's estate tax return, Hyland valued the two paintings at $600,000, attaching Wachter's valuation letter as evidence.

Also that September, Hyland consulted with a fine art services firm about having the paintings reframed and, if appropriate, cleaned. After insuring the paintings for a combined $1.2 million, the restoration proceeded. By all accounts, the paintings were much improved in the process.

In January 2009, Sotheby's sold the Maypole painting for $2.1 million.

The IRS challenged the estate's valuations of the paintings, at a date not specified in the decision. At trial, Wachter offered several reasons for the discrepancy between his valuation and the subsequent sale price. When he valued the Maypole it was quite dirty, and whether it could be cleaned was unknown. There is a risk that an attempt to clean an old work of art will damage it, even destroy it. That would depress the price a buyer would be willing to pay. The restoration in this case was very successful, which increased its value more than Wachter could have anticipated. Finally, the market for Old Masters paintings had improved significantly in the interim, due to an influx of Russian buyers.

However, Wachter presented the court with no comparables to justify his conclusions. Another Sotheby's expert prepared a report with comparables, but she was not available to testify. Accordingly, her report was ruled inadmissible.

The Tax Court rejected Wachter's valuation, believing that it was self-serving. He had a conflict of interest, in that he was seeking to be the agent for the auction of the paintings. The Court also felt that Wachter had exaggerated the dirtiness of the painting and the effect it would have on value [ Estate of Eva Franzen Kollsman et al. v. Commissioner; T.C. Memo. 2017-40].

The IRS expert did use comparables, even though that can be problematic when it comes to art--when every piece is unique, what is truly comparable? The Service nevertheless found the value at death to be $2.1 million. The Court accepted the IRS position, subject to a 5% discount to account for the dirtiness. 

The Orpheus painting, which remains in Hyland's possession, was valued by the Court at $395,000, after accepting the IRS' methodology for that piece as well.

In a per curiam opinion, the Ninth Circuit Court of Appeals has now affirmed the Tax Court's judgment. The Tax Court correctly applied the law, and did not improperly rely upon the painting's later sale price.

(August 2019)

© 2019 M.A. Co. All rights reserved.