Tax Court Enforces 10% Penalty on Deemed Distribution

A tax court has upheld a 10% early distribution penalty that the Internal Revenue Service (IRS) imposed on a deemed distribution of a plan loan.

According to EBIA, the participant in the case took a plan loan from a federal government plan that operates under rules similar to those that apply to 401(k) plans that satisfied the Code’s requirements when the loan was made. Subsequently, the participant was removed from employment under circumstances that resulted in years of litigation before the employer’s action was ultimately upheld.  

Under regulations governing the plan, a participant who is separated from government service must repay any outstanding loan balance in full within the period specified in a notice to the participant. When the participant did not make the full repayment by the date specified in his notice, the plan reported the loan balance as a taxable distribution on Form 1099-R.  

The participant included the loan balance in his income for that year but did not pay the 10% early distribution penalty. The IRS then issued a notice of tax deficiency for the penalty amount, and the participant filed this action. 

EBIA reported that in tax court, the participant took the position that he had erroneously included the loan balance in his taxable income. Based on an interim ruling that ordered his employment reinstated (later undone), the participant argued that he had not separated from service and, thus, the plan should not have reported his loan balance as a deemed distribution.  

The court found, however, the regulations governing the plan required the participant to notify the plan of his reinstatement in order to restore the loan, which the participant never did. Therefore, the court held that the unpaid loan balance was a deemed distribution.  

Because the participant had not argued that the deemed distribution satisfied an exception to the 10% percent early distribution penalty, the penalty applied.