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Tax Court reminder – IRS levies on IRA accounts are taxable

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Tax Court reminder – IRS levies on IRA accounts are taxable


The United States Tax Court recently issued a Memorandum opinion reminding taxpayers that when the Internal Revenue Service (IRS) seizes an Individual Retirement Account (IRA), the seized IRA needs to be included as taxable income.  Lonnie Wayne Hubbard v. Commissioner of Internal Revenue (T.C. Memo. 2024-16).

In 2017, disgraced 41-year-old pharmacist Lonnie Wayne Hubbard was convicted of 57 crimes involving the illegal dispensing of controlled substances without a legitimate medical purpose and dispensing pseudoephedrine knowing it would be used to manufacture methamphetamine and for maintaining a drug premises. In the process, he was also convicted of 13 additional counts involving money laundering.[1]  As part of his sentence, in addition to 30 years in prison, Mr. Hubbard was required to forfeit his T. Rowe Price IRA to the IRS.  Mr. Hubbard began serving his term of incarceration on February 16, 2017.  During 2017, as ordered by the Court, T. Rowe Price turned over Mr. Hubbard’s IRA to the IRS in the amount of $427,518.[2]  T. Rowe Price issued a Form 1099-R to Mr. Hubbard for 2017 and designated the distributions as an early withdrawal subject to the 10% penalty under Internal Revenue Code (I.R.C.) section 72(t).

Mr. Hubbard failed to file a tax return for 2017 or make any tax payments for that year.  As a result, in 2020, the IRS was permitted to file a “substitute return” under I.R.C. 6020(b) for 2017 to report the income from the T. Rowe Price 1099-R for the seized IRA account. In addition, the return included the early withdrawal penalty and the standard late-filing and late-payment penalties.  Mr. Hubbard filed a petition with the United States Tax Court to challenge the substitute return.  His primary argument was that the IRA assets were not income to him because the funds were transferred directly to the IRS without him ever receiving them.  He also argued that he should not be liable for penalties because (i) he was incarcerated on February 16, 2017, (ii) his assets were criminally forfeited, (iii) he never received the 1099-R because it went to his ex-wife, and (iv) his prior tax compliance was spotless.

In response to Mr. Hubbard’s petition to challenge the assessment of income, the IRS filed a motion to have the challenge dismissed.  Since the factual background was not in dispute, a ‘summary judgment’[3] could be warranted as long as the Tax Court agreed with the IRS’s position that the IRA assets should count as taxable income for Mr. Hubbard.  Ultimately, after reviewing the prior case law regarding retirement accounts that are seized to satisfy criminal forfeiture judgments,[4] the Tax Court disagreed with the various arguments by Mr. Hubbard and ruled in favor of the IRS.  Including the seized IRA as a distribution on Mr. Hubbard’s substitute return was proper because Mr. Hubbard “constructively received” the IRA assets by having received the economic benefit of the assets through satisfaction of his criminal forfeiture liability.

After the Court’s determination that the IRA assets were includable as income, it addressed Mr. Hubbard’s request to remove the late-filing and late-payment penalties.  The Court explained that these penalties, which were assessed pursuant to I.R.C. sections 6651(a)(1) and (2), could be reduced or removed if Mr. Hubbard could affirmatively establish that his failure to file the 2017 tax return and pay the resulting tax were due to “reasonable cause and not willful neglect”.  Mr. Hubbard argued that the penalties should be abated because (I) he never received the 1099-R from T. Rowe Price, (ii) he had not earned any income since 2015, (iii) he was unaware of any filing obligation related to the 1099-R, and (iv) as a result of the criminal forfeiture and his divorce in March 2018, he had no money to pay the tax due.

The Court reviewed all of his arguments but ultimately denied his request for penalty abatement.  It stated that Mr. Hubbard knew of a general duty to file tax returns, as he stated in his own declaration that he had “habitually” done so in previous years, and he also knew that the IRA forfeiture was part of the judgment in his criminal case.  The Court said that Mr. Hubbard should have recognized that there might have been tax implications as a result of the forfeiture of his IRA and should have sought counsel accordingly.  Moreover, non-receipt of tax information forms, such as a 1099-R, does not excuse a taxpayer from his/her duty to report income – and it also does not constitute reasonable cause to prevent the application of penalties.  Finally, the Court stressed that it has held repeatedly that incarceration is not a reasonable cause for such delinquency penalties.

Notably, the IRS conceded that the early withdrawal penalty included on the substitute return should not be charged.  As mentioned by the Tax Court, past cases have held that IRA accounts that are seized by the IRS under forfeiture are not subject to the early withdrawal penalty under I.R.C. 72(t).

On a related note, what if a non-criminal taxpayer owing back taxes wanted to have the IRS seize his/her IRA account to pay off its tax liabilities while avoiding the early withdrawal penalty?  Theoretically, this would work.  However, procedurally, it is very difficult for the IRS to levy on a taxpayer’s IRA account for civil purposes, and it does not occur easily or with regularity.  Per the Internal Revenue Manual, in order for the IRS to seize an IRA account, even if it is at the request of the taxpayer, a collections officer must get approval from higher levels and also follow special instructions on the mandatory Form 668-R, Notice of Levy on Retirement Plans.  See IRM

[1] Eastern District of Kentucky | Berea Pharmacist Found Guilty of Illegally Dispensing Hundreds of Thousands of Prescription Pills and Thousands of Boxes of Pseudoephedrine and Money Laundering | United States Department of Justice

[2] In New Jersey, an Individual Retirement Account can receive some creditor protection under N.J.S.A. 25:2-1; 25:2-25, but the protection may not protect criminal activity.

[3] A decision by a court without a factual hearing.

[4] See e.g., Gambina v. Commissioner, 91 T.C. 826 (1988); Carione v. Commissioner, 96 T.C. Memo 2008-262; and Rodrigues v. Commissioner, T.C. Memo 2015-178.

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