By: Steven D. Hamilton, Principal, Steven D. Hamilton, CPA

July 10, 2015 9:22 am EDT

I have a friend who damaged his back, leading to nerve complications which have greatly affected his ability to work. Granted, he can still work, but not with the same intensity as before and certainly not for as many continuous hours. Sometimes by midday he has to take pain medications, which tend to knock him out. It is an unfortunate cycle, and the impact on his earning power is significant.

Let’s talk about disability. Then let’s talk about a disability exception to a penalty.

First, is disability income taxable or nontaxable?

Let’s confine this discussion to a disability policy purchased from an insurance company, omitting coverage from workers compensation and social security. There is a rule of thumb that is very important when thinking about disability insurance:

If you deducted the insurance, then payments under the insurance are taxable.

Let’s say that you purchased a short-term disability policy through your cafeteria plan. Amounts run through a cafeteria plan are generally not taxable to you. That is the point of the cafeteria, after all. Collect on the policy, however, and you trigger the above rule.

As a consequence, just about any financial or tax advisor will tell you to pay for disability insurance with after-tax dollars. The issue becomes even more important when purchasing long-term disability, as you would be permanently disabled (however defined) should you collect. You do not need the tax burden at the same time that your earning power is compromised.

You may recall that there is a 10% penalty if you take monies out of your 401(k) or IRA early. Early has different meanings, depending upon whether it is an IRA (or IRA-based) plan or a qualified plan. You can take money from a 401(k) at age 55 without penalty, for example, if you no longer work for the employer. An IRA does not care about your employer, but it does make you wait instead to age 59 ½. Take a distribution before those ages and you are likely facing a penalty.

But there is an exception to the 10% penalty if you get disabled.

Let’s say that you are injured enough to collect disability. Will that count for purposes of avoiding the 10% penalty?

You would think so, right?

Let’s talk about the Trainito case.

Trainito worked with the Boston Department of Environmental Health (DEH).  He was diagnosed with type 2 diabetes in 2005. He unfortunately did not take good care of himself, and he had continuous and increasing issues with neuropathy. He worked for DEH until October 2010, when he resigned due to the diabetes. He did not pursue disability benefits from DEH. Perhaps they did not offer such benefits.

Then he stopped taking his meds.

Fast forward six months. Trainito took a retirement distribution of over $22 thousand in April 2011.

Two months later he was found at his home in a diabetic coma. He was taken to a hospital where he spent more than a month recuperating, leaving the hospital in late July 2011. Damage was done, and he had reduced use of an arm and leg. He then applied for disability benefits with the state.

When preparing his return for 2011 he claimed the disability exception to the 10% penalty on the retirement distribution. The IRS disagreed, and the two found themselves in Tax Court.

The Code section at play is Sec 72(m)(7):

(7) Meaning of disabled
For purposes of this section, an individual shall be considered to be disabled if he is 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. An individual shall not be considered to be disabled unless he furnishes proof of the existence thereof in such form and manner as the Secretary may require.

On first reading, it seems to make sense. Introduce an attorney and a couple of non-immediate points appear:

(1) The disability must be “total.”

This is a rewording of “unable to engage in any substantial gainful…” This is not an insignificant requirement, as it does not look to one’s regular and primary employment.

Many private disability policies will find you disabled if you are unable to perform your own occupation. The IRS definition is much stricter, requiring one to be unable to reasonably perform almost any occupation. As a consequence, it is possible that someone may be considered disabled by his/her insurance company but not considered so by this section.

(2) The distribution must be attributable to the disability.

The clearest way to show this is to take the distribution after being medically adjudged as disabled. Trainito did not do that. It is extremely likely that he knew he was seriously compromised by his diabetes, but he had not obtained a medical signoff to that effect.

The question before the Court was whether the absence of that medical signoff was fatal.

The Court acknowledged that “substantial gainful activity” can be impaired by progressive diseases, such as diabetes. The Court further clarified that the presence of an impairment (such as diabetes) does not necessarily mean that an individual is disabled as intended under Sec 72(m)(7).

COMMENT: Makes sense. Odds are we each know someone who is diabetic but has it under medical control.

Trainito provided the Court with the record of his six weeks in the hospital, from June through July, 2011.  He was in a coma for most of it.

The Court wanted records back to April, 2011, when Trainito took the distribution.

Trainito testified that he saw a primary care doctor twice a month after being diagnosed in 2005. He stopped that when he was no longer working at DEH.

The Court sniffed:

Thus the fact that petitioner suffered a diabetic coma on June 12, 2011 does not indicate whether he was disabled on April 22, 2011. Petitioner undoubtedly suffered from diabetes on April 22, 2011 but he has not provided sufficient evidence to show that his diabetes caused him to be disabled within the meaning of section 72(m)(7).”

This seems a bit harsh. There is a “duh” element considering that he has a progressive disease. Perhaps if Trainito had his doctor testify, perhaps if he introduced his earlier medical records …

But Trainito did not have his doctor testify nor did he provide his earlier medical records. Why? Who knows. I suspect there may have been a financial consideration, but the Court did not say. It is also possible that he thought his testimony, accompanied by his shortly-thereafter month-long coma, would be sufficient proof to the Court.

The Court concluded that Trainito did not meet test (2) above: he did not show that the distribution was attributable to the disability. Trainito owed the penalty.

What are my thoughts?

Sometimes tax is not just about Code sections and Regulations. Sometimes it is about facts and – more importantly – being able to prove those facts. I believe you when you tell me that you donated multiple rooms of furniture to charity when you moved, but you still need receipts and documentation. I believe you when you explain how you supported your children from a previous marriage, but I still need to review the divorce decree and related legal paperwork to determine whether you can claim the children as dependents.

The IRS told Trainito to “prove it.”

He didn’t.

The views and opinions expressed herein are those of the author(s). Core Compass’s Terms Of Use applies.

About the author

Steven D. Hamilton is a career CPA, with extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.

disability insuranceIRC Section 72IRC Section 72(m)(7)
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