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The Tax Court first found that the that diagnosis, including the year
website Lucas relied on addressed the that he received the distribution from Foreign Income & Taxpayers
applicability of the early-withdrawal his 401(k) plan account, and that he
penalty in cases of disability, which was effectively treating his diabetes Nonresident alien partner’s
it noted is a distinct subject from with a mix of insulin shots and other gain on inventory items
whether the distribution counts as medications. Thus, the court found sourced to US
income for those experiencing a that the diabetes did not render him The portion of a nonresident alien’s gain
disability. More significantly, the court “unable to engage in any substantial on the sale of an interest in a U.S. LLC
stated, the website does not constitute gainful activity” within the meaning of treated as a partnership that was at-
legal authority, and nothing in the Sec. 72(m)(7) and its accompanying tributable to inventory items held by the
Code, regulations, or the relevant case regulations, and therefore Lucas was LLC at the time of the sale was sourced
law supported Lucas’s interpretation. subject to the Sec. 72(t) addition to tax to the United States under Sec. 865(b).
Therefore, the court concluded that the on the 401(k) plan distribution.
retirement distribution income must be Background
included in his 2017 gross income. Reflections Indu Rawat was a nonresident alien in-
Sec. 72(t) addition to tax: As this case shows, having a specific dividual for federal income tax purposes
Under Secs. 72(t), 401(k), and 4974(c), ailment that could cause a qualifying during 2008 and 2009. She filed U.S.
distributions from a qualified retirement disability for a Sec. 72(m)(7) exception federal income tax returns as a nonresi-
account (which, as noted above, to the Sec. 72(t) addition to tax is not dent alien for the 2000 through 2007
includes a 401(k) account) to a taxpayer enough; the ailment must have actually tax years but did not file returns for the
under 59½ years of age at the time of caused a disability that prevents “any 2008 and 2009 tax years.
the distribution are subject to a 10% substantial gainful activity.” If the Innovation Ventures LLC (IV LLC),
additional tax unless an exception applies. taxpayer can control a condition and an LLC treated as a partnership for tax
One of these exceptions, provided under continue to work at the same job, the purposes, is a U.S. business that manu-
Sec. 72(t)(2)(A)(iii), is for a distribution exception does not apply. factures and sells popular consumer
“attributable to the employee’s being Although its provisions would not products including 5-Hour Energy
disabled within the meaning of subsection have helped Lucas, the SECURE drinks. Rawat acquired a 30% interest
(m)(7).” Under Sec. 72(m)(7) and 2.0 Act passed at the end of last in IV LLC between 2000 and 2007.
Regs. Sec. 1.72-17A(f)(1), a taxpayer is year (as part of the Consolidated She sold her interest for $438 million in
considered disabled if, at the time of the Appropriations Act, 2023, P.L. January 2008.
disbursement, the taxpayer is “unable to 117-328) expanded the exceptions When Rawat sold her interest in IV
engage in any substantial gainful activity to Sec. 72(t). Effective immediately, LLC, the company had inventory items
by reason of any medically determinable the act provided a new exception with a basis of $6.4 million, which it
physical or mental impairment which for distributions to terminally ill held for future sale in the United States.
can be expected to result in death or participants. Also, the exception for It later sold those inventory items for a
to be of long-continued and indefinite public safety officers is extended to profit of $22.4 million. Rawat and the
duration.” those who have at least 25 years of IRS agreed that of the $438 million sale
Although Regs. Sec. 1.72-17A(f)(2) service with the employer sponsoring price paid to Rawat for her interest in
identifies diabetes as an impairment the plan and is expanded to corrections IV LLC, $6.5 million was allocable to
that “would ordinarily be considered as officers who are employees of state inventory held in the United States for
preventing substantial gainful activity,” and local governments. Starting in sale therein (inventory gain).
it clarifies that “[a]ny impairment, 2024, participants who self-certify The IRS conducted an examination
whether of lesser or greater severity, that they experienced domestic abuse of IV LLC for the 2007 and 2008 tax
must be evaluated in terms of whether can withdraw the lesser of $10,000, years. As a result of this exam, the IRS
it does in fact prevent the individual indexed for inflation, or 50% of the determined that Rawat’s income for
from engaging in his customary or participant’s account. And, finally, 2008 should include the $6.5 million of
any comparable substantial gainful the act amended Sec. 72(t) to allow inventory gain. In 2016, the IRS issued
activity.” The Tax Court observed that for penalty-free withdrawals of up to a notice of deficiency for 2008 and 2009
Lucas was diagnosed with diabetes $22,000 for “qualified disaster recovery that included in the indicated deficiency
in 2015 but was able to work as a distributions.” $2.9 million in tax, interest, and addi-
software engineer for two years after Lucas, T.C. Memo. 2023-9 tions to tax for the 2008 tax year related

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