The 10% penalty imposed by the Internal Revenue Service for early withdrawal from a retirement account is a general unsecured claim, not a tax or compensation for pecuniary loss entitled to priority under Section 508(a)(8), according to District Judge Nathaniel M. Gorton of Boston.
In holding that the 10% exaction is not entitled to priority, Judge Gorton said he agreed with the Tenth Circuit, the only court of appeals to decide the issue. In re Cassidy, 983 F.2d 161 (10th Cir. 1992). He said that “multiple bankruptcy courts” have similarly held that the exaction is a penalty not entitled to priority.
A few years before bankruptcy, the chapter 13 debtors made early withdrawals from their qualified retirements accounts, making them liable to the IRS for about $17,000, representing the 10% exaction imposed by 26 U.S.C. § 72(t). The IRS filed a claim, contending that the $17,000 was a tax claim entitled to priority under Section 508(a)(8).
The debtors objected to the classification of the claim. Bankruptcy Judge Frank J. Bailey agreed with the debtors and relegated the $17,000 claim to unsecured status. On appeal, Judge Gorton agreed in his Aug. 2 opinion.
Section 508(a)(8)(A) gives the IRS an unsecured priority claim for “a tax measured by income . . . .” Section 508(a)(8)(G) extends priority status to “a penalty related to [a tax claim] and in compensation for actual pecuniary loss.”
To establish the analytical framework, Judge Gorton cited the Supreme Court for holding that the bankruptcy court “should place no weight on the ‘tax’ label” in ruling on the priority of the claim. Instead, the high court requires resting the decision “‘on the operation of the provision.’” United States v. Reorganized CF & I Fabricators of Utah Inc., 518 U.S. 213, 220 (1996). He also cited the Supreme Court for holding, in the context of the Affordable Care Act, that an exaction can be a tax for some purposes and a penalty for others.
Because he said the case at hand was “not remarkably complex,” Judge Gorton employed the so-called Feiring-Anderson test where taxes are defined as “pecuniary burdens . . . for the purpose of defraying the expenses of government . . . .”
Although the 10% exaction “may generate some revenue,” Judge Gorton said that “the presence of ‘hardship’ exceptions to the early withdrawal rule indicates that the purpose of the statutory provision is to deter unwanted conduct.” Because “the exaction functions as a penalty and not as a tax,” the 10% exaction did not qualify as a tax entitled to priority under Section 508(a)(8)(A).
Alternatively, the IRS contended that the 10% exaction was a penalty for actual pecuniary loss, qualifying it for priority status under Section 508(a)(8)(G).
Judge Gorton gave short shrift to the argument, saying that the exaction was “not to compensate the government for lost revenue” but “to deter taxpayers from making early withdrawals.”
Because the exaction was neither a tax nor compensation for actual pecuniary loss, Judge Gorton upheld Judge Bailey and ruled that the $17,000 claim was not entitled to priority.