Seventh Circuit: Medication-Induced Compulsive Gambling Is Not a Disability Excusing Penalty on IRA Withdrawal

(Parker Tax Publishing February 2020)

The Seventh Circuit affirmed a Tax Court holding that a taxpayer who suffered from compulsive gambling as a side effect of a prescription medication was not disabled for purposes of the exceptions to the Code Sec. 72 penalty tax on early retirement fund withdrawals because, even assuming the taxpayer suffered from a qualifying impairment, it was remediable. The Seventh Circuit also held that an IRS settlement officer properly rejected the taxpayer's offer in compromise because the taxpayer had sufficient net equity in real estate and could have sold assets to pay the taxes due, and the rejection of the taxpayer's offer was not contrary to public policy or inequitable. Gillette et al. v. Comm'r, 2020 PTC 6 (7th Cir. 2020).

Background

Kathryn Gillette developed a compulsive gambling problem which was linked to Mirapex, a prescription medication she took for restless leg syndrome. Gillette first began taking Mirapex in the early 2000s and over the years, her doctor gradually increased her dosage as the medicine became less effective. After a large dosage increase in 2010, Gillette began to exhibit compulsive behavior, especially gambling. By 2012, her gambling was out of control and she often stayed at casinos for days. Gillette also stopped associating with family and friends and neglected her hygiene. To fuel her gambling, Gillette eventually made an early withdrawal of $104,000 from her individual retirement account (IRA), less than two years before she could do so without penalty.

Gillette's gambling also threatened a rental property business she had built up over several decades. While continuing to collect rents from the rental properties she owned, Gillette stopped paying the mortgages, property taxes, and maintenance expenses, instead spending the income at casinos. As a result, by 2013, several of her properties were in foreclosure or scheduled for tax sales. In 2013, Gillette first learned that Mirapex had been linked to the onset of impulse-control disorders in some patients. She responded by weaning herself off the medicine, but did not stop taking it completely until the second half of 2015.

Gillette filed a joint tax return with her husband, Raif Szczepanski, for year 2012 reporting gambling winnings of $1.3 million, almost the same amount in gambling losses, and $126,465 net profit from rental properties. The couple's tax liability for that year was $75,954, which included a 10 percent tax of $10,400 for Gillette's early IRA withdrawal and $17,851 of alternative minimum tax (AMT). Gillette and Szczepanski did not pay their taxes for 2012.

In 2014, the IRS sent the couple a notice of intent to levy certain property to satisfy the tax debt. They requested a collection due process (CDP) hearing before the IRS's Office of Appeals. Gillette and Szczepanski submitted an offer-in-compromise (OIC), proposing to pay $38,968 to resolve their back taxes for 2012. They checked a box on the offer form identifying the reason for their offer as "Exceptional Circumstances (Effective Tax Administration)." By checking that box, the couple acknowledged they owed the full amount of taxes and had sufficient assets to pay in full, but asserted that due to exceptional circumstances, requiring full payment would cause an economic hardship or would be unfair and unequitable. Specifically, the couple cited Gillette's gambling and their related financial troubles. For support, they submitted medical records, documents explaining the side effects of Gillette's medication, and an income analysis listing their 26 rental properties (including 11 with no mortgage balance).

The IRS examiner calculated the couple's net equity to be $813,484 - more than enough to pay the full amount due. The examiner suggested that Gillette and Szczepanski could satisfy their tax liability by selling two rental properties. Gillette disagreed, insisting she needed income from those properties for retirement. A settlement officer (SO) concluded that the couple had sufficient equity in real estate to pay their full liability and that their circumstances did not otherwise warrant a compromise. Gillette and Szczepanski sought review in the Tax Court, which remanded the case to the Office of Appeals for a supplemental CDP hearing. The SO again rejected the couple's OIC and sustained the proposed levy. The officer observed that the side effects of Gillette's medicine were listed on the label six years before her increase in dosage and concluded that, by continuing to gamble after 2013 and failing to follow advice on treating her compulsive gambling, Gillette did not act "reasonably or responsibly."

Gillette and Szczepanski took their case back to the Tax Court, which upheld the Office of Appeals' decision. The Tax Court held that Gillette was not disabled under Code Sec. 72(m)(7) because, even assuming she suffered from a qualifying impairment, it was remediable under Reg. Sec. 1.72-17A(f)(4). With respect to the AMT, the Tax Court held that no authority permitted an equitable exemption. The Tax Court also held that it was not an abuse of discretion for the SO to reject the couple's OIC. The Tax Court held that while Gillette's circumstances were unfortunate, the SO committed no abuse of discretion in rejecting the proposed settlement.

Gillette and Szczepanski appealed to the Seventh Circuit. First, they argued that the 10 percent early IRA withdrawal penalty should not have been imposed because Gillette's compulsive gambling was a disability under Code Sec. 72(t)(2)(A)(iii). They argued that they should not be liable for the AMT because it was only Gillette's gambling income and failure to pay property taxes or mortgages due to her gambling that subjected them to the tax. With respect to their OIC, the couple argued that the SO should have accepted their offer based on both economic hardship and public policy grounds. Specifically, they contended that selling two of their properties would prevent them from paying basic living expenses and that they had negative monthly income. They also claimed that the SO discriminated against Gillette by stating that she did not act reasonably or responsibly.

Seventh Circuit's Analysis

The Seventh Circuit upheld the Tax Court's decision. The court agreed that Gillette's condition was remediable. The court noted that under Reg. Sec. 1.72-17A(f)(4), an impairment is remediable if with reasonable effort and safety it can be diminished to the extent that the individual will not be prevented from engaging in substantial gainful activity. The court found that Gillette continued to operate her rental property business and the couple still reported $126,465 in profit from the business on their tax return. The court also said that even if she were temporarily unable to operate her business, she received treatment for compulsive gambling in a reasonable and safe manner with the help of her family and doctors without interrupting her business. The court also upheld the Tax Court's finding that the AMT has no equitable exception.

Next, the Seventh Circuit found that the SO committed no abuse of discretion in rejecting the OIC. The court found that selling two rental properties to pay taxes would not result in an economic hardship for Gillette and Szczepanski; rather, the court noted that Gillette did not want to sell the properties because she planned to use the rental income for her retirement. While the couple contended that they had negative monthly income, the court found that that the basis of the SO's rejection was not the couple's monthly income but their $813,484 of net equity in real estate. It also was not unreasonable, in the view of the Seventh Circuit, for the Tax Court to determine that Gillette's situation was not so extraordinary that it required a compromise, especially when she was able to file her tax returns accurately and continue to collect rents from her properties.

The Seventh Circuit found that Gillette and Szczepanski did not offer a reasonable basis to challenge the SO's determination that acceptance of their offer - less than half their total liability, despite their substantial assets - would undermine taxpayer compliance with the tax laws, as required for obtaining relief on public policy grounds under Reg. Sec. 301.7122-1(b)(3)(iii). The court also found that the SO did not discriminate against Gillette and her compulsive gambling by stating that she did not act reasonably or responsibly. The court said that the SO's language was perhaps worded sharply but found that the conclusion was supported by the record, given what the court described as Gillette's spotty treatment history.

For a discussion of the tax treatment of early IRA distributions, see Parker Tax ¶134,555. For a discussion of the AMT, see Parker Tax ¶12,101. For a discussion of OICs, see Parker Tax ¶263,165.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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