T.C. Memo. 2005-171

UNITED STATES TAX COURT

SYLVIA A. DUNCAN, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 329-04. Filed July 12, 2005.

Sylvia A. Duncan, pro se.

Daniel N. Price, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

COHEN, Judge: Respondent determined a deficiency of $2,251

in petitioner’s Federal income tax for 2001. The issues for

decision are: 

(1) Whether the unpaid balance of a loan taken by petitioner

from her qualified retirement plan in 2000 should be deemed a
- 2 -

taxable distribution to petitioner in 2001 that is subject to the

10-percent additional tax under section 72(t) and, if so, 

(2) whether petitioner’s medical expenses incurred in 2000

and 2001 can be applied to reduce the taxable amount of the

distribution. 

Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the year in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

FINDINGS OF FACT

Some of the facts have been stipulated, and the stipulated

facts are incorporated in our findings by this reference. 

Petitioner resided in San Antonio, Texas, at the time that she

filed her petition.

Petitioner was employed by United Services Automobile

Association (USAA) until December 26, 2000. During her

employment with USAA, petitioner contributed to USAA’s section

401(k) plan, the USAA Savings and Investment Plan (USAA SIP). On

October 1, 2000, petitioner’s balance in her USAA SIP account was

$20,919.05. 

On October 23, 2000, petitioner borrowed $10,400 from her

USAA SIP account. This loan was documented by an agreement

entitled “Savings and Investment Plan Truth in Lending

Disclosures/Promissory Note” (loan agreement). Petitioner
- 3 -

granted to USAA a security interest in her vested USAA SIP

account balance to the extent necessary to secure the loan. 

The loan agreement provided:

Payroll Deduction Authorization

I authorize USAA to institute continuing payroll

deductions in the full amount of each installment of

principal and interest payable on this note until the

loan is repaid in full. I understand that principal

and interest payments shall be due and payable at the

end of each payroll period throughout the term of the

loan. * * * If my employment with USAA ends, then the

unpaid balance of the loan plus any interest as of my

last day of employment shall become due and payable

immediately. * * *

* * * * * * *

Separation From Service 

I understand that after I separate from service, I have

90 days to repay my outstanding loan balance plus any

interest as of my last day of employment. Also, I

understand that if I do not make such repayment within

90 days after my separation from service, the accounts

in which I have given a security interest will be

permanently reduced by the amount of the outstanding

loan and will be treated for all purposes as a

distribution to me. I also understand that the

outstanding balance may be taxable income to me.

On December 21, 2000, petitioner was paid for the period

from December 3 through 16, the last period paid in 2000. In

accordance with the loan agreement, $122.67 was withheld from her

pay as a payment on the loan. On December 26, 2000, petitioner’s

employment with USAA was terminated. On January 2, 2001,

petitioner was paid for the period from December 17, 2000,

through her termination date of December 26, 2000. The $122.67

loan payment was not deducted from her pay for this period
- 4 -

because the net pay due to petitioner was only $34.93. 

Petitioner received a Form W-2, Wage and Tax Statement, from USAA

reflecting the January 2 payment as income for 2001.

In a statement dated January 16, 2001, USAA informed

petitioner that she had a vested balance of $11,929.32 and an

outstanding loan of $10,480.27 in her USAA SIP account as of that

date. Petitioner was informed that she had to pay her

outstanding loan balance by April 17, 2001, or it would be

considered in default and subject to Federal and/or State income

taxes. Petitioner was also informed that a 10-percent penalty

might apply. Petitioner did not pay the outstanding loan

balance. 

As of March 31, 2001, petitioner had received a distribution

payment of $11,961.16 from her USAA SIP account, less $4,487.24

withheld for Federal income taxes. The balance of petitioner’s

USAA SIP account, $10,480.27, was applied to her outstanding loan

balance. USAA reported this transaction to petitioner and to the

Internal Revenue Service (IRS) on a Form 1099-R, Distribution

From Pensions, Annuities, Retirement or Profit-Sharing Plans,

IRAs, Insurance Contracts, etc., for 2001 as a taxable

distribution of $22,441.43 to petitioner.

Petitioner reported the USAA SIP distribution on her

Form 1040, U.S. Individual Income Tax Return, for 2001. The IRS
- 5 -

determined that petitioner owed a 10-percent additional tax on

the early distribution from the USAA SIP.

OPINION

Section 402(a) provides generally that distributions from a

qualified plan are taxable to the distributee, in the taxable

year of the distributee in which distribution occurs, pursuant to

section 72. The amount of a distribution to a taxpayer from a

qualified pension plan generally includes the proceeds of any

loan from the plan to the taxpayer. See Scott v. Commissioner,

T.C. Memo. 1997-507, affd. without published opinion 182 F.3d 915

(5th Cir. 1999); Murtaugh v. Commissioner, T.C. Memo. 1997-319.

Section 72(p)(1)(A) provides: “If during any taxable year a

participant or beneficiary receives (directly or indirectly) any

amount as a loan from a qualified employer plan, such amount

shall be treated as having been received by such individual as a

distribution under such plan.” Section 72(p)(2) provides an

exception to this general rule. The exception will apply and the

loan will not be treated as a taxable distribution if: (1) The

principal amount of the loan (when added to the outstanding

balance of all other loans from the same plan) does not exceed a

specified limit; (2) the loan, by its terms, must be repaid

within 5 years from the date of its inception or is used to

finance the acquisition of a home that is the principal residence

of the participant; and (3) the loan must have substantially
- 6 -

level amortization with quarterly or more frequent payments

required over the term of the loan. Sec. 72(p)(2)(A) to (C). A

loan from a qualified employer plan no longer satisfies the

requirement of section 72(p)(2)(C) when the participant fails to

make a loan payment either on the date that it is due or within

the allowed grace period. See, e.g., Molina v. Commissioner,

T.C. Memo. 2004-258; see also Estate of Gray v. Commissioner,

T.C. Memo. 1995-421.

Petitioner argues that the amount of the USAA SIP account

applied to her outstanding loan balance should be deemed a

distribution in 2000, the year that the loan was made, as opposed

to 2001. Petitioner’s loan satisfied the requirements of section

72(p)(2) at the time that it was made and throughout 2000. Thus,

the loan was not treated as a distribution in 2000. When

petitioner failed to repay the loan in 2001 under the terms of

the loan agreement, the application of her USAA SIP account

balance to the loan discharged her debt and became a taxable

distribution to her in 2001. 

Section 72(t) provides for a 10-percent additional tax on

early distributions from a qualified retirement plan for the

taxable year in which the distribution is received. The

10-percent additional tax, however, does not apply to certain

distributions. Section 72(t)(2) sets forth specific exemptions. 

Section 72(t)(2)(B) provides that the additional tax shall not
- 7 -

apply to distributions made to employees “to the extent such

distributions do not exceed the amount allowable as a deduction

under section 213 to the employee for amounts paid during the

taxable year for medical care (determined without regard to

whether the employee itemizes deductions for such taxable year).” 

The deduction allowed under section 213(a) is for “the expenses

paid during the taxable year * * * for medical care * * * to the

extent that such expenses exceed 7.5 percent of adjusted gross

income.”

Petitioner argues that her medical expenses for 2000 and

2001 should be applied to reduce the taxable amount of the

distribution. The clear language of section 72(t)(2)(B) limits

the scope of the exemption to the amount of deductible medical

expenses “paid during the taxable year” of the distribution. 

Thus, the section 72(t)(2)(B) exemption does not apply to the

medical expenses that petitioner paid in 2000 because the taxable

year of the early distribution from her USAA SIP account was

2001. 

To reflect the foregoing and the parties’ agreement as to

the amount of petitioner’s allowable 2001 medical expenses,

Decision will be entered

under Rule 155.