This is Two Different provisions: "So does the 10% penalty still apply? or can that be spread out in the 3 years?"

The distribution has to meet the disaster eligibility. That covers the 10% penalty.

Of course this distribution is taxable, unless they have basis or this is Roth 401(k). The disaster provision gives the taxpayer the ability to spread the reportable income over three years, so that spreads out the taxable amount. Or, optionally report it all as 2020 income and pay the full tax for 2020.

Withholding and estimates are all part of the pool of funds prepaid for the tax year. There is no spreading their payment over three years. It's already prepaid in against the entire result of the 1040.

Read the qualification information for the 8915-E for covid distribution to confirm they each qualify and their distributions qualify.