Saturday, November 8, 2014

Is Income From Investing Tax-Exempt Income Also Tax-Exempt?



Our story starts in 2005. Taxpayer (Lundy) received a Form 1099-R reporting approximately $42,000 of “retirement” income. The Lundys left it off their tax return. The IRS noticed and demanded payment. Off to Tax Court they went. Before there could be any hearing, the IRS settled, agreeing there was no tax due.

This action is referred to as a “stipulated” decision, and they tend to be about as terse as Bill Belichick at a press conference. We won’t read much there.

That said, I am thinking personal injury. We know that damages for personal injuries (think car accident) are tax-free. My hunch is that Lundy got injured, received a $42,000 settlement and a Form 1099-R to boot. Somebody messed up by issuing the 1099 in the first place. The IRS made a second mistake by not adequately investigating the facts before taking the matter to court.

Fast forward 6 years.

The Lundys file their tax return for 2011. Mr. Lundy has a W-2 from driving a school bus, and Mrs. Lundy has approximately $20,000 from a small business. There is some income tax, throw in some self-employment tax, and the Lundys owed about $3,500.

They send in the return. They do not send in any money, nor was there any withholding on Mr. Lundy’s W-2.

The IRS – of course – wants to know why. And they want their money.

The Lundy’s have no intention of sending money. 


The Lundys file a request for a due process hearing.

Their argument?

The funds that you are attempting to collect from are indeed part of my total and permanently [sic] disability benefits which were subject of the UNITED STATES TAX COURT CASE # 2759-07S***. We filed a timely appeal to the U.S. TAX COURT and laid out all of our affirmative defenses to the Commissioner of the Internal Revenue Service claims at that time. The most important claim that we made at that time is that whatever we funded, financed, and paid for with my total and permanently [sic] disability funds which were determined by this order to be non-reportable, tax free, and tax exempt from the clutches of the IRS was also off limits from the IRS.”

Well then.

Let’s think about their argument for a moment. The Lundys were arguing that any income earned from a tax-free source would – in turn – also be tax-free. Does this make sense? Let me give you a few situations:

·        You sell your primary residence, excluding $500,000 of gain. You invest the $500,000 in the next hot IPO. It takes off, and next thing you know you are rubbing shoulders with Gates, Buffett and Zuckerberg.
·        You take the interest from your municipal bond fund to fund the next great mobile app. You are subsequently acquired by Apple and you buy Ecuador.
·        You work overseas for a number of years, always claiming the foreign earned income exclusion. You invest your tax savings in raw land. Two decades later you sell the land to someone developing an outdoor mall. You buy a county in Wyoming so you have somewhere to hunt.

Of course it doesn’t make sense. It is clear that we have to separate the cart from the groceries. The cart stays at the store while the groceries go home with you. They are two different things, and the fate of the cart is not the fate of the groceries. Income from a tax-free pile of money does not mean that the earnings are magically tax-free. If only it were so. Could you imagine the ads from Fidelity or Vanguard if it were that simple?

The Lundys lost, of course.

Of surprise to me, as a practitioner, was the IRS restraint on penalties. The IRS popped them for late payment penalties, of course, but not for the super-duper penalties, such as for substantial accuracy. Why?

Who knows, but I did notice the Tax Court case was “pro se,” meaning that the Lundys represented themselves. There is a way to have a tax practitioner involved in a “pro se,” but I do not think that is what happened here. I suspect they actually represented themselves, without an accountant or attorney.

Not that an accountant or attorney could have represented them in any event. A practitioner is prohibited from taking frivolous positions. The Lundy positon was as close to frivolous as I have heard in a while.

And the IRS gave them a break.

Not that the Lundys would see it that way, though.

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