I intend someday
to return to college and teach tax. It would be an adjunct position, as I have
no intention of taking up another full-time job after this. One tax CPA career is enough.
I have previously
taught accounting but not tax. There is some order to accounting: debits and
credits, recording transactions and reconciling accounts. Tax and accounting
may be siblings, but the tax Code does not purport to show anyone’s net income according
to “generally accepted accounting principles.” It may, mind you, but that would
be a coincidence.
Sometimes
there are jagged edges to tax accounting. Have Johnson & Johnson issue financial
statements pursuant to the tax Code and they would likely find themselves in
front of the SEC.
Let's say you are taking your first tax course. The syllabus includes:
·
What
is income?
·
What
is deductible?
·
Why
doesn’t the answer make sense?
I am looking
at Tobias v Commissioner. I give the
taxpayers credit, as they were thinking outside the box. They knew they hadn’t
made any money, irrespective of what the IRS said.
Edward Tobias was an attorney and kept an
inactive CPA license. His wife was a school administrator. They had bought a variable
annuity in 2003 for almost $230,000. In order to free up the cash, they sold
stock at a loss of approximately $158,000. They put another $346,000 into the
annuity over the years.
Fast forward
to 2010. They withdrew $525,000 to buy and improve a residence. At that point
in time, the deferred income (that is, the inside buildup) in the annuity policy
was approximately $186,000. They insurance company sent them a Form 1099 for
$186,000.
But they
left the $186,000 off their 2010 tax return. They did attach an explanation,
however:
The … account was funded with after-tax funds and all
withdrawals have been made prior to annuitization. Accordingly, any potential
gains should be applied to the prior capital loss carryforward, which is
approximately $148,000. Additionally, this account has not recouped losses
incurred in prior years and has incurred substantial withdrawal penalties; the
calculation made by … is incorrect and is contested.”
You know the
IRS was going to match this up.
The Tobias’ had
a remaining capital loss of $148,000 from stock they sold to buy the annuity.
In addition they had already put approximately $576,000 into the annuity, an
amount less than the withdrawal. They were just getting their money back, even
without taking that capital loss into consideration.
The IRS on
the other hand said they had $186,000 in income. The IRS also wanted an early
distribution penalty of almost $19,000.
Who is
right?
When the
Tobias’ withdrew $525,000, they took deferred income with it. This is the “income
first” rule of Code Section 72(e), and the rule has been there a long time. It
says that – upon taking money from an annuity – the inside income is the first
thing to come out. Like the fable of the frog and scorpion, that is what
annuities do.
What about
the $148,000 capital loss? A capital loss has a separate set of rules. Capital
losses offset capital gains dollar-for-dollar. Past that they offset
non-capital-gain income up to $3,000 per year. Annuity income however is not
capital gain income, so we are stuck at $3,000.
But the economics
were interrelated, argued the Tobias’. They sold the stock to buy the annuity. The
loss on that should offset the income from the annuity, right?
No, not
right.
When these
transactions hit the tax return, each took on its own tax attribute. One attribute
went to house Gryffindor, another to house Hufflepuff. They are all in
Hogwarts, but they have been separated by the tax Sorting Hat. You cannot just
mix them together - unless the Code says you can mix them together.
Unfortunately, the Code does not say that.
So you have
the odd result that the Tobias’ owed tax and penalty on more money than they made from the deal.
The answer
makes sense to a tax guy.
It may just be a bit hard to teach.
