Owing Tax on Social Security Not Received

 

I am spending more time talking about social security.

The clients and I are aging. If it does not affect me, it affects them – and that affects me.

Social security has all manners of quirks.

For example, say that one worked for an employer which does not pay into social security. There are many - think teachers, who are covered instead by state plans. It is common enough to mix and match employers over the course of a career, meaning that some work may have been covered by social security and some was not. What does this mean when it comes time to claim benefits?

Well, if you are the employee in question, you are going to learn about the windfall elimination provision (WEP), which is a haircut to one’s social security for this very fact pattern.

What if this instead is your spouse and you are claiming spousal benefits? Well, you are going to learn about the “government pension offset,” which is the same fish but wrapped in different paper.

What if you are disabled?

Kristen Ecret was about to find out.

She worked a registered nurse until 2014, when she suffered an injury and became medically disabled. She started receiving New York workers compensation benefits.

Oh, she also applied for social security benefits in 2015.

In December 2017 (think about it) she heard back from the SSA. She was entitled to benefits, and those benefits were retroactive to 2015.

Should be a nice check.

In January 2018 she received a Form SSA-1099 for 14,392, meaning the SSA was reporting to the IRS that she received benefits of $14,332 during 2017.

But there was a bigger problem.

Kristen had received nothing – zippo, nada, emptitadad – from SSA. The SSA explained that her benefits had been hoovered by something called the “workers’ compensation offset.”

She filed a request for reconsideration of her benefits.

She got some relief.

It’s a year later and she received a Form SSA-1099 for 2018. It reported that she received benefits of $71,918, of which $19,322 was attributable to 2018. The balance – $52,596 – was for retroactive benefits.

Except ….

Only $20,749 had been deposited to her bank account. Another $5,375 was paid to an attorney or withheld as federal income tax. The difference ($45,794) was not paid on account of the workers’ compensation offset.

Something similar happened for 2019.

Let’s stay with 2019.

Instead of using the SSA-1099, Kristen reported taxable social security on her 2019 joint income tax return of $5,202, which is 85% of $6,120, the only benefits she received in cash.

I get it.

The IRS of course caught it, as this is basic computer matching.

The IRS had records of her “receiving” benefits of $55,428.

The difference? Yep: the “workers’ compensation offset.”

There was some chop in the water, as a portion of the benefits received in 2019 were for years 2016 through 2018, and both sides agreed that portion was not taxable. But that left $19,866 which the IRS went after with vigor.

The Court walked us through the life, times and humor of the workers’ compensation offset, including this little hummable ditty:

For purposes of this section, if, by reason of section 224 of the Social Security Act [i.e., 42 U.S.C. § 424a] . . . any social security benefit is reduced by reason of the receipt of a benefit under a workmen’s compensation act, the term ‘social security benefit’ includes that portion of such benefit received under the workmen’s compensation act which equals such reduction."

Maybe the Court will find a way ….

            Section 86(d) compels us to agree with respondent."

The “respondent” is the IRS. No help here from the Court.

Applying the 85% inclusion ratio, we conclude that petitioners for 2019 have taxable Social Security benefits of $16,886, viz, 85% of the $19,866 in benefits that were attributable to 2019. Because petitioners on their 2019 return reported only $5,202 in taxable Social Security benefits, they must include an additional $11,684 of such benefits ($16,886 − $5,202) in their gross income."

Kristen lost.

Oh, the IRS applied an accuracy-related penalty, just to make it perfect.

We know that tax law can be erratic, ungrounded, and nonsensical. But why did Congress years ago change the tax Code to convert nontaxable disability income into taxable social security income? Was there some great loophole here they felt compelled to squash?

Our case this time was Ecret v Commissioner, T.C. Memo 2024-23.

Primer On Research Expenses And The Research Credit

[In case you were wondering what a tax CPA does during weekdays, I drafted the following for a fellow CPA as a walkthrough through the tax terrain for research expenses and the related – but different – research credit. It is not recreational reading, but hopefully it may help another tax practitioner out there – CTG].

 

The research & development tax credit has been around since the early 1980s. Initially, only the largest of corporations seemed able to meet its requirements. The passage of years introduced more realistic standards, allowing even modest companies to benefit. Its decades of changes, requirements, limitations and alternate calculations make this a challenging area for almost any tax practitioner.

Let’s take a brief dive into the research credit.

Analysis of the credit, oddly enough, does not begin with a tax credit itself. No, it begins with the deduction for research expenses.

         § 174 Amortization of research and experimental expenditures.

(a)  In general.

In the case of a taxpayer's specified research or experimental expenditures for any taxable year-

(1) except as provided in paragraph (2), no deduction shall be allowed for such expenditures, and

(2)  the taxpayer shall-

(A)  charge such expenditures to capital account, and

(B)  be allowed an amortization deduction of such expenditures ratably over the 5-year period (15-year period in the case of any specified research or experimental expenditures which are attributable to foreign research (within the meaning of section 41(d)(4)(F) )) beginning with the midpoint of the taxable year in which such expenditures are paid or incurred.

 For years – decades actually – research and experimental expenses were deductible as incurred, although the taxpayer had the option to capitalize and amortize such expenses if preferred. For taxable years beginning on or after January 1, 2022, however, that option has been eliminated. Research and experimental expenditures must now be capitalized and amortized (that is, spread out over time). The only difference is the period:

·       Domestic research is amortized over 5 years.

·       Foreign research is amortized over 15 years.

This is a sea change in the treatment of such expenses. Many practitioners – including me – have only known one option, and that was the immediate deduction of relevant expenses. Granted, amortization does not mean the deductions are lost; it means only that the deduction is spread over a period of years. If the company is unprofitable (think a start-up), the difference between immediate deduction and amortization may be minimal. Take a mature company (Pfizer, for example), and the difference could be dramatic.

What type of expenses qualify for the Section 174 deduction?

·       Wages paid to employees directly involved in R&D, and individuals who support and supervise their work. Support or supervise is defined as one level above or below.   

·       Supplies and raw materials.

o   There is an issue here about depreciable equipment. In general, the taxpayer decides the matter by capitalizing or not capitalizing the equipment. If it does, then the equipment is not considered supplies and cannot be included in the expense pool.

·       Work performed by a third party, as long as the business retains the risk of failure.

·       Patent costs

·       Certain overhead expenses (think a research lab)

Now, we know that wages may qualify for the Section 174 deduction, but obviously not all wages will qualify. There are additional “qualities” for an expense to qualify as Section 174 expenses:

·       A permitted purpose

The underlying activity in which wages are incurred must relate to a new or improved business purpose. For example,

o   Something functions (at all)

o   Something functions more reliably

o   Something functions more efficiently 

·       Technological in nature

o   Must be based on a hard science

§  Think engineering, physics, chemistry

§  Scratch sociology and the like  

·       Elimination of uncertainty

o   There must be a realistic question whether the idea will work.

§  Mind you, it does not have to work, but there must be an initial question (or oppositely, a hope) that it will.  

·       Process of experimentation

o   Think classic trial and error.

There are best-practice recordkeeping standards for these expenses. At this point (that is, deduction), such practices may or may not be critical, but the recordkeeping becomes critical as we leave Section 174 and go to the tax credit under Section 41.

             § 41 Credit for increasing research activities.

(a)  General rule.

For purposes of section 38, the research credit determined under this section for the taxable year shall be an amount equal to the sum of-

(1)  20 percent of the excess (if any) of-

(A)  the qualified research expenses for the taxable year, over

 

(B)  the base amount,

(2)  20 percent of the basic research payments determined under subsection (e)(1)(A) , and

(3)  20 percent of the amounts paid or incurred by the taxpayer in carrying on any trade or business of the taxpayer during the taxable year (including as contributions) to an energy research consortium for energy research.

The research tax credit is a big deal because it gives you a second tax bang for doing something you were doing anyway. First, you get to deduct the expense of doing something (immediately under old law; over time under the new law). Second, you get a tax credit on top of the deduction.

The tax credit can be – to be diplomatic – confusing.

There are two main paths:

       

·       The regular credit

·       The alternate simplified credit

 

The Regular Credit

 

The regular credit begins with an odd question:

·       Did you have qualifying research expenses (QREs) before 1984?

If the answer is yes, you will have to accumulate information from the 1980s to calculate the credit, This requirement has been enough to break the hearts of many seeking the research credit.

If the answer no, then calculations become more doable.

The basic calculation is:

Current QREs – base amount = excess QREs         

The base amount involves a five-year period and can be any 5 years between the company’s 5th and 10th taxable year.     

Add up the 5-year QREs. [A]

Add up the 5-year gross receipts [B]

Divide [A] by [B] (called the fixed base percentage)

Let’s pause for a moment.

For its first 5 years, the company can just use 3% for its fixed base percentage.  

The fixed base percentage cannot exceed 16% (i.e., once outside the five year window).

 Back to math. 

Multiply the fixed base percentage by average annual gross revenues for the 4 preceding years (this is called the “base amount”).

Use the greater of the base amount or 50% of current QREs.

Subtract that amount from current year QREs (let’s call this the golden earring).

 Now what?

We multiply the golden earring by a percentage.

Easy: 20%, right?

Nothing is easy.

If we use 20%, then we have to add the amount of the research credit back into taxable income, meaning there is a loop-the-loop.

Fortunately, one can elect to use a reduced credit to avoid the loop-the-loop. The reduced credit is directly tied to the maximum corporate tax rate. Presently the maximum rate is 21%, so the reduced credit would be 20% times 79% = 15.8%.

The election must be claimed on an original, timely filed return and is good only for the year of election.

 Let’s look at an example. 

 

Current year QREs					164,000
Sum of 5-year QREs		[A]	250,000
Sum of 5-year gross receipts		[B]	960,000
Fixed base percentage			26%
Limit on fixed-base percentage				16%
Average gross receipts preceding 4 years				744,000
Base amount				119,040
Greater of base amount or 50% of current QREs					119,040
Subtract					44,960
Credit rate					20%
Credit					8,992

 

The Alternative Simplified Credit

This option came into the Code in 2007, offering an alternative to working with (possibly) decades-old data, There is a price for the simplification, though:     

The credit is 14% if the company has at least 3 years of QREs, otherwise … 

The credit is a flat 6% of current year QREs.  

You again have the loop-the-loop or you can elect to use the reduced credit. 

The nice part of the calculation is that you look at only the three years preceding the current year. 

Here is an example.  

Current year QRE					164,000
Average QREs previous 3 years			[A]	105,000
Multiply [A] by 50%					52,500
Subtract					111,500
Credit rate					14%
Credit					15,610

 

              

 

Here is an example with the reduced credit. 

Current year QRE					164,000
Average QREs previous 3 years			[A]	105,000
Multiply [A] by 50%					52,500
Subtract					111,500
Credit rate					11%
Credit					12,265

 

              

 

 

What if the company does not have 3 years of QREs? Then a flat 6% of current QREs applies.  

Current year QRE						164,000
Average QREs previous 3 years			[A]
Multiply [A] by 50%						0
Subtract						164,000
Credit rate						6%
Credit						9,840

              

              

 

 

The Payroll Tax Offset Option

The PATH Act of 2015 introduced yet another option to the research credit: use it instead to offset employer payroll tax.

More specifically: 

(1)  The offset applies to both the social security portion (6.2%) and Medicare portion (1.45%) of the employer FICA tax.

(2)  There is a $500,000 maximum.

(3)  Only companies with gross receipts for 5 years or less (think startups) qualify.

(4)  Only companies with gross receipts of $5 million or less in the year of the election qualify.

(5)  The election goes with the income tax return.

(6)  The offset applies to the first payroll tax quarter after the company files its income tax return.

(7)  Any unused credit carries over to the next payroll tax quarter.

(8)  Any ultimately unused credit, however, will not be refunded.

The provision was clearly directed at companies with payroll tax obligations but little or no immediate income tax liabilities to sop up that research credit.

Be cautioned, however: you would be exposing your tax filings (both income and payroll) to heightened scrutiny. R&D credits are a high priority for the IRS.