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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