Paying Tax Twice On The Same Income

Let me set up a scenario for you, and you tell me whether you spot the tax issue.

There is a fellow who is involved with health delivery services. He is paid by an insurance company, and he in turn pays out claims against that reimbursement. Whatever is left over is his profit.

In the first year, he received reimbursements from Cigna. There were issues, and in a second year he had to repay those monies. There was of course litigation. It turned out he was right, and Cigna – in yet a third year – paid him approximately $258,000.

Is the $258,000 taxable to him?

There is a doctrine in the tax Code that every tax year stands on its own. One has to resolve all the numbers that go into income for that year, even if some debate about an "exact" number exists. More commonly this is an issue for an accrual-basis taxpayer, meaning that one pays tax on amounts receivable even before receiving cash. Fortunately one is also able to deduct amounts payable (with exceptions) before writing the check. This is generally accepted accounting and is the way that almost all larger businesses report their income.

There is an alternative way. One can report income when cash is received and deduct expenses when bills are paid. This is the cash basis of accounting, and it too is generally accepted accounting.

For the most part, cash basis is the domain of smaller businesses. Depending upon the type of business, however, it may not matter if one is large or small. For example, an inventory-intensive business is required to use accrual accounting.

Our taxpayer is Udeobong, and he uses the cash basis of accounting.

When Cigna paid him the first time, he would have reported income in year one - the year he received the check.

When he repaid Cigna in year two, he had two options:

(1) He could deduct the payment in that second year, as he was repaying amounts previously taxed to him; or

(2) He could file his taxes for the second year using Section 1341, known in tax-speak as the “claim of right.”

The Code recognizes that just deducting the repayment in a second year could be unfair.  Let me give you an example. Let’s say that you received a very large bonus in 2014, large enough for you to retire. You invest the money and live comfortably, but 2014 was your bellwether year and is never to be repeated. Something happens – say that there is clawback - and you have to return some of the bonus in 2016. Sure, you could deduct the repayment, but that repayment could overwhelm your income in 2016. It is possible that you would lose any tax advantage once your income goes negative. If one looks at the two years together (2014 and 2016), you would have paid tax on income you did not get to keep.

That is where Section 1341 comes in. The Code allows you to do a special calculation:

·        You start off with the tax you actually paid in 2014

·        You then do a pro forma calculation, subtracting the repaid amount from your income in 2014. This gives you a revised tax amount.

·        You subtract the revised tax amount from the actual tax you paid in 2014.

·        The IRS allows you to claim that difference as tax paid in 2016.

The Code is trying to be fair, and for the most part it works.

There is one more piece you need to know. Udeobong did not either deduct the repayment or use the claim-of-right in year two. He did ... nothing.

Is the $258,000 in year three taxable to him?

Unfortunately, it is.

But why?

Because the Code gives him two options: deduct the payment in year two or use the claim of right alternative.

COMMENT: You may be wondering if he could amend his year-one return. This is the technical problem with every tax year standing on its own. Unless there were exceptional circumstances, the Code takes the position   that he received and had control over the income in year one, even if something occurs later requiring him to repay some or all of that income. Since he had control in year one, he had income in year one. Should he repay in a later year, then the repayment is reported in the later year.

The Code does not give him a third option of excluding the $258,000 in year three.

So he has to pay tax again.

It is a harsh result. One can understand the reasoning without the conclusion feeling fair or just ... or right.  I am also frustrated with Udeobong. There is no mention that he used a tax advisor. He had no idea of what he walked into.

He tried to save professional fees, perhaps because he saw his tax return as a simple matter of cash in and cash out. I understand, and I do not – in general – disagree. Still, one has to be cognizant when something unusual happens, like swapping real estate, exercising stock options or repaying Cigna a lot of money. The combination of "unusual" and "a lot" probably means it is a good time to see a tax expert.