Repaying a COVID-Related Distribution

Do you remember a tax break in 2020 that allowed you to take (up to) $100,000 from your IRA or your employer retirement plan? These were called “coronavirus-related distributions,” or CRDs in the lingo. In and of itself, the provision was not remarkable. What was remarkable is that one was allowed three years to return some, all, or none of the money to the IRA or employer plan, as one wished.

I was thinking recently that I do not remember seeing 2021 individual returns where someone returned the money.

Granted, we have a flotilla of returns on extension here at Galactic Command. I may yet see this beast in its natural state.

Let’s go over how this provision works.

To make it easy, let’s say that you took $100,000 from your 401(k) in 2020 for qualifying COVID-related reasons.

You had an immediate binary decision:

·      Report the entire $100,000 as income in 2020 and pay the taxes immediately.

·      Spread the reporting of the $100 grand over three years – 2020, 2021 and 2022 - and pay taxes over three years.

There was no early-distribution penalty on this distribution, which was good.

You might wonder how paying the tax immediately could be preferable to paying over three years. It could happen. How? Say that you had a business and it got decimated by COVID lockdowns. Your 2020 income might be very low – heck, you might even have an overall tax loss. If that were the case, reporting the income and paying the tax in 2020 might make sense, especially if you expected your subsequent years’ income to return to normal levels.

What was a COVID-related reason for a distribution?

The easy ones are:

·      You, a spouse or dependent were diagnosed (and possibly quarantined) with COVID;

·      You had childcare issues because of COVID;

·      You were furloughed, laid-off or had work hours reduced because of COVID.

Makes sense. There is one more:

·      You experienced other “adverse financial consequences” because of COVID.

That last one has an open-gate feel to me. I’ll give you an example:

·      You own rental cabins in Aspen. No one was renting your cabins in 2020. Did you experience “adverse financial consequences” triggering this tax provision?

You have – should you choose to do so – three years to put the money back. The three-year period starts with the date of distribution, so it does not automatically mean (in fact, it is unlikely to be) December 31^st three years later.

The money doesn’t have to return to the same IRA or employer plan. Any qualifying IRA or employer plan will work. Makes sense, as there is a more-than-incidental chance that someone no longer works for the same employer.

 Let’s say that you decide to return $50 grand of the $100 grand.

The tax reporting depends on how you reported the $100 grand in 2020.

Remember that there were two ways to go:

·      Report all of it in 2020

This is easy.

You reported $100 grand in 2020.

When you return $50 grand you … amend 2020 and reduce income by $50 grand.

What if you return $50 grand over two payments – one in 2021 and again in 2022?

Easy: you amend 2020 for the 2021 and amend 2020 again for the 2022.

Question: can you keep amending like that – that is, amending an amended?

Answer: you bet.

·       Report the $100 grand over three years.

This is not so easy.

The reporting depends on how much of the $100 grand you have left to report.

Let’s say that you are in the second year of the three-year spread and repay $30,000 to your IRA or employer plan.

The test here is: did you repay the includable amount (or less) for that year?

If yes, just subtract the repayment from the includable amount and report the difference on that year’s return.

In our example, the math would be $33,333 - 30,000 = $3,333. You would report $3,333 for the second year of the spread.

If no, then it gets ugly.

Let’s revise our example to say that you repaid $40,000 rather than $30,000.

First step: You would offset the current-year includable amount entirely. There is nothing to report the second year, and you still have $6,667 ($40,000 – 33,333) remaining.

You have a decision.

You have a year left on the three-year spread. You could elect to carryforward the $6,667 to that year. You would report $26,666 ($33,333 – 6,667) in income for that third and final year.

You could alternatively choose to amend a prior year for the $6,667. For example, you already reported $33,333 in 2020, so you could amend 2020, reduce income by $6,666 and get an immediate tax refund.

Which is better? Neither is inherently better, at least to my thinking. It depends on your situation.

There is a specific tax form to use with spreads and repayments of CRDs. I will spare us the details for this discussion.

There you have it: the ropes to repaying a coronavirus-related distribution (CRD).

If you reflect, do you see the complexity Congress added to the tax Code? Multiply this provision by however many times Congress alters the Code every year, and you can see how we have gotten to the point where an average person is probably unable to prepare his/her own tax return.

 

A Foreclosure And A Mortgage Interest Deduction

I am looking at a case involving mortgage interest. While I get the issue, I think the taxpayers got hosed.

I am going to streamline the details so we can follow the key points.

The Howlands had two mortgages on their house.

The first mortgage started with Countrywide and eventually wound up with Bank of New York Mellon.

The second mortgage started with Haven Trust Bank and wound up with CenterState Bank.

The house was foreclosed in 2016. It sold for $594,000.

The Howlands owed the following when the house was sold:

            Mellon        CenterState

        Principal      $     $377,060

        Interest     $100,607

        Interest & other    $247,046

The Howlands deducted mortgage interest of $103,498 on their 2016 joint tax return.

Neither bank, however, issued a Form 1098 for mortgage interest.

Allow for a little computer matching (or nonmatching in this case), and the IRS disallowed any interest deduction and assessed penalties to boot.

This story partially happened during the Great Recession of the late aughts. That is when we learned of “too big to fail,” of “ninja” loans and of banks playing musical chairs to survive. Good luck guessing where a given loan would wind up when the music stopped. Perhaps a taxpayer borrowed from someone (let’s call them “A”). A was acquired by B, which was later merged into C and yada, yada, yada. The data platforms between A and B were incompatible, meaning there was a one-way data transfer. The odds that someone years later – especially after the yada, yada, yada - could get back to A were astronomical.

While not clarified in the opinion, I suspect that is what happened here. CenterState Bank was not going to issue a 1098 because it could/would not time travel to determine if their interest calculations were correct. In the absence of such assurance, they were not going to issue a 1098. Or perhaps they were lazy and problem-solving outside a comfortable, numbing rote was a request beyond the pale. I prefer to believe the former reason.

But there was a problem: under the terms of the second mortgage, payments were to be applied first to interest.

COMMENT: Seems to me the Howlands paid interest of some amount.

Let’s focus in on that second mortgage. The money available to repay the second mortgage (after satisfaction of the first mortgage) would have been:

$594,000 – 247,046 = $346,954

There should also have been some interest embedded in the first mortgage, but let’s ignore that for now.

There is $347 grand to pay $377 grand of debt and $100 grand of back interest.

The IRS argued there was not enough money left to cover the principal, much less the interest. That is why the bank did not issue a 1098.

But we know that interest was to be paid first, per the loan agreement.

The Tax Court had to decide.

You know who was not in Court to testify? 

CenterState Bank – the second mortgage holder - that’s who.

Here is the Court:

The record before us is silent as to how CenterState applied the funds received and whether petitioners owe any remaining principal balance. These facts (if favorable) could support a finding that petitioners in fact paid home mortgage interest ….”

True.

However, statements in briefs do not constitute evidence.”

Again, true, but why say it?

Petitioners bear the burden of proof and must show, by a preponderance of evidence, that they are entitled to a home mortgage interest deduction ….”

Oh, oh.

... we conclude that petitioners have failed to meet their burden.”

Sheeshh.

I am not certain what more the Howlands could have done. They were at the mercy of the bank, and the new bank that took the payoff was not the same as the old bank that originated the loan. 

The Tax Court did strike down the penalties. Small consolation, but it was something.

Our case this time was Howland v Commissioner, TC Memo 2022-60.

Collections and Hutzpah

 

An old partner of mine would have called it “hutzpah.”

The case is ridiculous, but it does give us a chance to review the tolling of the statute of limitations.

Let’s start:

·      The IRS has – barring unusual circumstances – only so much time to collect taxes from you. This period is 10 years from the date of assessment. A key concept here is that the date of assessment is not necessarily the date you filed, and that one tax year can have more than one ten-year period running concurrently (think an IRS audit a couple of years after you filed).

·      The 10 years can be interrupted (the fifty-cent word is “tolled”) for certain things, such as filing for an offer in compromise. This means that that 10-year statute can stretch to much longer than 10 years in the real world.

Let’s look at the Ward case.

The IRS determined the Wards had underreported income by $197 grand for 1996 and $209 grand for 1997. The Wards took the matter to Tax Court and lost.

The 1996 tax was assessed in November 2002.

COMMENT: Plus ten years puts one at November 2012.

The 1997 tax was assessed in December 2002.

COMMENT: Plus ten years means December 2012.

Alright, how in the world does one get to 2022 with these dates and facts?

Let’s look at the following:

(1)  Offer in compromise dated 12/27/2002

(2)  Due process hearing requested 7/15/2003

(3)  Offer in compromise dated 3/15/2004

(4)  Offer in compromise dated 12/4/2008

(5)  Due process hearing requested 12/16/2011

(6)  Offer in compromise dated 3/6/2014

(7)  Offer in compromise dated 9/23/2015

Five offers? This has the signature of tax protest and will likely go poorly with the Court.

Each offer tolls the statute. The IRS has up to two years to resolve an offer, and it is not uncommon for an offer to take a year or more to resolve. The statute is tolled while an offer is being considered. Just reviewing the dates quickly, the Wards added at almost seven years to the statute.   

Then we have the due process hearings.

A CDP is a Collections hearing and generally means that the IRS wants you to pay more tax than you think you can pay. The hearing allows one to propose a payment alternative – think a smaller monthly payment than the IRS wants. The statute is tolled during CDP, and the IRS tacks-on another 30 days to boot after the determination.

I see that just one of the CDPs added over a year and a half to the statute.

Add all the seven tolling events and the statute had tolled until the summer of 2021.

Yep, the tax years were open, and the IRS could pursue collection.

Let’s go back.

Remember I said that the Tax Court had decided the matter?

Two of the offers were to contest the tax liability.

Let’s give some background about offers.

There are three types of offers:

(1) You argue that you do not owe the tax (or at least as much). This is a "liability” offer.

(2) You argue that you cannot pay the amount due in full. Think of a “pennies on the dollar” late-night commercial and you get the drift. This is a “collectability” offer.

(3)  You argue that fair and effective and fair tax administration requires acceptance of an offer. This third type is rare. I have never done one in practice, although we presently have a client where I intend to request one. The facts are extraordinary, though, and involve financial malfeasance while the client was a minor.

A key point is that a liability offer is off the table once the Tax Court has decided. The Wards’ first and fourth offers were liability offers and were therefore invalid.

Still, the offers tolled the statute.

So, the Wards played a wild card: they argued that the IRS considered two invalid offers in order to toll the statute. The IRS was playing a cynical game to buy time, and the Wards should not be punished for the IRS’ egregious behavior.

Hutzpah!

The Court shut them down immediately:

It was Defendants who primarily benefited from these delays. While the offers remained pending, the IRS could not collect payment on the underlying assessments…. [By] filing so many offers, [Defendants] successfully blocked collections for years.”

The statute tolled. The Wards owed. The Court had little patience with people who knew just enough to muck-up the tax collection process for the better part of two decades.

Our case this time was United States of America v Walter and Virginia Ward, USDC AK, Case 3:21-cv-0056, July 6, 2022.

Checks Not Cashed In Time Includible In Taxable Estate

 

Let’s talk about an issue concerning gifts.

We are not talking about contributions – such as to a charity - mind you. We are talking gifts to individuals, as in gift taxation.

The IRS spots you a $16,000 annual gift tax exemption. This means that you can gift anyone you want – family, friend, stranger – up to $16,000 and there is no gift tax involved. Heck, you don’t even have to file a return for such a straightforward transaction, although you can if you want. Say that you give $16,000 to your kid. No return, no tax, nothing. Your spouse can do the same, meaning $32,000 per kid with no return or tax.

That amount covers gifting for the vast majority of us.

What if you gift more than $16,000?

Easy answer: you now have to file a return but it is unlikely there will be any tax due.

Why?

Because the IRS gives you a “spot.”

A key concept in estate and gift taxation is that the gift tax and the estate tax are combined for purposes of the arithmetic.

One adds the following:

·      The gifts you have reported over your lifetime

·      The assets you die with

One subtracts the following:

·      Debts you die with

·      Certain spousal transfers and charitable bequests we will not address here.

If this number is less than $12.06 million, there is no tax – gift or estate.

Folks, it is quite unlikely that the average person will get to $12.06 million. If you do, congrats. Chances are you have been working with a tax advisor for a while, at least for your income taxes. It is also more likely than not that you and your advisor have had conversations involving estate and gift taxes.

Let’s take a look at the Estate of William E. DeMuth, Jr.

In January, 2007 William DeMuth (dad) gave a power of attorney to his son (Donald DeMuth). Donald was given power to make gifts (not exceeding the annual exclusion) on his dad’s behalf. Donald did so from 2007 through 2014.

In summer, 2015, dad’s health began to fail.

Donald starting writing checks for gift in anticipation that his dad would pass away.

Dad did pass away on September 11.

Donald had written eleven checks for $464,000.

QUESTION: Why did Donald do this?

ANSWER: In an attempt to reduce dad’s taxable estate by $464,000.

Problem: Only one of the eleven checks was cashed before dad passed away.

Why is this a problem?

This is an issue where the income tax answer is different from the gift tax answer.

If I write a check to a charity and put it in the mail late December, then income tax allows me to claim a contribution deduction in the year I mailed the check. One could argue that the charity could not receive the check in time to deposit it the same tax year, but that does not matter. I parted with dominion and control when I dropped the check in the mail.

Gift tax wants more from dominion and control. One is likely dealing with family and close friends, so the heightened skepticism makes sense.

When did dad part with dominion and control over the eleven checks?

Gift tax wants to see those checks cashed. Until then, dad had not parted with dominion and control.

Only one of the checks had cleared before dad passed away. That check was allowed as a gift. The other ten checks totaled $436,000 and potentially includible in dad’s estate.

But there was a technicality concern an IRS concession, and the $436,000 was reduced to $366,000.

Still, multiply $366,000 by a 40% tax rate and the issue got expensive.

Our case this time was the Estate of William E DeMuth, Jr., T.C. Memo 2022-72.