Is It Income If You Pay It Back?

You receive unemployment benefits.

You repay unemployment benefits.

Do you have taxable income?

To start with: did you know that unemployment benefits are taxable? I have long considered this a dim bulb in taxation. Taxing the little you receive as unemployment seems cruel to me.

Back to our question: it depends.

It depends on when you pay it back.

Let’s look at the Yoklic case.

Yoklic applied for unemployment benefits in 2012.  He received $3,360, and then the state determined that he was not entitled to benefits. The state sent him a letter in October, 2012 requesting repayment.

Yoklic sent a check in September, 2013.

And he left the unemployment off of his 2012 return. How could it be income, he reasoned, if he had to pay it back. It was more of a loan, or alternatively monies that he received and to which he was not entitled.

Makes sense.

But tax theory does not look at it that way.

Enter the “claim of right” doctrine. It is an oldie, tracing back to a Supreme Court case in 1932.

The problem starts with accounting periods. You and I file taxes every year, so our accounting period is the calendar year. Sometimes something will start in one period (say October, 2012) but not resolve until another period (say September, 2013).

This creates a tax accounting issue: what do you do with that October, 2012 transaction? Do you wait until it resolves (in this case, until September, 2013) before you put it on a tax return? What if it doesn’t resolve for years? How many years do you wait? Does this transaction hang out there until the cows come home?

Enter the claim of right. If you receive monies – and you are not restricted in how you can use the monies – then you are taxable upon receipt. If it turns out that you are restricted – say by having to repay the monies - then you have a deduction in the year of repayment.

If you think about it, this is a reason that a bank loan is not income to you: you are immediately restricted by having to repay the bank. There is no need to wait until repayment, as the liability exists from the get go.

Find a bag of money in a Brooks Brothers parking lot, however, and you probably have a different answer.

Unless you repay it by the end of the year. Remember: you have a deduction in the year of repayment. If you find the bag of money and the police require you to return it, then the income and deduction happen in the same year and they fizzle out.

What if you promise to return the bag of money by year-end, but you do not get around to it until January 5^th? You may have an argument here, albeit a weak one. You could reduce your promise to writing, say by signing a contract. That seems a better argument.

What did Yoklic do wrong?

He repaid the monies in the following year.

He had income in 2012.

He had a deduction in 2013.

The problem, of course, is that the 2012 income may hurt more than the 2013 deduction may help.

There is – by the way - a Code section that addresses this situation: Section 1341, aptly described as the “claim of right” section. It allows an alternate calculation to mitigate the income-hurt-more-than-the-deduction-benefited-me issue. We have talked about Section 1341 before, but let me see if I can find a fresh story and we can revisit this area again.

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.  

Lance Armstrong’s Tax Problem

You may have read or heard that Lance Armstrong has been stripped of his seven Tour de France victories because of doping. The UCI Management Committee stated that it would not award the titles stripped from Armstrong to any other riders. History books will show no winner of the race between the years 1999 and 2005. UCI has demanded that Armstrong return his winnings from the vacated years, an amount estimated at approximately $4 million.

SCA Promotions, a Dallas insurance firm, has indicated that it will demand repayment of bonuses it insured for Armstrong’s wins in 2002, 2003 and 2004. It is reportedly seeking approximately $12 million.

There wasn’t much goodwill between SCA and Armstrong to begin with. SCA delayed paying a $5 million bonus for his 2005 win, responding to then-swirling allegations and controversies surrounding possible drug use. Armstrong sued, and SCA settled the case.

Then there are the endorsements. Armstrong earned more than $17 million in endorsements and speaking fees in 2005, when he won his last Tour de France. That amount grew to an estimated $21 million in 2010. And do not forget that Armstrong was the founder and driving force behind the Livestrong Foundation, which assists those struggling with cancer. Nike, Honey Stinger and Easton Bell Sports have dropped his endorsement, for example, and make seek clawback of prior monies.

Let us suppose that Armstrong has to repay some of these monies. What are the tax consequences to Armstrong?

The first step is easy: Armstrong will be entitled to a deduction. The repayment is tied to monies originally earned in his trade or business as a cyclist or spokesman, so the tax linkage is clear.

The second question is one of tax benefit. Armstrong paid taxes on these monies in prior years. Can he go back and have the IRS refund those monies? There is the rub. What would be your argument for amending those tax years?

You:     He had to repay those monies.

Me:      Did he not have unrestricted access to those monies in the prior year?

You:     I am not saying that. He did, but now he has to pay it back.

Me:      So is the transaction we are talking about for the year he received the money or the year he   pays it back?

You:     What is the difference?

Me:      He earned it in 2004 but pays it back in 2013. What year do you amend?

You:     You cannot amend 2013. It hasn’t happened yet.

Me:      So you would amend 2004?

You:     Yep.

Me:      There are two issues. The IRS is going to have a problem with your argument that he did not receive the money and owe tax. He did receive the money. And the IRS will expect its tax, because in 2004 he had no reason to think that he wasn’t entitled to keep the money.

You:     What is the second issue?

Me:      You cannot amend 2004. Remember, a tax year is open for only three years. The statute period has long since expired.

You:     So I am stuck with 2013?

Me:      That’s right.

Let’s pursue this point of tax benefit a bit further. Let’s say that Armstrong was in the maximum tax bracket in 2004. Let’s also say that his income for 2013 is not what it was in 2004. How much tax does he recoup from repaying prior winnings? You guessed it: whatever the deduction saves him in 2013, which can be a very different – and much smaller – amount than what he actually paid in 2004.

You:     That doesn’t seem fair!

Me:      There is one more tax option.

That option is IRS Section 1341, sometimes referred to the “claim of right” section. The “claim of right” concept is something akin to “I thought at the time that the money was mine to keep.” Section 1341 gives one the option to:   

            

(1)    Deduct the payment in the year of repayment, or

(2)    Calculate a hypothetical tax, excluding the repaid income from the tax year originally received. That gives one a change in tax. One then calculates the tax for the year of repayment, not including the repayment itself, and subtracts the previously-calculated change in tax from that tax.

You:     Huh?

Me:      Let’s use an example. Say that Armstrong repays $3 million in 2013. Let’s further say (to keep this easy) that the entire $3 million was attributable to 2004 winnings and endorsements. We go back and recompute his 2004 income tax excluding that $3 million. Let’s say his tax goes down by $1,050,000 (3,000,000 * 35%).

You:     OK, so he gets a $1.05 million tax break.

Me:      Not yet. There is another step.

Let’s say that his 2013 taxable income is also $3 million. We estimate his 2013 tax on the $3 million to be $1,027,000 (granted, no one can guess what taxes will be).  His tax benefit is limited to $1,027,000, not the $1,050,000 from 2004.

You:     So he loses over $22 grand. That isn’t too bad, all things considered.

In our example, you are right. The $22 grand is small potatoes. But we used a very simple example. 

Let us complicate the scenario. What if the athlete’s knock-it-out-of-the-park income years are behind him or her? Let’s use a football player. Say that he had an 8-year NFL career. What if he has to pay back $2 million several years after retirement? It is very possible that he will never again be in the same tax bracket as when he was playing. That said, he would never get back the actual tax he paid on the income, whether one uses Section 1341 or not.

Let’s use another example. What if our athlete was frugal and saved his/her career earnings? He/she now has a very attractive portfolio of tax-exempt securities and dividend-paying stocks. Let’s say that the portfolio will generate $2 million in 2013. He/she pays back $2 million. What do you see? Tax-exempts are – well, tax-exempt. Their tax rate is zero. Next year tax rates on dividends may go to the maximum rate. Let’s say they do. He/she will offset the maximum rate on the dividends, but remember that dividends are only a part of the $2 million the portfolio is earning. He/she is still not whole.

Section 1341 many times helps, but there is no guarantee that one will get a tax break equal to the tax actually paid when one received the income.

P.S. Armstrong resigned from the Livestrong board of directors on November 4. He had previously resigned as chairman on October 17 but had kept a seat on the board.