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.