Is Income From Investing Tax-Exempt Income Also Tax-Exempt?

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.

Social Security Disability Payments and IRS Penalties

I have been thinking about IRS penalties.  I had a client that racked up payroll tax penalties, and we tried to get them waived. The IRS thought otherwise. Many tax practitioners will tell you that penalty abatement rests as much on drawing a sympathetic IRS officer as any technical argument the practitioner can offer. I am increasingly a member of that camp.

Let’s briefly discuss my client, and then let’s discuss the Arthur and Cheryl English Tax Court decision.

I acquired a new client from a sole practitioner. He had been their accountant for a number of years, and it was his usual routine to go out, review the books, prepare a payables listing, run payroll and whatnot. Fairly routine stuff. The client then bought a business. In addition to more complicated accounting, the accountant now had some additional payroll tax issues to address.

It did not go well. The accountant miscalculated certain third-quarter payroll tax deposits. Others he simply deposited late. He continued this into the fourth quarter. The client sensed something was wrong, and then decided something was in fact wrong. This took time, of course. By the time my client hired me, the prior accountant had affected two tax quarters.

The IRS –of course – came back quickly with penalties.

I disagreed with the penalties. My client – relying on a tax professional – paid as and when instructed. Granted, my client eventually realized that something was amiss, but surely there is permitted a reasonable period to investigate and replace a tax advisor. Payroll can have semiweekly tax deposit requirements, which timeframe may be among the most compressed in the tax Code. It does not mesh at all with replacing a nonperforming professional.

We got the third quarter penalties waived.

Then the IRS came after quarter four. I once again trotted out my reasonable cause request. The IRS denied abatement, in response to which we requested an Appeals hearing.  My heart sank a bit to learn that our case went before a newly minted Appeals officer. She could not understand why the client had not “resolved” the payroll issue by the end of quarter three. Surely, she insisted, my client “must have known” that there was a problem, and he should have done an “investigation” or something along those lines. She trotted out the well-worn trope that is the bane to many a reasonable cause request: a taxpayer is not allowed to “delegate” his tax responsibility to another, even if that other is a tax professional.

At what point does reliance on a tax professional extend to “delegation” of responsibilities? Apparently, my scale was quite different from that of this brand-new Appeals officer.

We lost the appeal.

Sigh. I suspect that – in about ten years – she would decide the same case differently.

Let’s talk about Cheryl English.

Cheryl became disabled in 2007. She carried a private disability policy with Hartford Insurance, and Hartford paid while she filed and waited on her social security disability claim. There was a catch, however. If Cheryl were successful in receiving social security, her Hartford benefits would be reduced by any social security benefits she received.

In 2010 she won her social security claim. She received a check of approximately $49,000, from which she forwarded approximately $48,000 to Hartford. She netted approximately $1,500 when the dust cleared.

And there is a nasty tax trap here.

If one purchases a private disability policy and pays for it on an after-tax basis, then any benefits received on the policy are tax-free. It is one of the reasons that many tax advisors – including me – frown on using a cafeteria plan to purchase disability coverage.

Cheryl received tax-free benefits from Hartford.

Then she received social security.

She consulted with two CPAs. Both assured her that – since the social security was being used to repay nontaxable benefits – it would be nontaxable.

There is symmetry to their answer.

However, taxes are not necessarily symmetrical. The Code states what is taxable. Both CPAs were wrong.

Social security can be taxable. The same is true for social security disability.

The IRS wanted tax of approximately $10,500. They also wanted an “accuracy” penalty of approximately $2,100.

OBSERVATION: Remember that Cheryl only cleared approximately $1,500 from the transaction. The IRS wanted approximately $12,600 in taxes and penalties. There clearly is lunacy here.

Cheryl took the case pro se to the Tax Court. 

            NOTE: “Pro se” means she represented herself.

The Court reviewed the Code, where it found that social security benefits could be nontaxable if one repays the benefits. That is not what happened here, however. Cheryl received social security benefits but repaid an insurance company, not the Social Security Administration. The Court looked for other exceptions, but finding none it determined that the benefits were taxable.

She owed the tax.

The Court struck down the “accuracy” penalty, though, observing that she sought the opinion of two CPAs and acted with reasonable cause and in good faith. The Court commented on the complexity of the tax law in this area, stating:

The disparate treatment of private and public disability benefits for tax purposes is curious and somewhat confusing,”

I am curious why Cheryl made no claim-of-right argument. There is a provision in the Code for (some) tax relief when a taxpayer recognizes something as income and later has to pay it back. I presume the reason is that Cheryl did not have tax (or much tax) in the Hartford years, so the tax break would have been zero or close to it when she repaid Hartford.        

Cheryl won on the penalty front, but she still had to pay taxes of $10,500 on approximately $1,500 of net benefits. Frankly, she may have been better off not having the Hartford policy in the first place.