Do Not Do This When Buying Disability Insurance

 

It is a tax trap. An employer thinks that they are doing a boon for their employees by providing a tax-exempt fringe benefit.

Where is the trap?

CTG: it has to do with insurance.

I don’t get it, you say. My employer pays for some/most/all my health insurance. When I see a doctor, the insurance pays some, I pay some. Granted, some health insurances are better than others, but where is the trap?

CTG: it is not health insurance.

I get life insurance at work, you continue. It is equal to a year’s salary or something like that. I have noticed that they charge me something for this on my W-2 every year.

CTG: Life insurance has a split personality. An employer can offer you up to $50 thousand of life insurance as a nontaxable fringe. Any insurance above that amount (for example, if your annual salary is more than $50 grand) is taxable to you. Mind you, the charge tends to be minimal - as the IRS uses favorable rates - but you are charged something.  

It is not life insurance.

It is disability insurance.

Let’s look at John Linford.

John sold Medicare supplement and Medicare Advantage plans. His employer decided to do a nice, and in 2011 it purchased a group disability policy from Principal Life. On the plan’s first iteration, the company paid 100% of the premiums. In 2013 the plan was amended, giving the company the option to charge an employee 25% of the premiums. The company said “nah” to the option, choosing to continue paying 100% of the premiums.

At first blush, this sounds like a beneficent employer.

John incurred a disability in 2014. He filed a worker’s compensation claim in December 2014.

John was fired a year later, in November 2015.

This may still be a beneficent employer. They might have been assisting John in getting to that disability policy.

In May 2017 Principal Life approved his disability claim.

At that speed, one could be homeless before the insurance kicks-in.

Principal Life paid him a $105 grand in retroactive benefits.

John heard that disability is generally nontaxable.

Yep.

John left the $105 grand off his tax return.

Nope.

The IRS caught it, of course.

The IRS wanted almost $22 thousand in tax, as well as a penalty chop of over $4 grand.

Off to Tax Court they went.

There is a Code section for this type of employer-provided insurance: Section 105.

           § 105 Amounts received under accident & health plans.

(a)  Amounts attributable to employer contributions.

Except as otherwise provided in this section, amounts received by an employee through accident or health insurance for personal injuries or sickness shall be included in gross income to the extent such amounts (1) are attributable to contributions by the employer which were not includible in the gross income of the employee, or (2) are paid by the employer.

Read the verbiage at (a).

Except as otherwise provided, any accident or health insurance is taxable to the extent the employer provides the insurance as a tax-free benny. Wait, you say, what about health insurance? That is not taxable. True, but health insurance is nontaxable via the “except as otherwise provided” language. There is no such exception for disability insurance.

This stuff can be confusing.

John had one more swing at the plate. Remember that the company amended the plan allowing them to charge employees 25% of the cost. John wanted to know if there was some relief there. I get it: 25% nontaxable is not as good as 100% nontaxable, but it is better than 100% taxable.

The Court said no. Potential is not actuality, and John never paid any of the premiums.

What about the penalties? Did the Court cut John some slack? One can get confused here: one rule for health insurance, another rule for different insurance.

Based on the record the Court concludes that the petitioner husband did not have reasonable cause and did not act in good faith in not reporting the disability payments.”

The Court upheld the penalties. There went another $4-plus grand.

Some companies allow one to purchase short-term disability through their cafeteria plan. Mind you, this means that the premiums are paid with pre-tax money and will result in taxable income if benefits are ever collected. I tend to back-off on short-term disability, although I prefer that one pay with after-tax dollars for either short- or long-term disability.

I, however, feel strongly about paying after-tax for long-term disability. Those benefits may continue until you reach social security age, and you do not need to be dragging taxes behind you until then. The small rush of a tax-free benny is insignificant if you are ever – in fact – disabled.

Our case this time was Cynthia L Hailstone and John Linford v Commissioner, T.C. Summary Opinion 2023-17.

Section 1202 Stock And A House Tax Proposal

I am not a fan of fickleness and caprice in the tax law.

I am seeing a tax proposal in the House Ways and Means Committee that represents one.

It has been several years since we spoke about qualified small business stock (QSBS). Tax practice is acronym rich, and one of the reasons is to shortcut who qualifies – and does not qualify – for a certain tax provision. Section 1202 defines QSBS as stock:

·      issued by a C corporation,

·      with less than $50 million in assets at time of stock issuance,

·      engaged in an active trade or business,

·      acquired at original issuance by an eligible shareholder in exchange for either cash or services provided, and

·      held for at least five years.

The purpose of this provision is to encourage – supposedly – business start-ups.

How?

A portion of the gain is not taxed when one sells the stock.

This provision has been out there for approximately 30 years, and the portion not taxed has changed over time. Early on, one excluded 50% (up to a point); it then became 75% and is now 100% (again, up to a point).

What is that point?

The amount of gain that can be excluded is the greater of:

·      $10 million, or

·      10 times the taxpayer’s basis in the stock disposed

Sweet.

Does that mean I sell my tax practice for megabucks, all the while excluding $10 million of gain?

Well, no. Accounting practices do not qualify for Section 1202. Not to feel singled- out, law and medical practices do not qualify either.

I have seen very few Section 1202 transactions over the years. I believe there are two primary reasons for this:

                 

(a)  I came into the profession near the time of the 1986 Tax Reform Act, which single-handedly tilted choice-of-entity for entrepreneurial companies from C to S corporations. Without going into details, the issue with a C corporation is getting money out without paying double tax. It is not an issue if one is talking about paying salary or rent, as one side deducts and the other side reports income. It is however an issue when the business is sold. The S corporation allows one to mitigate (or altogether avoid) the double tax in this situation. Overnight the S corporation became the entity of choice for entrepreneurial and closely-held companies. There has been some change in recent years as LLCs have gained popularity, but the C corporation continues to be out-of-favor for non-Wall Street companies. 

 

(b)  The sale of entrepreneurial and closely-held companies is rarely done as a stock purchase, a requirement for Section 1202 stock. These companies sell their assets, not their stock. Stock acquisitions are more a Wall Street phenomenon.

So, who benefits from Section 1202?

A company that would be acquired via a stock purchase. Someone like … a tech start-up, for example. How sweet it would have been to be an early investor in Uber or Ring, for example. And remember: the $10 million cap is per investor. Take hundreds of qualifying investors and you can multiply that $10 million by hundreds.

You can see the loss to the Treasury.

Is it worth it?

There has been criticism that perhaps the real-world beneficiaries of Section 1202 are not what was intended many years ago when this provision entered the tax Code.

I get it.

So what is the House Ways and Means Committee proposing concerning Section 1202?

They propose to cut the exclusion to 50% from 100% for taxpayers with adjusted gross income (AGI) over $400 grand and for sales after September 13, 2021.

Set aside the $400 grand AGI. That sale might be the only time in life that someone ever got close to or exceeded $400 grand of income.

The issue is sales after September 13, 2021.

It takes at least five years to even qualify for Section 1202. This means that the tax planning for a 2021 sale was done on or before 2016, and now the House wants to retroactively nullify tax law that people relied upon years ago.

Nonsense like this is damaging to normal business. I have made a career representing entrepreneurs and their closely-held businesses. I have been there – first person singular - where business decisions have been modified or scrapped because of tax disincentives. Taxing someone to death clearly qualifies as a business disincentive. So does retroactively changing the rules on a decision that takes years to play out. Mind you – I say that not as a fan of Section 1202.

To me it would make more sense to change the rules only for stock issued after a certain date – say September 13, 2021 – and not for sales after that date. One at least would be forewarned.   

Should bad-faith tax proposals like this concern you?

Well, yes. If our current kakistocracy can do this, what keeps them from retroactively revoking the current tax benefits of your Roth IRA?  How would you feel if you have been following the rules for 20 years, contributing to your Roth, paying taxes currently, all with the understanding that future withdrawals would be tax-free, and meanwhile a future Congress decides to revoke that rule - retroactively?

I can tell you how I would feel.

UberEats and Employer-Provided Lunches

It is 50 pages long. This is not the time of year for me to read this in detail.

I am referring to an IRS Technical Advice Memorandum. A TAM means that a taxpayer is under examination and the revenue agent has a question. The TAM answers the question.

This one has to do with excluding meals as income to employees when the meals are for the “convenience of the employer.”

I guess I long ago selected the wrong profession for this to be an issue. The instances have been few over the years where an employer has regularly brought in dinner during busy season. I had one employer who would do so on Tuesdays and Thursdays, but the offset was working until 9 p.m. or later. As I recall, one virtually needed a papal decree to deviate from their policies, and they had policies like the Colonel has chicken. At this age and stage, I would not even consider working for them, but at the time I was young and dumb.

The classic “convenience of the employer” example is a fireman: you have to be around in case of emergencies. There are other common reasons:

·      To protect employees due to unsafe conditions surrounding the taxpayer’s business premises;

·      Because employees cannot secure a meal within a reasonable meal period;

·      Because the demands of the employees' job functions allow them to take only a short meal break.

What has exacerbated the issue is not your job or mine, but the Googles and Microsofts of the world. For example, Google’s headquarter in Mountain View, California has over 15 cafeterias. Not to be overshadowed, Microsoft in Redmond, Washington has over two dozen. Why would one even bother to go to a grocery store?

Not my world. Not my reality.

The “reasonable meal period” has generally meant that there are limited dining options nearby. I have a family member who works at a nuclear facility. I do not know, but I would expect options thin-out the closer you get to said facility. That reasonable meal period is likely legit in his case.

The TAM is presented in question and answer form. Here is one of the answers:

While the availability of meal delivery is not determinative in every analysis concerning …, especially in situations where delivery options are limited, meal delivery should be a consideration in determining whether an employer qualifies under this regulation and generally when evaluating other business reasons proffered by employers as support for providing meals for the “convenience of the employer” under section 119.

So the IRS is working to incorporate the rising popularity of GrubHub and UberEats into the taxation of employer-provided meals. Wow, if you practice long enough…

I am not too worried about it, other than prompting a chuckle. Why? Because here at CTG command-center we do not provide the occasional lunch because of limited dining opportunities. Rather we bring-in lunch because of in-house training (as an example), and we want everyone there.

Think about it: we give you a sandwich and you get to hear me talk about taxes and watching paint dry.

I suspect you would rather just buy your own lunch.

Amos And Rodman

Do you remember Dennis Rodman?

He is more recently associated with traveling to North Korea and functioning as an off-the-record ambassador with Kim Jong-un, the dictator of that country. In the 1990s he was better known for playing with Michael Jordan and Scottie Pippen on the Chicago Bulls.

Early in 1997 the Bulls were playing the Minnesota Timberwolves. Rodman went after a loose ball, falling into a group of photographers on the sidelines. Rodman twisted his ankle. While getting back on his feet he kicked one of the photographers in the groin.

The photographer’s name was Eugene Amos. He went to a hospital, where he had difficulty walking and was in noticeable pain. The doctors offered pain medication but he refused, explaining that he was already taking medications for a preexisting back injury. Some dispute arose, and Amos left the hospital without being discharged.

He hired an attorney immediately upon leaving. 

The next day Amos went to another hospital. He complained about his groin, but the doctors did not notice anything other than the expected swelling. They were concerned about his back, though, and took a round of X-rays.

Before the lawsuit was filed, Rodman paid him $200,000 to go away.

Oh, and Amos had to sign a confidentiality provision to not discuss the matter. Standard stuff, but given that we are talking about it the agreement did not hold up as expected.

There is a Code section that addresses physical injuries:

          § 104 Compensation for injuries or sickness.

(a)  In general.

Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include-

(1)   amounts received under workmen's compensation acts as compensation for personal injuries or sickness;

(2)  the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness;

Relying upon Section 104(a)(2), Amos excluded the $200,000 from his 1997 tax return.

Wouldn’t you know the IRS pulled his return for audit?

And they disagreed with his exclusion of the $200,000 from taxable income. Why? As far as they were concerned, Rodman paid Amos all but $1 of the $200,000 to keep his mouth shut. The IRS was, however, willing to exclude the $1 from income.

Amos disagreed. He took one in the orchestra, after all.

Off to Tax Court they went.

The IRS argued that Amos had not proven his physical injuries, and that Mr. Rodman himself was skeptical that Amos sustained any injuries to speak of. The IRS further argued that Amos was required to pay $200,000 in damages to Rodman should he violate the confidentiality agreement, clearly indicating that Rodman did not intend to pay anything for alleged physical injuries.

The Court immediately dismissed the first argument, noting that if an action has its origin in a physical injury, then damages therefrom are treated as payments received on account of the injury.

The Court decided that the “dominant” reason for the settlement was to compensate Amos for his claimed injuries. However, the settlement also indicated that Rodman was paying some portion for Amos not to:

(1)   Defame Rodman

(2)   Disclose either the existence or amount of the settlement

(3)   Publicize facts relating to the incident, and

(4)   Assist in criminal prosecution against Rodman

Problem is, the agreement did not separate how much was paid for what.

The Court did what it had done many times before: it came up with a number.

The Court decided that $120,000 was payable for physical injuries and $80,000 was paid for confidentiality terms. Therefore $120,000 could be excluded under Section 104(a)(2). The $80,000 could not.

The Amos decision changed how personal injury attorneys draft documents. It is now expected that the injured party will not want to sign any confidentiality agreement. If there is one, anticipate the injured party to stipulate a nominal amount to the agreement and to request indemnification for any resulting taxes, penalties, interest, attorney fees and court costs.

And that is how Dennis Rodman contributed to the tax literature.

A Representative’s Tax Proposal for Credit Card Debt Forgivenesss

I am reading that Representative Scott Peters (D-CA) has proposed a change to the tax Code allowing forgiveness of credit card balances to be nontaxable.

I have two questions for you:

First, what is it with politicians from California?

Second, did you know that credit card forgiveness was taxable?

The tax Code is based on the concept of an increase in net wealth. The concept is simple, although it causes difficulty in application. Let’s look at the following example:

           

Monday morning you have to your name					400
Tuesday the credit card company forgave					125
Friday you got paid					1,000
You put gas in your car					(60)
You bought lunch all week					(40)
Friday afternoon you have to your name					1,425

You went from being worth $400 to being worth $1,425. Does that mean that you have $1,025 of income to report to the tax man? No, but you are thinking along the correct lines. Not every addition in our example is taxable, and not every subtraction is deductible. Let’s look at each.

•  $125 of your credit card balance was forgiven.

Code section 108 addresses the taxability when somebody forgives your debt. There are five subcategories:

·        108(a)(1)(A) applies in bankruptcy

·        108(a)(1)(B) applies if you are insolvent

·        108(a)(1)(C) applies to farm debt

·        108(a)(1)(D) applies to certain business debt

·        108(a)(1)(E) applies to your mortgage

I am not seeing an exception for credit cards, so for the time being it looks like the $125 will be income. I am assuming that you are not insolvent (meaning that you owe more than you are worth) or in bankruptcy (which sometimes follows owing more than you are worth).

• Your paycheck

That one is obvious. We should be thankful the government does not just decide to have all paychecks sent to them, allowing them to decide how much to return to us.

•  Buying gas and a week’s worth of lunches

Code section 262 disallows tax deductions for personal, living and family expenses. Granted, another Code section may override and allow a deduction for specific expenses (such as medical), but in general one cannot deduct groceries, utilities, rent and similar day-to-day-living expenses.

I would say that you have taxable income of $125 plus $1,000 = $1,125.

The credit card is a subset of “forgiveness of indebtedness” taxation. The seminal case is Kirby Lumber, which was decided by the Supreme Court back in 1931. Kirby Lumber had previously issued bonds of over $12 million. They later bought back the bonds for $137,000 less. The question before the Court was whether that $137,000 represented taxable income. It does seem a bit odd that someone can have income just from transacting in debt, but if you think of it as accession to wealth the tax reasoning becomes clearer. At the end of the day Kirby Lumber was worth $137,000 more (as it had less net debt), and the government wanted its cut.

Back to Representative Sun-Dance-Whispered-By-Hidden-Shadow, or whatever he is called back in his native land.

He is proposing that forgiveness of credit cards be excluded from income.

However, the most that a person could exclude from lifetime income is capped at $2,500.

Say that you excluded $1,000 in 2014. Under his proposal, the most you could exclude – over the rest of your life – is another $1,500. You cannot exclude more than $2,500 over your lifetime.

My first thought is that $2,500 is not enough to move the needle, if someone really got into credit card and personal debt problems. I have known and heard of people who have run up a mortgage-level balance on their credit cards.

My second thought is whether this is a wise use of the public purse. Congress provided a mortgage interest deduction because it wanted to increase home ownership. It provided a charitable deduction to promote societal benevolence and reduce strain on the public safety net. What is Congress saying by providing an exclusion for not repaying credit card debt?

And you can see how bad tax law happens. There is no theory of wealth creation, case precedence or administrative practicality at play with this proposal. An elected bludger panders, laws are passed without being read and the tax system (both the IRS and advisors) is left to making sense out of nonsense.