Social Security And A Claim Of Right

 

I am reading a Tax Court case.

I disagree with commentary on the case.

Let’s talk about Michael Smith and his 2022 tax return.

Michael worked a couple of jobs in 2022 and reported wages of $16 grand on his individual tax return. I see that one of his employers was New York City Transit. Michael would not have gotten far in New York with only $16 grand of earnings.

He applied for Social Security disability in April 2022.

I am thinking that he worked, got injured and applied for disability.

In November 2022, the SSA sent a letter saying that he qualified for SSI retroactive to March. He received SSI of $26,802 for the year.

And in April 2023 the SSA wanted the money back.

Why?

The SSA explained:

Your disability payments were stopped as of April 2023 because we learned that you had been working since April 2022.”

Well, so much for my guess that he got injured and stopped working.

Michael repaid what he could and set up a payment plan for the balance.

What makes this a tax case is that Michael left the SSI off his 2022 tax return.

Social security disability is taxed the same as regular social security. There is an unfortunate tax maze here, I admit. Up to a certain income, 50% of one’s social security is taxable. Keep increasing income and up to 85% is taxable. Land somewhere in-between and you almost need software to do the math. It is not a pretty area of the tax Code, frankly.

Michael explained that he omitted the social security because it was “an accidental overpayment” and was “repaid … in full.” He considered it more a loan than taxable income.

I get it, but Michael ran face first into a basic principle in taxation: you have to report what happened during the taxable period. In this case the period was 2022. By the end of 2022 he did not know that he would be required to return the money to the SSA. This was income free-and-clear when the New Year’s ball dropped.

OK, you ask: when would Michael make it right on his taxes?

In 2023, when he found out and returned the money.

How would Michael make it right?

He would do a special calculation on his 2023 return.

The concept here is called “claim of right,” and it goes back to a famous 1932 tax case. It was formalized into the tax Code in 1954 as Section 1341.

Have you ever read or heard a case about a corporate executive or professional athlete having to return money to his/her employer or team? The tax side (almost certainly) involves Section 1341.

How does it work?

First, there have to be (at least) two tax periods at play. If Michael had learned and repaid the SSA by the end of 2022 there would be no tax issue. It is flipping the calendar and starting another period that sets up the claim of right.

Second, there are two calculations, and you use the one yielding the smaller tax.

You run the tax for the year (of repayment) with the deduction, and

You (re)run the tax for the original year (that is, the claim of right year) with the deduction.

You use the smaller tax.

And yes, there can be trap here.

What if the repayment year has much less (or worse, no) income than the claim of right year?

You have a problem because the calculation takes the smaller of the two amounts. The flaw is baked into Section 1341.

The commentary I read speculated that the case may have involved a statute of limitations issue.

Nope, methinks.

Our secret mystery obscure Section 1341 kicks-in for the repayment year, which is 2023 in this case. The 2023 return was due on April 15, 2024. Let’s skip extensions and whatnot: the earliest that statute will expire is April 15, 2027.

No, I don’t think that was it.

Michael went for a long shot and hoped to exclude the income from his 2022 rather than 2023. Why?

Because Michael had no (or little) income in 2023 to absorb the Section 1341 lesser-of calculation.

I am again wondering if Michael was truly disabled in 2022 and subsequently got run over by both the SSA and IRS.

Our case this time was Smith v Commissioner, T.C. Memo 2026-25.

No Tax On Social Security

 

Is not. 

For decades, social security benefits were not taxable at all. 

This changed with the Social Security Amendment of 1983, with the intent to shore up the social security trust fund. Beginning in 1984, if one’s income exceeded certain stairsteps ($25,000 for singles and $32,000 for marrieds), then benefits could be up to 50% taxable. 

Flip the calendar and The Omnibus Budget Reconciliation Act of 1993 raised the taxable portion up to 85% and added two more stairsteps ($34,000 for singles and $44,000 for marrieds). 

COMMENT: The taxation of social security is Congressional pratfall. There are two separate calculations here. The first calculation starts taxing benefits at $25,000 (for singles; $32,000 for marrieds) up to 50 percent. If your income keeps going, then you hit the second stairstep ($34,000 for singles; $44,000 for marrieds) up to 85%. Fall in between these two phaseout zones and you may want to use software to prepare your return. 

COMMENT: BTW, Congress has never inflation-adjusted those 1984 or 1993 dollars. 

No tax on social security became a political slogan during the presidential election. I have heard the phrase repeated since then, but it is not accurate. 

It would be more accurate to describe it as an age-based deduction. 

Take a look at the tax provision in its feral state:

 

SEC. 70103. TERMINATION OF DEDUCTION FOR PERSONAL EXEMPTIONS OTHER THAN TEMPORARY SENIOR DEDUCTION

 

(a)(3)(C) Deduction for seniors

 

(i)                   In general.—In the case of a taxable year beginning before January 1, 2029, there shall be allowed a deduction in an amount equal to $6,000 for each qualified individual with respect to the taxpayer.

(ii)                Qualified individual.—For purposes of clause (i), the term ‘qualified individual’ means—

(I)                  the taxpayer, if the taxpayer has attained age 65 before the close of the taxable year, and

(II)                in the case of a joint return, the taxpayer’s spouse, if such spouse has attained age 65 before the close of the taxable year.

(iii)               Limitation based on modified adjusted gross income.

(I)                  In general.—In the case of any taxpayer for any taxable year, the $6,000 amount in clause (i) shall be reduced (but not below zero) by 6 percent of so much of the taxpayer’s modified adjusted gross income as exceeds $75,000 ($150,000 in the case of a joint return).

(II)                (II) Modified adjusted gross income.—For purposes of this clause, the term ‘modified adjusted gross income’ means the adjusted gross income of the taxpayer for the taxable year increased by any amount excluded from gross income under section 911, 931, or 933.

(iv)               Social security number required.

(I)                  In general.—Clause (i) shall not apply with respect to a qualified individual unless the taxpayer includes such qualified individual’s social security number on the return of tax for the taxable year.

(II)                Social security number.—For purposes of subclause (I), the term ‘social security number’ has the meaning given such term in section 24(h)(7).

(v)                 Married individuals.—If the taxpayer is a married individual (within the meaning of section 139, this subparagraph shall apply only if the taxpayer and the taxpayer’s spouse file a joint return for the taxable year.”

What do I see? 

•  There is no mention of social security benefits.
•  There is no mention, in fact, of retirement income at all.
•  You do have to be at least age 65 to qualify.
•  The deduction is (up to) $6,000 per qualifying individual.
•   Make too much money ($75,000 for singles and $150,000 for marrieds) and you start losing the deduction. The deduction phases-out completely at $150,000 (singles) and $250,000 (marrieds).
•  If you are married, you must file jointly. Married filing separately will not work here.
• The only mention of social security is that one must include one’s social security number on the tax return, otherwise the IRS will consider it a math error and send you a bill for taxes due.

What do I not see?

• No tax on social security.

I get it: for many if not most people, social security benefits would not have been taxable anyway because of the stairsteps, the increased standard deduction and the additional standard deduction for taxpayers age 65 and over. I would prefer that we use the English language with more precision, but such is not our fate. 

We didn’t even mention the insolvency of the social security system itself. 

Take advantage if you can, as the deduction has a shelf life of only four years. Granted, a future Congress can extend (and re-extend) this deduction ad infinitum, but I suspect that will not happen here.

 

A Surprise Tax From Life Insurance Loans

 

For some reason, the taxability of life insurance seems to be an old reliable in tax controversy.

Granted, there are areas involving life insurance that are not intuitive. The taxation of a split-dollar life insurance policy to an employee can be a bit puzzling until you have studied it one or ten times. There is also the tax history of “janitors insurance,” which resulted in yet another tax acronym (“EOLI”), the creation of Form 8925, and the recurring question “what is the purpose of this form” from young tax accountants ever since.

 

No, what we are talking about is the income taxation of vanilla-ice cream-on-a-regular-cone life insurance. Life insurance is normally nontaxable. You can change that answer by not ordering vanilla.

David and Cindy Fugler bought permanent (that is, cash value) life insurance on their two children in 1987. There was the initial year payment, plus additional yearly premiums, some of which were paid by borrowing against the policies. After many years, they cashed-in the policies. The life insurance company sent Forms 1099, which the Fuglers did not report on their joint tax return.

COMMENT: As we have discussed before, the IRS loves to trace Forms 1099 to tax returns, as the process can be computerized and requires no IRS manpower. You, on the other hand, have no such luck and will likely contact your tax preparer/advisor – and incur a fee - to make sense of the notice. There you have current tax administration in a nutshell: increasingly shift compliance to taxpayers by requiring almost everything to be reported on a 1099. It is a brilliant if not cynical way to increase taxes without – you know – actually increasing taxes.

Here is a recap of the relevant Fugler numbers:      

		Policy #1		Policy #2
Cumulative premiums paid		6,850		6,850
Accumulated cash value		22,878		23,428
Outstanding loan & interest		(19,845)		(20,699)
Settlement check		3,033		2,729

 

On first impression, it might seem odd that the Fuglers did not report the two distribution checks: the $3,033 and the $2,729. This is the amount they received upon policy cancelation – and after repaying policy loans and related interest and whatnot charges. Then again, one does not normally expect to have taxable income from life insurance. One should still report the 1099 amount (so the IRS computers have something to latch onto) and thereafter adjust the numbers to what one considers correct. Without that latch, these IRS matching notices are automatic.

So, what do you think:

·      Do the Fuglers have income?

·      If so, what is the income amount?

To reason through this, think of the life insurance policies as savings accounts. Granted, inefficient savings accounts, but the tax reasoning is similar. If you put in $6,850 and years later receive $22,878, the difference is likely (some type of) income. The same reasoning applies to the second policy.

So, you have income. Is there some way to not have income? Sure, if the cumulative premiums you paid exceed any cash value. In that case any refund would be a return of your own money.

But what is the income amount: is it the checks they received: $3,033 (for policy #1) and $2,729 (for policy #2)?

Normally, this would be correct, but the Fuglers borrowed against the polices. The loan did not create income at the time (because of the obligation to repay). That obligation has now been repaid with cash that would otherwise have been included in those distribution checks. You cannot avoid income by having a check go directly to your lender. Tax advisors would have a field day if only that were possible.

I would say that the income amount is the cash received plus the loan forgiven: $16,028 (policy #1) and $16,578 (policy #2).

Before thinking the result unfair, remember that the Fuglers did receive the underlying cash. The timing for the taxation of the loan was delayed, but even that result was pro-taxpayer. This is not phantom income that we sometimes see in other areas of the Code.

There is some chop in the numbers for the loan forgiven. As you can imagine, there are all kinds of fees and charges in there, as well as possibly accrued interest on the loan.  The Fuglers thought of that also, arguing that the accrued interest should not be taxable – or at least should be deductible.

The “should not be taxable” is a losing argument, as all income is taxable unless the Code says otherwise. It does not, in this case.

That leaves a possible interest deduction.

The problem here is that Congress limited the type of nonbusiness loans whose interest is deductible: loans on a principal residence; loans used to buy or carry investments, college loans; loans (starting in 2026) on a new car with final assembly in the United States. Any other nonbusiness loans are considered personal, meaning the interest thereon is also personal and thus nondeductible.

The Fuglers could not fit into any of those deductible categories. There was no subtraction for interest, no matter what the insurance company called it.

The Fuglers had taxable income. They reported none of it on their return. The IRS – as usual – wanted interest and penalties and whatever else they could get.

The Tax Court agreed.

Our case this time was Fugler v Commissioner, T.C. Summary Opinion 2025-10.