The Change-Of-Address Rules Matter

 

The IRS requests that one alert them of change-of-address when one moves. There is even a form, but I do not often see the form used in practice. Normally the IRS is alerted when one files the next tax return with the new address.

It is, by the way, a good idea to alert the IRS of a change of address in case you have the misfortune of tax notices. There is a clock for certain tax notices, and once they start it can be difficult to reverse the clock.

I will give you one, as it has become more repetitive in practice than I would have liked: the notice of deficiency, also called a “statutory” notice of deficiency. I generally refer to it as the SNOD.

We have talked about the SNOD before. The IRS wants to reduce its tax assessment to a judgement. That requires the intervention of a court - the Tax Court in this case - and the IRS sends out a multipage, impressive, imposing if not intimidating notice to the taxpayer.

Who in turn collects it with other tax documents - unread - and drops the bundle off a-half-year later (or more) when it is time to meet with the CPA.

There is a problem here: one has 90 days to respond to a SNOD.

Which has passed. The level of difficulty has increased. The matter has already defaulted in favor of the IRS, of course, as the taxpayer never responded. The IRS has unleashed its Collections berserkers, who have little interest whether you actually owe the tax or not.

Here is a Collections story from several years ago. The IRS proposed changes to a client’s tax return. Sure enough, the SNOD got lost in the mail, was stolen from the mailbox, was thrown in the trash, whatever. The IRS changed numbers here and there. Some numbers were small and of minor import. Others were 1099s issued to our client but belonging elsewhere among related taxpayers. Then there was the big number: the rollover of a 401(k) or IRA. A 1099 is issued for a rollover, although it is normally a nontaxable event. The 1099 has a unique code for a rollover. The IRS, the taxpayer and accountant see the code, and everybody moves on.

Not this time.

The IRS did not see the code. Underreported income! Fair share! Tax the rich! The IRS went through its dunning notice series, eventually its SNOD, and then Collections activity. They filed a lien. They were irate, as they thought the taxpayer was ignoring them.

The taxpayer had no idea. It was only when trying to sell some real estate that the lien – and the rest of the story - came to light.

We went all Sherlock on what had happened.

We filed an amended return to reverse the IRS adjustment. We had Collections hold back the war dogs to allow the IRS time to process the amended return.

Which never happened. Collections came back more frenzied than before.

The system had failed. We wanted to know where that amended return was. The IRS is not built for self-reflection, BTW, but we eventually found the return. Someone in Kansas City had started to work the file, I presume quitting time arrived and – as an example of why people hate government unions – never got back to our client. Never. As in ever.

Yeah, the matter eventually got resolved, but it had become a sinkhole of professional time. I did talk with a very pleasant IRS attorney from Nashville, who - once the matter got to her - moved heaven and earth to reverse the lien.

And there you have an example of how not responding to a SNOD can sour someone’s life.

And an example of why I believe that the IRS should be required to reimburse a tax professional’s time when the IRS fails to follow procedures or otherwise just do their job.

Let’s look at Keith Phillips.

Phillips went to prison in 2010.

Somewhere in there something else bad happened: he was injured and lost almost all vision in his right eye. He filed a civil lawsuit against the prison and received a $201 thousand settlement in 2014. He did not file a tax return for 2014.

Nor would I. Damages for physical injuries are nontaxable, and this sounds very physical to me.

The IRS thought otherwise and wanted almost $52 grand in tax, plus penalties, interest, a safe room, coloring books and a binkie while they worked through the microaggression.

They sent a SNOD.

Phillips had no idea. He was in prison.

The Tax Court rubber-stamped the assessment. The IRS began collection activity. They sent letters to the same address as the SNOD but heard nothing back. They filed a tax lien. They notified the State Department that Phillips was seriously delinquent, and State should begin revoking his passport. That State Department matter was fortunately sent to Phillip’s correct address.

Now Phillips was wondering what had happened, although he had no plans to travel overseas in the near future. He filed with the Tax Court.

IRS:            More than 90 days have passed. We win, you lose. Why? Because you are a loser, you big loser you.  

Phillips:       Hey, IRS, you sent the SNOD to the wrong address.

IRS:            Nope, we sent it to the right address.

Phillips:       I never lived at this address.

IRS:             You did. We have a USPS notice for change of address.

Phillips:       Let me see it.

IRS:             Knock yourself out, loser.

Phillips:       This is my son. We have the same name. He was living with his mom. I had been here … in prison … years before this change of address was sent.

IRS:             Oops.

If the SNOD is sent to the wrong address, then the SNOD is not valid. To the IRS’ credit, this error is not common, but it happens.

Mind you, this does not technically mean that the matter is over. Phillips never filed a return for 2014, so the statute of limitations has never started for that year. On the other hand, now that the IRS is aware that the settlement was for personal injury – and thus nontaxable – what is the point?

Our case this time was Phillips v Commissioner, T.C. Memo 2024-44.

A Firefighter Sues

The taxation of legal settlements can be maddening.

The general rule is found in IRC Section 61, which can be colloquially summarized as:

If it breathes, moves, or eats, it is taxable.

Then come the exceptions.

The Code begins with a broad rule, and then you must find and fit into an exception to avoid taxability. A big exception for legal settlements is Section 104(a)(2):

        § 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;

What can we learn here?

(1) The Code does not care whether the judge decides or if the parties instead come to an agreement.  

(2)  It does not care if one gets paid in a lump sum or in a series of payments.

(3) It cares very much that the settlement is for something physical – whether injury or sickness.  

What about something nonphysical, such as mental or emotional distress?

Reviewing the history of the Code helps here, as we learn that the Code was changed in 1996 to clarify that mental and emotional injury settlements are excludable from income only if they arose from physical injury or sickness.

This gives the following rule of thumb:

          Physical               =       nontaxable

          Nonphysical        =       taxable      

The attorney must be aware of the above demarcation and wordsmith accordingly if some or all the settlement is for nonphysical damages. 

Can it be done?

Let’s look at the Montes case.

Suzanne Montes wanted to be a firefighter since she was a little girl. She was one of the few women to pass the exam to get into the San Francisco Fire Academy. She then was one of the few women to graduate from the program.

Good for her.

In 2016 she received a sweet assignment to a firehouse in downtown San Francisco.

You may know that firefighters work as a team and in 24-hour shifts. There are about 10 shifts per month, so they spend a LOT of time together. Suzanne was a woman. The remainder of the team were men. Many did not welcome her. First came the disparaging comments, then sabotaging her equipment, then doing - I do not know what specifically and I do not want to know – “disgusting and extremely unsanitary” things to her personal property and effects.

Thanks, guys, for painting men as knuckle-dragging Neanderthals. Way to represent the team.

She complained.

She sued.

She won approximately $380 grand.

Good.

She went to a CPA when it was time to file. The CPA advised that the $380 grand was not taxable.

Even better.

You know the IRS balked, as we are looking at a Tax Court case.

The IRS’s first argument?

Start with the complaint, which claimed sex discrimination and retaliation, including the intentional infliction of emotional distress.

There are no allegations of physical disease or harm to her in the complaint.”

We are not seeing the magic words here: physical injury, physical sickness or micrato raepy sathonich.

Hopefully her attorney salvaged this in the settlement agreement.

Here is the Court:

Our detective work here begins and ends with the settlement agreement.”

Oh oh.

There are no allegations of physical injury …, and indeed, in the summary of the complaint it says, ‘She has lost compensation for which she would have been entitled. She has suffered from emotional distress, embarrassment, and humiliation and her prospects for career advancement have been diminished.’”

No magic words.

Yep, she lost her case. The settlement was taxable.

The Court did hand her a small victory, though. Penalties did not apply because she took a reasonable position based on the advice of a CPA.

Our case this time was Montes v Commissioner, Docket No. 17332-21, June 29, 2023.

 

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.

Incompetent Employees And IRS Penalties

 

“Taxes are what we pay for civilized society.” Compania General De Tabacos de Filipinas v. Collector, 275 U.S. 87, 100 (1927) (Taft, C.J.). For good reason, there are few lawful justifications for failing to pay one's taxes. Plaintiff All Stacked Up Masonry, Inc. (“All Stacked Up”), a corporation, believes it has such an excuse. It brings this suit to challenge penalties and interest assessed by the Internal Revenue Service (“IRS”) following its failure to file the appropriate payroll tax documents and its failure to timely pay payroll tax liabilities for multiple tax periods.

The above is how the Court decision starts.

Here are the facts from 30,000 feet.

·      The company provides masonry services.

·      The company got into payroll tax issues from 2013 through 2015.

·      The company paid over $95 thousand in penalties and interest.

·      It now wanted that money back. To do so it had to present reasonable cause for how it got into this mess in the first place.

Proving reasonable cause is not easy, as the IRS keeps shrinking the universe of reasonable cause.  An example is an accountant missing a timely extension. There is a case out there called Boyle, and the case divides an accountant’s services into two broad camps:

·      Advice on technical issues, and

·      Stuff a monkey could do.

Let’s say that CTG Galactic Command is planning a corporate reorganization and we blow a step, causing significant tax due. Reliance on us as your advisors will probably constitute reasonable cause, as the transaction under consideration was complex and required specialized expertise. Let’s say however that we fail to extend the corporate return – or we file it two days after its extended due date. Boyle stands for the position that anyone can google when the return was due, meaning that relying on us as your tax advisors to comply with your filing deadline is not reasonable.

As a practitioner, I have very little patience with Boyle. We prepare well over a thousand individual tax returns, not to mention business, nonprofit, payroll, sales tax, paper airplanes and everything in between. Visit this office during the last few days before April 15th, for example, and you can feel the tension like the hum from an electrical transformer. What returns are finished? What returns are only missing an item or two and can hopefully be finished? What returns cannot possibly be finished? Do we have enough information to make an educated guess at tax due? Who is calling the client?  Who is tracking and recording all this to be sure that nothing is overlooked? Why do we do this to ourselves?

Yeah, mistakes happen in practice. Boyle just doesn’t care. Boyle holds practitioners to a standard that the IRS itself cannot rise to. I have several files in my office just waiting, because the IRS DOES NOT KNOW WHAT TO DO. I brought in the Taxpayer Advocate recently because IRS Kansas City botched a client. We filed an amended return in response to a Notice of Deficiency the client did not inform us about. The amended must have appeared as “too much work” to some IRS employee, and we were informed that Kansas City inexplicably closed the file. This act occurred well before but was fortuitously masked by subsequent COVID issues. The after-effects were breathtaking, with lien notices, our requests for releases, telephone calls with IRS attorneys, Collection’s laughable insistence on a payment plan, and – ultimately – a delay on the client’s refinancing. IRS incompetence cumulatively cost me the better part of a day’s work. Considering what I do for a living, that is time and money I cannot get back

I should be able to bill the IRS for wasting my time over stuff a monkey could do.

The Advocate did a good job, by the way.

Let’s get back to All Stacked Up, the company whose payroll issues we were discussing.

The owner fell on ice and suffered significant injuries. This led to the owner relying on an employee for tax compliance. That reliance was misplaced.

·      The first two quarterly payroll returns for 2013 were filed late.

·      The fourth quarter, 2013 return would have been due January 31, 2014. It was not filed until July 13, 2015.

·      None of the 2014 quarterly returns were filed until the summer of 2015.

·      To complete this sound track, the payroll tax deposits were no timelier than the filing of the returns themselves.

Frankly, the company should just have let its CPA firm take care of the matter. Had the firm botched the work this badly, at least the company would have a possible malpractice lawsuit.

The company pleaded reasonable cause. The owner was injured and tried to delegate the tax duties to someone during his absence. Granted, it did not go well, but that does mean that the owner did not try to behave as a prudent business person.

I get the argument. All Stacked Up is not Apple or Microsoft, with acres and acres of lawyers and accountants. They did the best they could with the (clearly limited) resources they had.

The company appealed the penalties. IRS Appeals was willing to compromise – but only a bit. Appeals would abate 16.66% of the penalties and related interest. This presented a tough call: accept the abatement or go for it all.

The company went for it all.

Here is the Court:

Applying Boyle to this case, it is clear as a matter of law that retention of an employee or software to prepare and remit tax filings, make required deposits, and tender payments cannot, in itself, constitute “reasonable cause” for All Stacked Up’s failure to satisfy those tax obligations. The employee’s failures are All Stacked Up’s failures, no matter how prudent the delegation of those duties may have been.”

And there is full Boyle: we don’t care about your problems and you doing your best with the resources available. Your standard is perfection, and do not ask whether we hold ourselves to the same standard.

I wonder if that employee is still there.

I mean the one at IRS Kansas City.

Our case this time was All Stacked Up v U.S., 2020 PTC 340 (Fed Cl 2020).

A Bank Of America Horror Story

A major corporation hounds you almost to the point of death. You sue. You receive a settlement. Is it taxable?

Like so much of tax law, it depends. For example, did the attorney include the magic words that complete the incantation?  

Mr. and Mrs. French received a deficiency notice for their 2012 tax year. The IRS wanted $7,231 in taxes and $1,446 in penalties.

At issue was whether a settlement payment was taxable.

Let’s lay out the story:

·      In 2008 the French’s bought a house.

·      Shortly thereafter Bank of America bought their mortgage.

·      In August, 2009 Bank of America transferred their loan to a subsidiary, BAC Home Loan Servicing.

·      In December, 2009 Mr. and Mrs. French signed a loan modification agreement. The modification was to become effective February 1, 2010.

A loan modification means that that payments were temporarily suspended, an interest rate was changed, the loan term was lengthened and so on. There was a lot of modifications going on around that time.

·      Mrs. French suffered from a very bad back. She was admitted to the hospital in October, 2009 for surgery.

·      From late 2009 into early 2010 Bank of America began calling the French’s on a routine basis, sometimes up to 5 times a day. They were hounding the French’s that their mortgage was about to go into foreclosure.

·      Mr. French was concerned about the effect of these endless calls on his wife. He requested that Bank of America call him on another line, that way he could shield his wife from the stress. Bank of America couldn’t care less. If anything, they were continued receiving multiple calls from multiple people across multiple BAC offices.

·      Mrs. French went into the hospital in December, 2009 and again in January, 2010.

·      In January, 2010 Mr. French spoke with a BAC representative. He explained the loan modification. The representative had no idea what Mr. French was talking about. He explained that – whoever Mr. French sent the modification to – it was not BAC. He instructed Mr. French to redo the paperwork, stop payment on the old check and enclose a new check.

·      After much hassle, Mr. French was told that the modification was accepted and that he should start making payments per the new agreement. He made 10 payments of $1,067.10.

·      When she was finally discharged from the hospital on January 21, 2010, a Bank of America representative called to tell Mrs. French that “officers were on their way to evict” them.

·      On January 23, she started experiencing chest pain and shortness of breath. She went back to the hospital. He suffered two pulmonary emboli, passed away twice but was resuscitated. She was discharged February 4, 2010.

·      BAC did not process the first modification as they promised Mr. French. BAC kept their higher monthly payments and interest rate. To make matters worse, they posted their monthly payments to a non-interest- bearing escrow account and treated the payments as if they were processing fees.

·      In October 2010 BAC told Mr. French that they were not honoring the first modification and that the loan was severely delinquent. They sent a second modification, with conditions and terms injurious to the French’s. For example, the second modification did not even address the 10 payments the French’s had previously sent. Mr. French, his back to a wall, signed the second modification in November, 2010.

·      BAC continued, increasing their monthly payment from $1,067.10 to $1,081.49. In September, 2011, BAC sent the French’s a notice that their checks would not be applied and would instead be returned if not for the higher amount.

Finally, the French’s hired an attorney.

The phone calls stopped.

The French’s sued on six claims, alleging fraud, integration of the first and second loan modifications, punitive damages, additional damages, attorney fees and so forth.

What they did not sue for was personal damages to Mrs. French’s health. 

They settled in 2012. The French’s received $41,333, and the attorneys received $20,666.

The French’s did not report the settlement as income on their 2012 tax return.

The IRS wanted to know why.

The French’s presented several arguments:

(1)  $7,500 of the settlement was not taxable under the “disputed debt” doctrine.

If one party does not agree to the terms of a debt, later settlement does not necessarily mean income. It may mean repayment of amounts improperly charged the borrower, for example. An interesting argument, but the Court noted that the settlement agreement never mentioned disputed or contested debt.

(2)  They were being repaid their own money.

(3)  IRC Section 104(a)(2)

 § 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;

To me, this was – by far – their best argument.

But it is one that BAC would never, ever put in writing.

The Court was however willing to look back to the six claims the attorneys filed for Mr. and Mrs. French. Unfortunately, the only language it found was the following:

… suffered lost time, inconvenience, distress [and] fear, and have been denied the benefit of the loan modification they were promised, and are being charged too much on their loan.”

These, folks, are not the magic words to open the Section 104(a)(2) door. For one thing, the words referred to both Mr. and Mrs. French.

The French’s owed the tax, but the IRS relented on the penalties.

Too bad the attorneys did not run the paperwork past a competent tax practitioner before it was too late.

Our case this time was French v Commissioner, T.C. Summary Opinion 2018-36.

Taxation of Disability Insurance

I was recently reviewing an individual tax return. There was something on there that distresses me.

This client walked into a tax trap, and that trap has gone off.  Unfortunately, there is nothing that can be done.

Let’s talk about disability insurance.

This client is a personal friend. You and I would agree that he is a high-incomer. He works for a large employer on the Kentucky side. One of the advantages of a large employer is the benefits. One of the benefits his provides is employer-funded long-term disability insurance.

He got hurt and hurt badly. He is now collecting on the disability insurance, and probably will be for a long time.  

Did you know that disability insurance can be taxable?

How?

There is extensive tax law on the taxation of disability insurance, and there are different answers depending upon who is paying the premiums and whether it is a group or individual policy. There is an overarching theme, though:

Disability benefits are taxable to the extent that the premiums were not included in income.

His long-term insurance was 100% employer-paid and 100% excluded from W-2 income. While this was beneficial to him then, it is the worst-case scenario now.

Long-term policies can be expensive. Take someone who is pushing the top tax brackets, and a recommendation to pay tax can mean thousands of extra dollars. Combine that with an all-too-human “it cannot happen to me” response, and it is easy to understand the reluctance.

And that is assuming the tax advisor is even aware of what is happening. Employer-provided disability insurance would not necessarily appear on any documents one would be reviewing. There are good odds that you and your tax advisor will be learning about your disability insurance together.

And so he has to pay tax on disability at the same time that his earning power is reduced.

Is there a compromise?

I think so, but – again – it has to be done upfront. I have no problem with short-term disability being taxable, whether because the premiums are employer-paid or because you run the premiums through your cafeteria plan. This is the insurance you buy from Aflac, for example, and it pays you for six months or a year if you get hit by the proverbial bus. Yes, it would stink to have to pay taxes, but it would only be for a short period of time. The expectation of this insurance is that you will heal and get back to work.

But long-term disability is different enough to warrant a different answer. You almost surely want to make sure this is paid with after-tax monies. If you are unfortunate enough to collect on this type of insurance, you do not need to compound the misfortune by having taxes as part of your household budget.