Repaying The Health Care Subsidy

Twice in a couple of weeks I have heard:

“They should check on the Exchange.”

The Exchange refers to the health insurance marketplace.

In both cases we were discussing someone who is between jobs.         

The idea, of course, is to get the subsidy … as someone is unemployed and can use it.

There might also be a tax trap here.

When you apply for Obamacare, you provide an estimate of your income for the coverage year. The answer is intuitive if you are applying for 2020 (as we are not in 2020 yet), but it could also happen if you go in during the coverage year. Say you are laid-off in July. You know your income through July, and you are guessing what it might be for the rest of the year.

So what?

There is a big what.

Receive a subsidy and you have to pay it back – every penny of it – if your income exceeds 400% of the poverty line for your state.

Accountants refer to this as a “cliff.” Get to that last dollar of income and your marginal tax rate goes stratospheric.

Four times the poverty rate for a single person in Kentucky is approximately $50 grand.  Have your income come in at $50 grand and a dollar and you have to repay the entire subsidy.

It can hurt.

How much latitude does a tax preparer have?

Not much. I suppose if we are close we might talk about making a deductible IRA contribution, or selling stock at a loss, or ….

There may be more latitude if one is self-employed. Perhaps one could double-down on the depreciation, or recount the inventory, or ….

Massoud and Ziba Fanaieyan got themselves into this predicament.

The Fanaieyans lived in California. He was retired and owned several rental properties. She worked as a hairstylist.

They received over $15,000 in subsidies for their 2015 tax year.

Four times the California poverty line was $97,000.

They reported adjusted gross income of $100,767.

And there was (what I consider) a fatal preparation mistake. They failed to include Form 8962, which is the tax form that reconciles the subsidy received to the subsidy to which one was actually entitled based on income reported on the tax return.

The IRS sent a letter asking for the Form 8962.

The Fanaieyans realized their mistake.

Folks, for the most part tax planning is not a retroactive exercise. Their hands were tied.

Except ….

Mr. Fanaieyan remembered that book he was writing. All right, it was his sister’s book, but he was involved too. He had paid some expenses in 2012 and 2013. Oh, and he had advanced his sister $1,500 in 2015.

He had given up the dream of publishing in 2015. Surely, he could now write-off those expenses. No point carrying them any longer. The dream was gone.

They amended their 2015 tax return for a book publishing loss.

The IRS looked at them like they had three eyes each.

To Court they went.

There were technical issues that we will not dive into. For example, as a cash-basis taxpayer, didn’t they have to deduct those expenses back in 2012 and 2013? And was it really a business, or did they have a (dreaded) hobby loss? Was it even a loss, or were they making a gift to his sister?

The Court bounced the deduction. They had several grounds to do so, and so they did.

The Fanaieyans had income over four times the poverty level.

They had to repay the advance subsidies.

I cannot help but wonder how this would have turned out if they had claimed the same loss on their originally-filed return AND included a properly-completed Form 8962.  

Failing to include the 8962 meant that someone was going to look at the file.

Amending the return also meant that someone was going to look at the file.

Too many looks.

Depression And Disability

I am reading a Tax Court case where the taxpayer represented himself. This is referred to as “pro se.” Technically, it does not mean that you cannot have an attorney or advisor with you; it rather means that the attorney or advisor is not admitted to practice before the Tax Court. If I was your CPA, for example, I would field the questions-and-answers on your behalf while you sat there silent and forlorn. You would still be considered to be “pro se,” as I do not practice before the Court. Had I practiced in the D.C. area or with the national tax office of a large firm, I might have been more interested in pursuing admission to practice.

The taxpayer’s name is Walter Kowsh, and he had an incredible string of misfortune. Walter lived in New York. His wife died at age 53, leaving him with two teenage children and an elderly parent.

Then he lost several friends on the 9/11 attacks on the World Trade Center. Some of those friends had gone to his wife’s funeral.

By 2002 he could longer work because of depression and anxiety attacks.

He started taking prescriptions, including Wellbutrin and Paxil.

His depression became debilitating.

He started collecting on his private disability insurance.

He did not however apply for Social Security disability. Too bad, as there is a case (Dwyer) that accepts social security as proof of disability.

He took an early distribution from his 401(k) or IRA in 2003. He did not however file a tax return for 2003.

So the IRS tentatively prepared one for him.

After a string of IRS notices, he finally prepared and filed his 2003 return.

The IRS next wanted penalties for late filing as well as the 10% penalty on the early distribution.

Walter needed an out from both penalties. Is there way to do it?

Yep.

Disability would do it. Disability is an exception to the 10% penalty and is also reasonable cause to abate a late filing penalty.

Walter argued that he was disabled.

Question is: did Walter’s depression rise to the level of a disability?

Incredible story, said the IRS. Get us a doctor’s letter, and let’s wrap this up.

Walter could not – or would not - get a doctor’s letter. His own doctor refused to provide one.

This was a bad start.

How about a prescription history from the pharmacy? asked the IRS. They might be able to print out your history for the whole year.

Nope, said Walter.

I am already collecting disability, continued Walter. What part of “disability” do you not understand?

Walter could really have used a tax advisor at this point.

You see, collecting disability from an insurance company lends strong credibility to Walter’s claim, but disability is a medical diagnosis. The insurance reinforces the diagnosis but is not a substitute for it.

Rest assured the Court was curious why Walter’s doctor would not provide a letter, or why he refused to have another doctor provide one…

… despite numerous requests from respondent.”

Respondent means the IRS.

And I am curious myself.

I do not doubt that he was depressed. I also do not doubt that he considered himself disabled. What I don’t understand is the big pushback on what appears to be a reasonable request.

It is not personal, Walter. Stop taking it that way.

Walter lost.

You see the downside to a true pro se.

I would have been screaming at Walter for sabotaging his own case. He would have gotten that doctor’s letter or I would have fired him.

But Walter made the tax literature for the point that collecting private disability insurance, by itself and without further substantiation, does not prove disability for purposes of the tax Code.

Tax geeks will remember Walter for decades.

Getting Married And ObamaCare Subsidies

I am reading a case that reminds me of a return from last year’s filing season. I had an accountant who became upset, arguing that the result was unfair.

I agree, but this is tax.

I started practice in the eighties, and a significant portion of my tax education was at a law school.  Tax accounting classes tended to be staccato-like:  issue-driven, procedural and reliably arithmetic. Tax law classes were case and doctrine-focused: what is income, for example, and we would study the concept of income as it evolved over the decades.

It seemed to me that tax law early in my career followed – as a generalization - more of that law school feel: corporate liquidations and the General Utilities doctrine; the claim of right doctrine and North American Oil; business purpose and Helvering v Gregory. There were strong Ways and Means and Finance Committee chairs with some understanding of the issues (and precedent) their committees were addressing.  

But those were different politicians. Both they and taxes have gotten progressively weirder.

Congress went on to introduce something called uniform capitalization, arguing that accountants did not know how to absorb costs into inventory; tax items – personal exemptions or itemized deductions, for example – that would evaporate like a Thanos movie moment; an alternative minimum tax that would tax something that ultimately went down in value; the increasing refundability of tax credits, meaning that those at the low end of the income scale had as much if not more opportunity to game the system than any big-baddy McMoneybags did.

Let’s look at the Fisher case.

Christina Fisher began the year as a single mom. She married Timothy in November. Christina was struggling, and she received Obamacare subsidies.

You may recall that there are two relevant aspects to Obamacare that will come into play in this case:

(1)  If you are below a certain income level, you might be entitled to some – or even full – subsidy of your health insurance premiums.

(2)  You can use that subsidy to pay your premiums immediately rather than wait to the end of the year and receive the subsidy via a tax refund.

There was no question that Christina was entitled to a subsidy for more than 10 months. Her circumstances changed when she married; she no longer qualified.

Time to prepare her taxes.

One is supposed to attach a reconciliation of projected income when receiving the subsidy to actual income ultimately reported on the tax return. The Fishers did not.

The IRS did it for them. They also wanted approximately $4,500, saying she was not entitled to the subsidy.

A rational mind would expect that the tax law would go to a month-by-month calculation. There was no doubt that she qualified for 10 months. Let’s allow for some doubt in the month of marriage. Let’s also disqualify the last month of the year because of Timothy’s income.

At worst she would have to pay back 2 months, right?

Nah.

She has to use her household income for the year – including Timothy’s income.

Then she takes half of that amount for her monthly testing.

Not her OWN income, mind you, but one-half of combined income for the year.

Who came up with this?

Not the best and brightest exercising due deliberation, clearly.

Well, using even one-half of the combined household income, Christina failed all 10 months one would have expected her to pass. She owed almost $4,500 to the IRS.

And that is why my accountant lost his mind last year. He could not believe that what he was reading is really what was meant. It made no sense! Surely there is an alternative calculation? Does the tax Code allow a facts and circumstances …?

Ahh, he is still young. He will learn.

Paying Back The ObamaCare Subsidy

I do not see many tax returns with the ObamaCare health exchange subsidy.

Our fees make it unlikely.

However, take an ongoing client with variable income or business losses and we do see some.

I saw one this busy season that gave me pause.

Let’s discuss the McGuire case to set up the issue.

Mr. McGuire was working and Mrs. McGuire was not. In 2013, they applied with the Covered California and qualified for a monthly subsidy of $591, or $7,092 per year. They enrolled in a plan that cost $1,182 monthly. After the subsidy, their cost was (coincidentally) $591 monthly.

Mrs. McGuire started a job that paid $600 per week. She contacted Covered California, as she realized that her paycheck would affect that subsidy.

This being a government agency, you can anticipate the importance they gave Mrs. McGuire.

That would be “none.”

Several months later they did send a letter stating that the McGuires did not qualify for a subsidy.

The letter did not talk about switching to a lower cost plan. Or dropping the plan altogether. Or – be still my heart - provide a phone number to speak with an actual government bureaucrat.

It did not matter.

The McGuires had moved. They tried to get Covered California to update their address, but it was the same story as getting Covered California to update their premium subsidy for her new job.

The McGuires never received the letter.

It goes without saying that they never received Form 1095-A in 2014 either. This is the tax form for reporting an Exchange subsidy.

There are two main individual penalties under the Affordable Care Act:

(1) There is a penalty for not having “qualified” insurance. This is not the same as being uninsured. Have insurance that the government disapproves of and you are treated as having no insurance at all. 

(2) Subsidies received have to be reconciled to your actual household income. Make less that you thought and you may get a few bucks back. Make more and you may have to repay your subsidy. While technically not a “penalty,” it certainly acts like one.

The McGuires indicated on their tax return that they had health insurance (thereby avoiding penalty (1), but they did not complete the subsidy reconciliation (which is penalty (2)).

The IRS did, however.

Sure enough, the McGuires did not qualify for a subsidy. The IRS wanted its money back. All of it.

The McGuires fired back:

We would never have committed to paying for medical coverage in excess of $14,000 per year.”

True that.

We cannot afford it and would have continued to shop in the private sector to purchase the minimal, least expensive coverage or gone without coverage completely and suffered the penalties.”

That is, they would have avoided penalty (2) by not accepting subsidies and instead paid penalty (1), which would have been cheaper.

If we are deemed responsible for paying back this deficiency, it would be devastating and completely unjust. ….  The whole purpose of the Affordable Care Act was to provide citizens with just that, affordable healthcare. This has been an absolute nightmare and we hope that you will rule fairly and justly today.”

Here is the Tax Court:

But we are not a court of equity, and we cannot ignore the law to achieve an equitable end.”

Equity means fairness, so the Court is saying that – if the law is otherwise bright-line – they cannot decide on the grounds of fairness. 

Although we are sympathetic to the McGuires’ situation, the statute is clear; excess advance premium tax credits are treated as an increase in the tax imposed. The McGuires received an advance of a credit to which they were ultimately not entitled.”

The McGuires had to pay back $7 grand, despite the incompetence of Covered California.

Ouch.

Let’s return to CTG Galactic Command. How did my client get into a subsidy-repayment situation?

Gambling.

The tax Code is odd about gambling. It forces you to take gambling winnings into income. The subsidy calculation keys-off that income number.

Wait, you say. What about gambling losses?

The tax Code requires you to take gambling losses as an itemized deduction.

The subsidy calculation pays no attention to itemized deductions.

Win $40 grand and the subsidy calculation includes it. Your household income just went up.

Say that you also lost $40 grand. You netted nothing in real life.

Tough. The subsidy calculation does not care about your losses.

Heads you lose. Tails you lose. 

That was my client’s story.

Is There Any Point To Middle Class Entitlements?

I was reading a Bloomberg article last week titled “Those Pointless Upper-Middle-Class Entitlements.” It is - to be fair - an opinion piece, so let’s take it with a grain of salt.

The article begins:

Let’s talk about upper-middle-class entitlements, the subsidies that flow almost entirely to those in the upper fifth or even tenth of the income distribution. You know, the home mortgage interest deduction and the tax subsidies for 401(k)s, IRAs and other retirement plans.

Then we have a spiffy graph: 

I am confused with what is considered a “tax break.”

The true “tax break” here is the earned income credit. We know that this began as encouragement to transition one from nonworking to working status, and we also know that it is the font of massive tax fraud every year. The government just sends you a check, kind of like the tooth fairy. An entire tax-storefront industry has existed for decades just to churn-out EIC returns. Too often, their owners and practitioners are not as … uhh, scrupulous … as we would want.

And this is a surprise how? Give away free money to every red-headed Zoroastrian Pacific Islander and wait to be surprised by how many red-headed Zoroastrian Pacific Islanders line up at your door. Even those who are not red-headed, Zoroastrian or Pacific Islander in any way. 

Here is more:

Of course, we wouldn’t want to take away all of those tax expenditures, would we? The earned income tax credit and the Social Security exclusion, for example, are targeted at people with pretty low incomes.

Doesn’t one need to have income before receiving an INCOME TAX expenditure?

Then we have these bright shiny categories:

·       Defined contribution retirement plans

·       Defined benefit retirement plans

·       Traditional IRAs

·       Roth IRAs

Interesting. One would think that saving for retirement would be a social good, if only to lessen the stress on social security.

We read:

Wealthy people who would save for retirement in any case respond to subsidies by shifting assets into tax-sheltered accounts; the less wealthy don’t respond much at all.

It makes some sense, but don’t you feel like you are being conned? Step right up, folks; make enough money to save for retirement and you do not need a tax break to save for retirement.

When did we all become wealthy? Did someone send out letters to inform us?

Did you know that the majority of income tax breaks are claimed by people with the majority of the income?  

Think about that one for a second, folks.

This following is a pet peeve of mine:

·       Deferral of active income of controlled foreign corporations

We have discussed this issue before. Years ago, when the U.S. was predominant, it decided that U.S. corporations would pay tax on all their earnings, whether earned in the U.S. or not.

There is a problem with that: the U.S. is almost a solo act in taxing companies on their worldwide income. Almost everyone else taxes only the profit earned in their country (the nerd term is “territoriality”).

Let’s be frank: if you were the CEO of an international company, what would you do in response to this tax policy?

You would move the company – at least the headquarters - out of the U.S., that’s what you would do. And companies have been moving: that is what "inversions" are.

So, the U.S. had no choice but to carve-out exceptions, which is how we get to “deferral of active income of controlled foreign corporations.” This is not a tax break. It is a fundamental flaw in U.S. international taxation and the reason Congress is currently considering a territorial system.

By the way, how did these tax breaks come to be, Dudley?

Why do these subsidies continue nonetheless? Mainly, it seems, because they’ve been granted to a sizable, influential population who, it is feared, will fight any effort to take them away. 

Politicians giving away money. Gasp.

But mainly it’s the millions of upper-middle-class Americans who, like me and my family, are beneficiaries of tax subsidies for home mortgages, retirement accounts and/or college savings.

To state another way: It is unfair that people with more money can do more things with money than people with less money.

Profound.

What offends about this bella siracha is:

You train for a career.

You set an alarm clock daily, dress, fight traffic and do your job.

You get paid money.

You take some of this money and save for nefarious causes such as your kids’ college and your eventual retirement.

Yet you keeping your own money is the equivalent of receiving a welfare check euphemistically described as an “earned income credit.”

No, no it is not.

And the false equivalence is offensive.

I get the issue. I really do. The theory begins with all income being taxable. When it is not, or when a deduction is allowed against income, there is – arguably - a “tax break.” The criticism I have is equating one-keeping-one’s-money (for example, a 401(k)) with flat-out welfare (the earned income credit). Another example would be equating a deeply-flawed statutory tax scheme (multinational corporations) with the state income tax deduction (where approximately 30% of this tax break goes to two states: California and New York). 

And somebody please tell me what “wealthy” means anymore. It has become one of the most abused words in the English language.

Bloomberg

A Tax Shelter In The Making

Have you ever heard of a “captive” insurance company?

They have become quite cachet. They have also drawn the IRS’ attention, as people are using these things for reasons other than insurance and risk management.

Let’s walk through this.  

Let’s say that you and I found a company manufacturing sat-nav athletic shoes

COMMENT: Sat-nav meaning satellite navigation. That’s right: you know you want a pair. More than one.

We make a million of them, and we have back orders for millions more. We are on the cover of Inc. magazine, meet Jim Cramer and get called to the White House to compliment us for employing America again.

Sweet.

Then tax time.

We owe humongous taxes.

Not sweet.

Our tax advisor (I am retired by then) mentions a captive.

LET’S EXPLAIN THIS: The idea here is that we have an insurable risk. Rather than just buying a policy from whoever-is-advertising-during-a-sports-event, we set up our own (small) insurance company. Granted, we are never going to rival the big boys, but it is enough for our needs. If we can leap through selected hoops, we might also get a tax break from the arrangement.

What risks do you and I have to insure?

What is one of those shoes blows out or the satellite-navigation system shorts and electrocutes someone? What if it picks up contact from an alien civilization – or an honest political journalist? We could get sued.

Granted, that is what insurance is for. The advisor says to purchase a policy from one of the big boys with a $1.2 million deductible. We then set up our own insurance company – our “captive” – to cover that $1.2 million.

We are self-insuring.

There is an election in the tax Code (Section 831(b) for the incorrigible) that waives the income tax on the first $1.2 million of premiums to the captive. It does pay tax on its investment income, but that is nickels-to-dollars.

You see that I did not pick the $1.2 million at random.

Can this get even better?

Submitted for your consideration: the You & Me ET Athletic Shoe Company will deduct the $1.2 million as “Insurance Expense” on its business return.

We skip paying tax on $1.2 million AND we deduct it on our tax return?

Easy, partner. We can still be sued. We would go through that $1.2 million in a heartbeat.

Is there a way to MacGyver this?

Got it. Three ways come quickly to mind, in fact:

(1) Let’s make the captive insurance duplicative. We buy a main policy with a reputable insurance company. We then buy a similar – but redundant -  policy from the captive.  We don’t need the captive, truthfully, as Nationwide or Allstate would provide the real insurance. We do get to stuff away $1.2 million, however – per year. We would let it compound. Then we would go swimming in our money, like Scrooge McDuck from the Huey, Dewey and Louie comics.

(2) A variation on (1) is to make the policy language so amorphous and impenetrable that it is nearly impossible to tell whether the captive is insuring whatever it is we would submit a claim for. That would make the captive’s decision to pay discretionary, and we would discrete to not pay.

(3) We could insure crazy stuff. Let’s insure for blizzards in San Diego, for example. 

a.    Alright, we will need an office in San Diego to make this look legitimate. I volunteer to move there. For the team, of course.

The tax advisor has an idea how to push this even further. The captive does not need to have the same owners as the You & Me ET Athletic Shoe Company. Let’s make our kids the shareholders of the captive. As our captive starts hoarding piles of cash, we are simultaneously doing some gifting and estate tax planning with our kids.

Heck, we can probably also put something in there for the grandkids.

To be fair, we have climbed too far out on this limb. These things have quite serious and beneficial uses in the economy. Think agriculture and farmers. There are instances where the only insurance farmers can get is whatever they can figure-out on their own. Perhaps several farms come together to pool risks and costs. This is what Section 831(b) was meant to address, and it is a reason why captives are heavily supported by rural state Senators.

In fact, the senators from Wisconsin, Indiana and Iowa were recently able to increase that $1.2 million to $2.2 million, beginning in 2017.

Then you have those who ruin it for the rest of us. Like the dentist who captived his dental office against terrorist attack.

That nonsense is going to attract the wrong kind of attention.

Sure enough, the IRS stepped in. It wants to look at these things. In November, 2016 the IRS gave notice that (some of) these captive structures are “transactions of interest.” That lingo means that – if you have one – you must file a disclosure (using Form 8886 Reportable Transaction Disclosure Statement) with the IRS by May 1, 2017.

If this describes you, this deadline is only a few months away. Make sure that your attorney and CPA are on this.

Mind you, there will be penalties for not filing these 8886s.

That is how the IRS looks at things. It is good to be king.

The IRS is not saying that captives are bad. Not at all. What it is saying is that some people are using captives for other than their intended purpose. The IRS has a very particular set of skills, skills it has acquired over a very long career. Skills that make the IRS a nightmare for people like this. If these people stop, that will be the end of it. If they do not stop, the IRS will look for them, they will find them, and they will ….

Ahem. Got carried away there.

When this is over, we can reasonably anticipate the IRS to say that certain Section 831(b) structures and uses are OK, while others are … unclear. The IRS will then upgrade the unclear structures and uses to “reportable” or “listed” status, triggering additional tax return disclosures and potential eye-watering penalties.

In the old days, listed transactions were called “tax shelters,” so that will be nothing to fool with.

HRAs Are Back

I am glad to see that Health Reimbursement Accounts (HRAs) are coming back.

They should never have gone away. They were, unfortunately, sacrificed to the idiocracy. That crowd would rather have you starve than give you half a loaf.

And henceforce they shall be called Qualified Small Employer Health Insurance Arrangements (QSEHRAs).

They are sorta like the former HRAs, with a couple of twists.

So what are these things?

Simple. I used to have one.

My HRA covered all the medical incidentals: deductibles, co-pays, chiropractor, dental, eyeglasses and so on. One would submit out-of-pocket medical expenses, and the firm would reimburse. There was a ceiling, but I do not recall what it was. The ceiling was fairly high, as my partner had some ongoing medical expenses.  The HRA was a way to help out.

Then they went away.

One now didn’t have “insurance.” One now had “plans.”

The demimondes, of course, decided they could tell you what had to be in your “plan.”

Take a nun.

No problem: you had to have contraceptives in your plan.

A 50-year old tax CPA?

No sweat: prenatal care in your plan.

But you don’t need prenatal care.

Stinks to be you. 

HRAs were sacrificed to the loudest of the boombots.

You see, an HRA did not “cover” pre-existing conditions. It did not offer “minimum essential” coverage. It also could not do your laundry or fix a magnificent BLT on football Sunday, but those latter limitations were not politically charged.

The HRA did not cover pre-existing. True. It did however pay for your co-pays, out-of-pocket and deductibles, but not – technically – your preexisting. It seems covering existing was just not good enough.

It did not provide minimum essential. True. It was not insurance. It was there to help out, not to replace or pretend to be insurance. But it was sweet to have the extra money.

Too bad. HRAs had to go.

People complained. People like my former partner. Or me, for that matter.

So a compromise was reached. You could have an HRA as long as you matched it with insurance that met all the necessary check-the-box features we were told to buy.

What if you did not provide health insurance? Perhaps you were a small company of 8 people, and insurance was not financially feasible at the moment. Could you offer an HRA (say $2,000) to help out your employees? Something is better than nothing, right?

Nope.

Well, technically you could.

But there was a fine. Of $100 per day. Per employee.

Let me do the math on this: $100 times 365 days = $36,500 per year.

Per employee.

There goes that $2,000 you could give your employees.

To be fair, the government indicated that they would not enforce these penalties through 2016, but you would have to trust them.

Right ….

I had this conversation with clients. More than once.

Multiply me by however many tax practitioners across the nation giving the same advice.

How many people lost their $2,000 because of this insanity?

Fortunately, HRAs are back.

In 2017. Sort of. 

They will be available to employers with fewer than 50 full-time-equivalent employees.  

All employees with more than three years of service must be eligible to participate.

Employees employed less than 90 days, are under age 25, are part-time or seasonal can be excluded.

Must be funded 100% by the employer.

Salary reductions are not permitted.

There are dollar limitations ($4,950 if employee-only, $10,000 if family/dependent).

There may be a hitch from the employee side:

·      The HRA is tax-free as long as the employee has health insurance.

·      The HRA is taxable if the employee does not have health insurance.

COMMENT: I suppose an employer will require proof of insurance/non-insurance before writing the first check. This will tell them whether the HRA reimbursement will be taxable to the employee.

·      If the employee is on an Exchange, any subsidy will be reduced by the amount reimbursable under the HRA. This is an indirect way of saying that a purpose of the new HRA is to allow small employers to reimburse employees for individual insurance premiums. Prior to 2017, this act was prohibited under ObamaCare.

Not surprisingly, there will be yet-another-code on the W-2 to report the benefit available under the HRA, but we do not have to worry about it until next year’s (that is, the 2017) W-2.

And they did away with the $100/employee/day/yada yada yada absurdity.

Hey, progress. Back to the way it used to be.

What Does It Take To Get Reasonable Cause Around Here?

My partner has a difficult IRS penalty issue.

He expects a client to be penalized for more than one year. This complicates how we handle the first year.

The IRS has reorganized its penalty review function to a system called the Reasonable Cause Assistant (RCA). There however is a problem: the system does not work well. The Treasury Inspector General for Tax Administration (TIGTA) reported that RCA was inaccurate 89% of the time in 2012.

Step away from RCA and you still have the following:

 * It used to be that penalties were assessed as a means to encourage voluntary compliance. Many tax pros feel that is no longer the case, and penalties are being used as a means to raise revenue.  An example is the penalty assessed for late filing of a partnership return: $195 per month per partner. Take a 10-person partnership, file a week late and face a $1,950 penalty. There is little consideration for the size of the partnership, its total assets or revenues - or the fact that partnerships do not pay federal taxes.            

* Penalties are assessed even when taxpayers are trying to do the right thing. For example, enter into a reportable transaction, disclose it on your tax return but forget to file a copy with a second office and you will be assessed a penalty. Fail to disclose the transaction at all and you will be subject to the same penalty.

 * The IRS is automatically asserting penalties. For example, for fiscal year 2015, the IRS assessed over 40 million penalties on individuals and businesses. To put that in context, there were approximately 243 million returns filed for the period.

* Many penalties can be waived if the taxpayer can show "reasonable cause," but many tax professionals believe the IRS has so narrowed the definition as to be almost unreachable, unless you are willing to die. To aggravate the matter, the IRS has also instructed its personnel to substitute "first time abatement" (FTA) for reasonable cause as a matter of policy. While the IRS argues that FTA is easier to review and administer than reasonable cause, there exists a high degree of skepticism. Why would a taxpayer automatically burn a "get out of penalty-jail free" card if the taxpayer otherwise has reasonable cause? Wouldn't a taxpayer want to keep that card available just in case?

My partner - by the way - has that last situation: burning his FTA chip without a reasonable-cause backup for the second year. Ironically, he may have reasonable cause for the first year, but that sequence does not follow IRS policy. I anticipate going to Appeals to obtain reasonable cause and preserve the FTA for the second year.

Let's talk about the Carolyn Rogers (Rogers v Commissioner) case.

Carolyn lived in New York. In 2006 she had a small business (Talk of the Town Singles) which she operated from her cooperative. In 2006 there was a fire which rendered the place uninhabitable.

She moved. In 2007 there was another fire, one she appears to have caused herself. The local newspaper called her out, and she was thereafter harassed by people in her neighborhood.

She moved to the YWCA until 2010. She did not have a pleasant time there, and in 2009 she fell off a subway platform and fractured her skull on the rails. She was in the hospital for days, and she continued to suffer from dizzy spells thereafter.

Prior to this period, she had a record of filing timely returns. She also made significant efforts to correctly prepare her tax returns, consulting books and references and more than once contacting the IRS. She did not use a paid preparer.

The IRS penalized her for not filing a 2009 return.

She explained that the insurance company settled the second fire in 2009, and she lost a bundle. According to her research, the casualty loss would wipe out her income, and she was therefore below the filing threshold. She did not need to file.

The IRS then trotted technical guidance on a casualty loss. While the layperson might think that the loss would be deferred until the insurance is settled, the tax Code uses a different test:

* If an insurance claim is not paid in the year of casualty AND there is a reasonable prospect of recovery, then the loss is deferred until one can determine the amount of recovery.

* If there is no hope for insurance - or the prospect of recovery is unreasonable - then the loss is deductible in the year of the casualty.

 The IRS said that she came under the second rule. She knew that insurance would not cover the full loss from the 2007 fire. The loss was therefore deductible in 2007.

COMMENT: There is enough "what if" to this rule that even a tax professional could blow it.

The IRS wanted penalties for not filing that 2009 return.  

The Tax Court reviewed her filing history and her chaotic life. It noted:

Petitioner's error (regarding the proper year of deduction of the portion of a casualty loss for which there is no reasonable prospect of recovery from insurance) is considerably different from the errors made by a taxpayer whose failure to file, late filing, or late payment is chronic. Erroneously deducting a loss in a year later than the correct year is not usually considered to be a blatant tax avoidance technique ..."

Ouch. The Court did not appreciate the IRS wasting its time.

Taking into account all of the facts and circumstances, we conclude that petitioner exercised ordinary business care and prudence under the difficult circumstances in which she was living at the time leading up to the due date of her 2009 return...."

The Court found reasonable cause. She owed the tax, but she did not owe the penalties.

The IRS should have found reasonable cause too. It is troubling that it didn't.