Using An Annuity To Teach Tax

I intend someday to return to college and teach tax. It would be an adjunct position, as I have no intention of taking up another full-time job after this. One tax CPA career is enough.

I have previously taught accounting but not tax. There is some order to accounting: debits and credits, recording transactions and reconciling accounts. Tax and accounting may be siblings, but the tax Code does not purport to show anyone’s net income according to “generally accepted accounting principles.” It may, mind you, but that would be a coincidence.

Sometimes there are jagged edges to tax accounting. Have Johnson & Johnson issue financial statements pursuant to the tax Code and they would likely find themselves in front of the SEC.   

Let's say you are taking your first tax course. The syllabus includes:

·        What is income?

·        What is deductible?

·        Why doesn’t the answer make sense?

I am looking at Tobias v Commissioner. I give the taxpayers credit, as they were thinking outside the box. They knew they hadn’t made any money, irrespective of what the IRS said.

Edward Tobias was an attorney and kept an inactive CPA license. His wife was a school administrator. They had bought a variable annuity in 2003 for almost $230,000. In order to free up the cash, they sold stock at a loss of approximately $158,000. They put another $346,000 into the annuity over the years.

Fast forward to 2010. They withdrew $525,000 to buy and improve a residence. At that point in time, the deferred income (that is, the inside buildup) in the annuity policy was approximately $186,000. They insurance company sent them a Form 1099 for $186,000.

But they left the $186,000 off their 2010 tax return. They did attach an explanation, however:

The … account was funded with after-tax funds and all withdrawals have been made prior to annuitization. Accordingly, any potential gains should be applied to the prior capital loss carryforward, which is approximately $148,000. Additionally, this account has not recouped losses incurred in prior years and has incurred substantial withdrawal penalties; the calculation made by … is incorrect and is contested.”

You know the IRS was going to match this up.

The Tobias’ had a remaining capital loss of $148,000 from stock they sold to buy the annuity. In addition they had already put approximately $576,000 into the annuity, an amount less than the withdrawal. They were just getting their money back, even without taking that capital loss into consideration. 

The IRS on the other hand said they had $186,000 in income. The IRS also wanted an early distribution penalty of almost $19,000.

Who is right?

When the Tobias’ withdrew $525,000, they took deferred income with it. This is the “income first” rule of Code Section 72(e), and the rule has been there a long time. It says that – upon taking money from an annuity – the inside income is the first thing to come out. Like the fable of the frog and scorpion, that is what annuities do.

What about the $148,000 capital loss? A capital loss has a separate set of rules. Capital losses offset capital gains dollar-for-dollar. Past that they offset non-capital-gain income up to $3,000 per year. Annuity income however is not capital gain income, so we are stuck at $3,000.

But the economics were interrelated, argued the Tobias’. They sold the stock to buy the annuity. The loss on that should offset the income from the annuity, right?

No, not right.

When these transactions hit the tax return, each took on its own tax attribute. One attribute went to house Gryffindor, another to house Hufflepuff. They are all in Hogwarts, but they have been separated by the tax Sorting Hat. You cannot just mix them together - unless the Code says you can mix them together. Unfortunately, the Code does not say that.

So you have the odd result that the Tobias’ owed tax and penalty on more money than they made from the deal.

The answer makes sense to a tax guy.

It may just be a bit hard to teach.

Social Security Disability Payments and IRS Penalties

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

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

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

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

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

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

We got the third quarter penalties waived.

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

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

We lost the appeal.

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

Let’s talk about Cheryl English.

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

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

And there is a nasty tax trap here.

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

Cheryl received tax-free benefits from Hartford.

Then she received social security.

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

There is symmetry to their answer.

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

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

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

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

Cheryl took the case pro se to the Tax Court. 

            NOTE: “Pro se” means she represented herself.

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

She owed the tax.

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

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

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

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