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.

Repaying a COVID-Related Distribution

Do you remember a tax break in 2020 that allowed you to take (up to) $100,000 from your IRA or your employer retirement plan? These were called “coronavirus-related distributions,” or CRDs in the lingo. In and of itself, the provision was not remarkable. What was remarkable is that one was allowed three years to return some, all, or none of the money to the IRA or employer plan, as one wished.

I was thinking recently that I do not remember seeing 2021 individual returns where someone returned the money.

Granted, we have a flotilla of returns on extension here at Galactic Command. I may yet see this beast in its natural state.

Let’s go over how this provision works.

To make it easy, let’s say that you took $100,000 from your 401(k) in 2020 for qualifying COVID-related reasons.

You had an immediate binary decision:

·      Report the entire $100,000 as income in 2020 and pay the taxes immediately.

·      Spread the reporting of the $100 grand over three years – 2020, 2021 and 2022 - and pay taxes over three years.

There was no early-distribution penalty on this distribution, which was good.

You might wonder how paying the tax immediately could be preferable to paying over three years. It could happen. How? Say that you had a business and it got decimated by COVID lockdowns. Your 2020 income might be very low – heck, you might even have an overall tax loss. If that were the case, reporting the income and paying the tax in 2020 might make sense, especially if you expected your subsequent years’ income to return to normal levels.

What was a COVID-related reason for a distribution?

The easy ones are:

·      You, a spouse or dependent were diagnosed (and possibly quarantined) with COVID;

·      You had childcare issues because of COVID;

·      You were furloughed, laid-off or had work hours reduced because of COVID.

Makes sense. There is one more:

·      You experienced other “adverse financial consequences” because of COVID.

That last one has an open-gate feel to me. I’ll give you an example:

·      You own rental cabins in Aspen. No one was renting your cabins in 2020. Did you experience “adverse financial consequences” triggering this tax provision?

You have – should you choose to do so – three years to put the money back. The three-year period starts with the date of distribution, so it does not automatically mean (in fact, it is unlikely to be) December 31^st three years later.

The money doesn’t have to return to the same IRA or employer plan. Any qualifying IRA or employer plan will work. Makes sense, as there is a more-than-incidental chance that someone no longer works for the same employer.

 Let’s say that you decide to return $50 grand of the $100 grand.

The tax reporting depends on how you reported the $100 grand in 2020.

Remember that there were two ways to go:

·      Report all of it in 2020

This is easy.

You reported $100 grand in 2020.

When you return $50 grand you … amend 2020 and reduce income by $50 grand.

What if you return $50 grand over two payments – one in 2021 and again in 2022?

Easy: you amend 2020 for the 2021 and amend 2020 again for the 2022.

Question: can you keep amending like that – that is, amending an amended?

Answer: you bet.

·       Report the $100 grand over three years.

This is not so easy.

The reporting depends on how much of the $100 grand you have left to report.

Let’s say that you are in the second year of the three-year spread and repay $30,000 to your IRA or employer plan.

The test here is: did you repay the includable amount (or less) for that year?

If yes, just subtract the repayment from the includable amount and report the difference on that year’s return.

In our example, the math would be $33,333 - 30,000 = $3,333. You would report $3,333 for the second year of the spread.

If no, then it gets ugly.

Let’s revise our example to say that you repaid $40,000 rather than $30,000.

First step: You would offset the current-year includable amount entirely. There is nothing to report the second year, and you still have $6,667 ($40,000 – 33,333) remaining.

You have a decision.

You have a year left on the three-year spread. You could elect to carryforward the $6,667 to that year. You would report $26,666 ($33,333 – 6,667) in income for that third and final year.

You could alternatively choose to amend a prior year for the $6,667. For example, you already reported $33,333 in 2020, so you could amend 2020, reduce income by $6,666 and get an immediate tax refund.

Which is better? Neither is inherently better, at least to my thinking. It depends on your situation.

There is a specific tax form to use with spreads and repayments of CRDs. I will spare us the details for this discussion.

There you have it: the ropes to repaying a coronavirus-related distribution (CRD).

If you reflect, do you see the complexity Congress added to the tax Code? Multiply this provision by however many times Congress alters the Code every year, and you can see how we have gotten to the point where an average person is probably unable to prepare his/her own tax return.

 

A Foreclosure And A Mortgage Interest Deduction

I am looking at a case involving mortgage interest. While I get the issue, I think the taxpayers got hosed.

I am going to streamline the details so we can follow the key points.

The Howlands had two mortgages on their house.

The first mortgage started with Countrywide and eventually wound up with Bank of New York Mellon.

The second mortgage started with Haven Trust Bank and wound up with CenterState Bank.

The house was foreclosed in 2016. It sold for $594,000.

The Howlands owed the following when the house was sold:

            Mellon        CenterState

        Principal      $     $377,060

        Interest     $100,607

        Interest & other    $247,046

The Howlands deducted mortgage interest of $103,498 on their 2016 joint tax return.

Neither bank, however, issued a Form 1098 for mortgage interest.

Allow for a little computer matching (or nonmatching in this case), and the IRS disallowed any interest deduction and assessed penalties to boot.

This story partially happened during the Great Recession of the late aughts. That is when we learned of “too big to fail,” of “ninja” loans and of banks playing musical chairs to survive. Good luck guessing where a given loan would wind up when the music stopped. Perhaps a taxpayer borrowed from someone (let’s call them “A”). A was acquired by B, which was later merged into C and yada, yada, yada. The data platforms between A and B were incompatible, meaning there was a one-way data transfer. The odds that someone years later – especially after the yada, yada, yada - could get back to A were astronomical.

While not clarified in the opinion, I suspect that is what happened here. CenterState Bank was not going to issue a 1098 because it could/would not time travel to determine if their interest calculations were correct. In the absence of such assurance, they were not going to issue a 1098. Or perhaps they were lazy and problem-solving outside a comfortable, numbing rote was a request beyond the pale. I prefer to believe the former reason.

But there was a problem: under the terms of the second mortgage, payments were to be applied first to interest.

COMMENT: Seems to me the Howlands paid interest of some amount.

Let’s focus in on that second mortgage. The money available to repay the second mortgage (after satisfaction of the first mortgage) would have been:

$594,000 – 247,046 = $346,954

There should also have been some interest embedded in the first mortgage, but let’s ignore that for now.

There is $347 grand to pay $377 grand of debt and $100 grand of back interest.

The IRS argued there was not enough money left to cover the principal, much less the interest. That is why the bank did not issue a 1098.

But we know that interest was to be paid first, per the loan agreement.

The Tax Court had to decide.

You know who was not in Court to testify? 

CenterState Bank – the second mortgage holder - that’s who.

Here is the Court:

The record before us is silent as to how CenterState applied the funds received and whether petitioners owe any remaining principal balance. These facts (if favorable) could support a finding that petitioners in fact paid home mortgage interest ….”

True.

However, statements in briefs do not constitute evidence.”

Again, true, but why say it?

Petitioners bear the burden of proof and must show, by a preponderance of evidence, that they are entitled to a home mortgage interest deduction ….”

Oh, oh.

... we conclude that petitioners have failed to meet their burden.”

Sheeshh.

I am not certain what more the Howlands could have done. They were at the mercy of the bank, and the new bank that took the payoff was not the same as the old bank that originated the loan. 

The Tax Court did strike down the penalties. Small consolation, but it was something.

Our case this time was Howland v Commissioner, TC Memo 2022-60.

The IRS Does Not Believe You Made A Loan

The issue came up here at command center this past week. It is worth discussing, as the issue is repetitive and – if the IRS aims it your way – the results can be brutal.

We are talking about loans.

More specifically, loans to/from yourself and among companies you own.

What’s the big deal, right? It is all your money.

Yep, it’s your money. What it might not be, however, is a loan.

Let’s walk through the story of James Polvony.

In 1996 he joined his wife’s company, Archetone Limited (Limited) as a 49% owner. Limited was a general contractor.

In 2002 he started his own company, Povolny Group (PG). PG was a real estate brokerage.

The real estate market died in 2008. Povolny was looking for other sources of income.

He won a bid to build a hospital for the Algerian Ministry of Health.

He formed another company, Archetone International LLC (LLC), for this purpose.

The Algerian job required a bank guaranty. This created an issue, as the best he could obtain was a line of credit from Wells Fargo. He took that line of credit to a UK bank and got a guarantee, but he still had to collateralize the US bank. He did this by borrowing and moving monies around his three companies.

The Algerian government stopped paying him. Why? While the job was for the Algerian government, it was being funded by a non-Algerian third party. This third party wanted a cut of the action. Povolny did not go along, and – shockingly – progress payments, and then actual job progress, ceased.

The deal was put together using borrowed money, so things started unravelling quickly.

International was drowning. Povolny had Limited pay approximately $241,000 of International’s debts.

PG also loaned International and Limited approximately $70 grand. PG initially showed this amount as a loan, but PG amended its return to show the amount as “Cost of Goods Sold.”

COMMENT: PG was making money. Cost of goods sold is a deduction, whereas a loan is not, at least not until it becomes uncollectible. I can see the allure of another deduction on a profitable tax return. Still, to amend a return for this reason strikes me as aggressive.

Limited also deducted its $241 grand, not as cost-of-goods-sold but as a bad-debt deduction.

Let’s regroup here for a moment.

• Povolny moved approximately $311 grand among his companies, and
• He deducted the whole thing using one description or another.

This caught the IRS’ attention.

Why?

Because it matters how Polvony moved monies around.

A loan can result in a bad debt deduction.

A capital contribution cannot. Granted, you may have a capital loss somewhere down the road, but that loss happens when you finally shut down the company or otherwise dispose of your stock or ownership interest.

Timing is a BIG deal in this area.

If you want the IRS to respect your assertion of a loan, then be prepared to show the incidents of a loan, such as:

• A written note
• An interest rate
• A maturity date
• Repayment schedule
• Recourse if the debtor does not perform (think collateral)

Think of yourself as SunTrust or Fifth Third Bank making a loan and you will get the idea.

The Court made short work of Povolny:

·       The $241 thousand loan did not have a written note, no maturity date and no required interest payments.

·       Ditto for the $70 grand.

The Court did not find the commercially routine attributes of debt, so it decided that there was no debt.

Povolny was moving his own capital around.

He as much said so when he said that he “didn’t see the merit” in creating written notes, interest rates and repayment terms.

The Polvony case is not remarkable. It happens all the time. What it does, however, is to tentpole how important it is to follow commercially customary banking procedures when moving monies among related companies.

But is it all your money, isn’t it?

Yep, it is. Be lax and the IRS will take you at your word and figure you are just moving your own capital around.

And there is no bad debt deduction on capital.

Our case this time was Povolny Group, Incorporated et al v Commissioner, TC Memo 2018-37.

When The IRS Says Loan Repayments Are Taxable Wages

Here is a common-enough fact pattern:

(1) You have a company.

(2) You loan the company money.

(3) The company has an unprofitable stretch.

(4) Your accountant tells you to reduce or stop your paycheck.

(5) You still have bills to pay. The company pays them for you, reporting them as repayments of your loan.

What could go wrong?

Let’s look at the Singer Installations, Inc v Commissioner case.

Mr. Singer started Singer Installations in 1981. It was primarily involved with servicing, repairing and modifying recreational vehicles, although it also sold cabinets used in the home construction.

After a rough start, the business started to grow. The company was short of working capital, so Mr. Singer borrowed personally and relent the money to the company. All in all, he put in around two-thirds of a million dollars.

PROBLEM: Forget about the formalities of debt: there was no written note, no interest, no repayment schedule, nothing. All that existed was a bookkeeping entry.

The business was growing. Singer had problems, but they were good problems.

Let’s fast-forward to 2008 and the Great Recession. No one was modifying recreational vehicles, and construction was drying up. Business went south. Singer had tapped-out his banks, and he was now borrowing from family.

He lost over $330 grand in 2010 and 2011 alone. The company stopped paying him a salary. The company paid approximately $180,000 in personal expenses, which were reported as loan repayments.

The IRS disagreed. They said the $180 grand was wages. He was drawing money before and after. And – anyway – that note did not walk or quack like a real note, so it could not be a loan repayment. It had to be wages. What else could it be?

Would his failure to observe the niceties of a loan cost him?

Here is the Court:

We recognize that Mr. Singer’s advances have some of the characteristics of equity – the lack of a promissory note, the lack of a definitive maturity date, and the lack of a repayment schedule …”

This is going to end poorly.

 … but we do not believe those factors outweigh the evidence of intent.”

Wait, is he going to pull this out …?

 … because intent of parties to create [a] loan was overwhelming and outweighed other factors.”

He won …!

However, we cannot find that all of the advances were loans.”

Then what would they be?

While we believe that Mr. Singer had a reasonable expectation of repayment for advances made between 2006 and 2008, we do not find that a similarly reasonable expectation of repayment existed for later advances.”

Why not, Sheldon?

 After 2008 the only source of capital was from Mr. Singer’s family and Mr. Singer’s personal credit cards.”

And …?

No reasonable creditor would lend to petitioner.”

Ouch.

The Court decided that advances in 2008 and earlier were bona fide loans. Business fortunes changed drastically, and advances made after 2008 were not loans but instead were capital contributions.

This “no reasonable creditor would lend” can be a difficult standard to work with. I have known multimillionaires who became such because they did not know when to give up. I remember one who became worth over $30 million – on his third try.

Still, the Court is not saying to fold the company. It is just saying that – past a certain point – you have injected capital rather than made a loan. That point is when an independent third party would refuse to lend money, no matter how sweet the deal.

Why would the IRS care?

The real-world difference is that it is more difficult tax-wise to withdraw capital from a business than it is to repay a loan. Repay a loan and you – with the exception of interest – have no tax consequence.

Withdraw capital – assuming state law even allows it – and the weight of the tax Code will grind you to dust trying to make it taxable – as a dividend, as a capital gain, as glitter from the tax fairy.

It was a mixed win for Singer, but at least he did not have to pay taxes on those phantom wages.

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.