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.

Loan Warehousing And The Claim of Right

 

Tax returns are generally filed in one-year increments.

That raises an accounting question: what if the transaction being accounted for stretches over more than one year?

A variation is:

Set aside whether the whether the transaction resolved in the same period. Was there doubt as to a material fact affecting the transaction? If one were to redo the accounting knowing what one knows now, would there be a different answer?

This is the backdrop for the claim of right doctrine. Judge Brandeis referred to it in North American Oil Consolidated v Burnet (1932):

If a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent.”

You can immediately see a couple of requirements:

(1) The taxpayer is later required to return the money.

(2) The taxpayer, however, initially received the money without restriction upon its use.

If you are preparing a tax return and learn of the above, what do you do?

(1)  Amend the original tax return?

(2)  Deduct the repayment in the year of repayment?

It might not seem significant upon first hearing, but it can be. Here are two common ways it can be significant:

(1) The original year (that is, the year the income was reported) is closed under the statute of limitations.

(2) Tax rates have changed substantially between the years.

Congress finally passed a Code section codifying the claim of right doctrine in 1954:

26 U.S. Code § 1341 - Computation of tax where taxpayer restores substantial amount held under claim of right

(a) General rule If—

(1) an item was included in gross income for a prior taxable year (or years) because it appeared that the taxpayer had an unrestricted right to such item;

(2) a deduction is allowable for the taxable year because it was established after the close of such prior taxable year (or years) that the taxpayer did not have an unrestricted right to such item or to a portion of such item; and

(3) the amount of such deduction exceeds $3,000,

then the tax imposed by this chapter for the taxable year shall be the lesser of the following:

(4) the tax for the taxable year computed with such deduction; or

(5) an amount equal to—

(A) the tax for the taxable year computed without such deduction, minus

(B) the decrease in tax under this chapter (or the corresponding provisions of prior revenue laws) for the prior taxable year (or years) which would result solely from the exclusion of such item (or portion thereof) from gross income for such prior taxable year (or years).

This is a rare find in the tax Code, as Congress actually expanded the claim of right to make it more taxpayer friendly. The Code still allows a deduction in the year of repayment, but it also allows a recalculation using the original year’s tax rates. If tax rates have decreased (overall or yours personally), the recalculation of the original year may be the better way to go.

Let’s look at Norwich Commercial Group v Commissioner.

Here is the first sentence of the decision:

P overreported more than $7 million in income on its 2007 through 2013 federal income tax returns."

Big number. It caught my attention.

Norwich was a residential mortgage loan originator. It engaged in warehouse lending, a term that may sound mysterious but is really not. Here is what warehousing means in a lending context: 

• Norwich (call it the warehouse) borrows money, likely on a line of credit, to start the transaction. 
• The warehouse lends the money to a customer (in this case, a home buyer) in exchange for a promissory note. 
• The warehouse sells the promissory note to an investor. The money received from the sale is (almost certainly) deposited with the lender the warehouse itself borrowed the money from. 
• The lender does its calculations: how much is owed, how much interest is due and other charges, if any. It subtracts this amount from the amount deposited. Whatever is leftover is returned to the warehouse as gross profit (in this context called: mortgage fee income).

If you think about it, this is an inventory accounting of sorts, except that the inventory is money lent.

So, Norwich was a warehouse.

Liberty was Norwich’s primary lender. There were others, but let’s sidestep as they are not necessary to understand the tax issue at play.

Norwich had to design an accounting procedure for its mortgage fee income. It did the following: 

• First, all mortgage deposits were posted to Mortgage Fee Income.
• Second, the amounts kept by Liberty reduced Mortgage Fee Income.
• Third, Norwich would adjust Mortgage Fee Income to whatever Liberty said it was.
• Fourth, the difference was assumed to be Unsold Mortgages.

I get it, but Norwich should backstop its critical accounts.

Let’s see:

(1)  Cash

a.     Well, that is easy to backstop with a bank statement.

(2)  Loan payable to Liberty.

a.     Again: easy. Liberty should be able to tell them that number.

(3)  Unsold Mortgages.

a.     Liberty cannot help Norwich here, as these have not entered Liberty’s accounting system. They are off the radar as far as Liberty is concerned.

We have identified the weak spot in the accounting, as Unsold Mortgages are just a subtraction. Best practice would involve keeping detail – more or less, as required – to have a reality check on the running balance.

In 2014 Norwich started using new accounting software.

It could not reconcile certain accounts.

COMMENT: This is my shocked face.

Norwich contacted Liberty, who in turn provided detail and balances to help with reconciliations. One of those numbers was collateral held by Liberty to secure the line of credit. The collateral included everything, including loans in process or otherwise but not yet sold by Norwich.

If that sounds a lot like Norwich’s Unsold Mortgages account, that is because it is.

Liberty’s number was significantly less than Norwich’s – by over $7 million. Mind you, all this stuff was collateral for the line of credit. If the actual Unsold Mortgages balance was substantially less than previously reported, Norwich might be undercollateralized. The term for this is “out of trust,” and it could also cause problems for Liberty on the regulator side.

BTW Liberty did not initially believe that Norwich was correct or that the situation was urgent. Norwich tried repeatedly to schedule meetings with Liberty. Liberty in turn delayed, expecting nothing to be amiss.

We will fast forward through the banking side of this.

Norwich filed its claim of right refund – for $7.5 million – on its 2014 tax return.

The IRS denied the refund entirely.

You know this went to Court.

And the arguments are easy to predict:

Norwich: We had an unrestricted right to that income in prior years. It was not until 2014 that we discovered otherwise. Under claim of right, 2014 is the proper year for the deduction.

IRS: Everything here is a loan. Norwich issued loans. Norwich borrowed on loans. When originated loans were sold, Norwich in turn paid back its loans. Everything that happened here circles around loans of one type or another. The claim of right has nothing to do with loans.

Both sides had a point.

Here is the Court:

This, the Commissioner focuses on the origin of the funds rather than the origin of the transaction ….”

I agree. The business activity required extensive use of loans, but the intended result of all the loans was to generate a profit, not to maintain a loan into perpetuity.

The Court noted that everybody - including Liberty - thought that Norwich was entitled to the money when Norwich received it.

The repayment was also deductible as an ordinary and necessary business expense and was not barred by another Code section.

2014 was also the correct year for the deduction. It was the year Norwich found the error, which discovery was memorialized in paperwork between Norwich and Liberty. Norwich agreed to either (1) provide more collateral or (2) pay down its line of credit with Liberty.

The Court did tweak some numbers, but overall Norwich prevailed in its claim of right refund request.

Our case this time was Norwich Commercial Group v Commissioner, T.C. Memo 2025-43.

An S Corporation Nightmare

Over my career the preferred entities for small and entrepreneurial businesses have been either an S corporation or a limited liability company (LLC). The C corporation has become a rarity in this space. A principal reason is the double taxation of a C corporation. The C pays its own taxes, but there is a second tax when those profits are returned to its shareholders. A common example is dividends. The corporation has already paid taxes on its profits, but when it shares its profits via dividends (with some exception if the shareholder is another corporation) there is another round of taxation for its shareholders. This might make sense if the corporation is a Fortune 500 with broad ownership and itself near immortal, but it makes less sense with a corporation founded, funded, and  grown by the efforts of a select few individuals – or perhaps just one person.

The advantage to an S corporation or LLC is one (usually - this is tax, after all) level of tax. The shareholder/owner can withdraw accumulated profits without being taxed again.

Today let’s talk about the S corporation.

Not every corporation can be an S. There are requirements, such as:

·       It cannot be a foreign corporation.

·       Only certain types of shareholders are allowed.

·       Even then, there can be no more than 100 shareholders.

·       There can be only one class of stock.

Practitioners used to be spooked about that last one.

Here is an example:

The S corporation has two 50% shareholders. One shareholder has a life event coming up and receives a distribution to help with expenses. The other shareholder is not in that situation and does not take a distribution.

Question: does this create a second class of stock?

It is not an academic question. A stock is a bundle of rights, one of which is the right to a distribution. If we own the same number of shares, do we each own the same class of stock if you receive $500 while I receive $10? If not, have we blown the S corporation election?

These situations happen repetitively in practice: maybe it is insurance premiums or a car or a personal tax. The issue was heightened when the states moved almost in concert to something called “passthrough taxes.” The states were frustrated in their tax collection efforts, so they mandated passthroughs (such as an S) to withhold state taxes on profits attributable to their state. It is common to exempt state residents from withholding, so the tax is withheld and remitted solely for nonresidents. This means that one shareholder might have passthrough withholding (because he/she is a nonresident) while another has no withholding (because he/she is a resident).

Yeah, unequal distributions by an S corporation were about to explode.

Let’s look at the Maggard case.

James Maggard was a 50% owner of a Silicon Valley company (Schricker). Schricker elected S corporation status in 2002 and maintained it up to the years in question.

Maggard bought out his 50% partner (making him 100%) and then sold 60% to two other individuals (leaving him at 40%). Maggard wanted to work primarily on the engineering side, and the other two owners would assume the executive and administrative functions.

The goodwill dissipated almost immediately.

One of the new owners started inflating his expense accounts. The two joined forces to take disproportionate distributions. Apparently emboldened and picking up momentum, the two also stopped filing S corporation tax returns with the IRS.

Maggard realized that something was up when he stopped receiving Schedules K-1 to prepare his personal taxes.

He hired a CPA. The CPA found stuff.

The two did not like this, and they froze out Maggard. They cut him off from the company’s books, left him out of meetings, and made his life miserable. To highlight their magnanimity, though, they increased their own salaries, expanded their vacation time, and authorized retroactive pay to themselves for being such swell people.

You know this went to state court.

The court noted that Maggard received no profit distributions for years, although the other two were treating the company as an ATM. The Court ordered the two to pay restitution to Maggard. The two refused. They instead offered to buy Maggard’s interest in Schricker for $1.26 million. Maggard accepted. He wanted out.

The two then filed S corporation returns for the 2011 – 2017 tax years.

They of course did not send Maggard Schedules K-1 so he could prepare his personal return.

Why would they?

Maggard’s attorney contacted the two. They verbally gave the attorney – piecemeal and over time – a single number for each year.

Which numbers had nothing to do with the return and its Schedules K-1 filed with the IRS.

The IRS took no time flagging Maggard’s personal returns.

Off to Tax Court Maggard and the IRS went.

Maggard’s argument was straightforward: Schricker had long ago ceased operating as an S corporation. The two had bent the concept of proportionate anything past the breaking point. You can forget the one class of stock matter; they had treated him as owning no class of  stock, a pariah in the company he himself had founded years before.

Let’s introduce the law of unintended consequences:

Reg 1.1361-1(l)(2):

Although a corporation is not treated as having more than one class of stock so long as the governing provisions provide for identical distribution and liquidation rights, any distributions (including actual, constructive, or deemed distributions) that differ in timing or amount are to be given appropriate tax effect in accordance with the facts and circumstances.

Here is the Tax Court:

… the regulation tells the IRS to focus on shareholder rights under a corporation’s governing documents, not what the shareholders actually do.”

That makes sense if we were talking about insurance premiums or a car, but here … really?

We recognize that thus can create a serious problem for a taxpayer who winds up on the hook for taxes owed on an S corporation’s income without actually receiving his just share of distributions.”

You think?

This especially problematic when the taxpayer relies on the S corporation distributions to pay these taxes.”

Most do, in my experience.

Worse yet is when a shareholder fails to receive information from the corporation to accurately report his income.”

The Court decided that Maggard was a shareholder in an S corporation and thereby taxable on his share of company profits.

Back to the Court:

The unauthorized distributions in this case were hidden from Maggard, but they were certainly not memorialized by … formal amendments to Schricker’s governing documents. Without that formal memorialization there was no formal change to Schricker’s having only class of stock.”

I get it, but I don’t get it. This reasoning seems soap, smoke, and sophistry to me. Is the Court saying that – if you don’t write it down – you can get away with anything?      

Our case this time was Haggard and Szu-Yi Chang v Commissioner, T.C. Memo 2024-77.

 

Patents, Capital Gains and Hogitude

I have an acquaintance who has developed several patents.  He works for a defense contractor, so I suspect he has more opportunity than a tax CPA.

COMMENT: Did you know that tax advisors have tried to “patent” their tax planning? I suppose I could develop a tax shelter that creates partnership basis out of thin air and then pop the shelter to release a gargantuan capital loss to offset a more humongous capital gain…. Wait, that one has already been done. Fortunately, Congress passed legislation in 2011 effectively prohibiting such nonsense.

Let’s say that you develop a patent someday. Let’s also say that you have not signed away your rights as part of your employment package. Someone is now interested in your patent and you have a chance to ride the Money Train. You call to ask how about taxes.

Fair enough. It is not everyday that one talks about patents, even in a CPA firm.

Think of a patent as a rental property. Say you have a duplex. Every month you receive two rental checks. What type of income do you have?

You have rental income, which is to say you have ordinary income. It will run the tax brackets if you have enough income to make the run.

Let’s say you sell the duplex. What type of income do you have?

Let’s set aside depreciation recapture and all that arcana. You will have capital gains.

People prefer capital gains to ordinary income. Capital gains have a lower tax rate.

Patents present the same tax issue as your duplex. Collect on the patent - call it royalties, licensing fees or a peanut butter sandwich – and you have ordinary income. You can collect once or over a period of time; you can collect a fixed amount, a set percentage or on a sliding rate scale. It is all ordinary income.

Or you can sell the patent and have capital gains.

But you have to part with it, same as you have to part with the duplex. 

Intellectual property however is squishier than real estate, which make sense when you consider that IP exists only by force of law. You cannot throw IP onto the bed of a pickup truck.

Congress even passed a Code section just for patents:

§ 1235 Sale or exchange of patents.

(a)  General.

A transfer (other than by gift, inheritance, or devise) of property consisting of all substantial rights to a patent, or an undivided interest therein which includes a part of all such rights, by any holder shall be considered the sale or exchange of a capital asset held for more than 1 year, regardless of whether or not payments in consideration of such transfer are-

(1)  payable periodically over a period generally coterminous with the transferee's use of the patent, or (2) contingent on the productivity, use, or disposition of the property transferred.

The tax Code wants to see you part with “substantial rights,” which basically means the right to use and sell the patent. Limit such use – say by geography, calendar or industry line – and you probably have not parted with all substantial rights.

Bummer.

What if you sell to yourself?

It’s been tried, but good thinking, tax Padawan.

What if you sell to yourself but make it look like you did not?

This has potential. Your training is starting to kick-in.

Time to repeat the standard tax mantra:

pigs get fat; hogs get slaughtered

Do not push the planning to absurd levels, unless you are Google or Apple and have teams of lawyers and accountants chomping on the bit to make the tax literature.

Let’s look at the Cooper case as an example of hogitude.

James Cooper was an engineer with more than 75 patents to his credit. He and his wife formed a company, which in turn entered into a patent commercialization deal with an independent third party.

So far, so good. The Coopers got capital gains.

But the deal went south.

The Coopers got their patents back.

Having been burned, Cooper was now leery of the next deal. Some sharp attorney advised him to set up a company, keep his ownership below 25% and bring in “independent” but trusted partners.

Makes sense.

Mrs. Cooper called her sister to if she wanted to help out. She did. In fact, she had a friend who could also help out.

Neither had any experience with patents, either creating or commercializing them.

Not fatal, methinks.

They both had full-time jobs.

So what, say I.

They signed checks and transferred funds as directed by the accountants and attorneys.

They did not pursue independent ways to monetize the patents, relying almost exclusively on Mr. Cooper.

This is slipping away a bit. There is a concept of “agency” in the tax Code. Do exactly what someone tells you and the Code may consider you to be a proxy for that someone.

Maybe the tax advisors should wrap this up and live to fight another day.

The sister and her friend transferred some of the patents back to Cooper.

Good.

For no money.

Bad.

The sister and her friend owned 76% of the company. They emptied the company of its income-producing assets, receiving nothing in return. Real business owners do not do that. They might have a career in the House of Representatives, though.

Meanwhile, Cooper quickly made a patent deal with someone and cleared six figures.

This mess wound up in Tax Court.

To his credit, Cooper argued that the Court should just look at the paperwork and not ask too many questions. Hopefully he did it with aplomb, and a tin man, scarecrow and cowardly lion by his side.

The Tax Court was having none of his nonsense about substantial rights and 25% and no-calorie donuts.

The Court decided he did not meet the requirements of Section 1235.

The Tax Court also sustained a “substantial understatement” penalty. They clearly were not amused. 

Cooper reached for hogitude. He got nothing.