The Stealth Tax On Your Social Security

Social security benefits first became taxable in 1983.

The law was relatively straightforward:

·        Half of one’s social security became taxable as adjusted gross income exceeded

o   $32,000 for marrieds filing jointly,

o   $25,000 for everyone else, except for

o   Marrieds filing separately, whose threshold was zero (-0-)

Clearly the tax law frowned on married social security recipients filing separately.

The Senate Finance Committee Report commented on why any social security was being taxed at all:

… by taxing social security benefits and appropriating these revenues to the appropriate trust funds, the financial solvency of the social security trust funds will be strengthened.”

Uh, sure.

In 1993 Congress laid a second grid on top of the 1983 law:

·        85% of one’s social security as adjusted gross income exceeded

o   $44,000 for marrieds filing jointly

o   $34,000 for everyone else, except for

o   Marrieds filing separately, whose threshold remained at zero (-0-)

Depending on where one is income-wise, part of one’s social security can be taxed at 50% and another part at 85%. Make enough and a clawback kicks-in: all your social security will be taxable at 85%.

Seems a bit complicated for a tax provision that snags ordinary people.

So in 1983, if you were married, filing joint and your income was less than $32 grand, your social security was not taxed.

I was curious: what is the equivalent of $32,000 of 1983 dollars in 2019?

Approximately $82 grand.

Wow!

I was also curious: how have the income thresholds for social security changed over three-plus decades?

Here are the thresholds for 2018:

·        $32,000/$25,000

·        $44,000/$34,000

They have not changed at all.

Meanwhile you need almost three 2019 dollars to equal one dollar from 1983.

So let me get this right.

IRA deductions are indexed for inflation. Gift taxes are indexed for inflation. The income thresholds for the new 20% passthrough deduction are indexed for inflation.

But the tax on social security is not.

What a nice gimmick. Even if you started out below the tax threshold, inflation over time would probably put you above the tax threshold.

The cynicism from our politicians is stunning.

Data Security And Your Tax Preparer

I annually reflect on what was unique about every tax season, other than this is a difficult profession. I can understand why accounting graduates increasingly dismiss public accounting as a career choice.

I am concerned with the increasing concentration of confidential information in an accounting office.

We have always had your name, address, birthdate and social security number.

Right there is big bucks to an Eastern European identity thief.

Riding the best-intentions train, you now have states – Tennessee comes to mind – that will not allow you to pay their (Hall) tax with a check. No sir, you have to have that bad boy drafted against your bank account. I understand Tennessee’s position – it is cheaper than handling a check – but I do not care about their position. How dare they coerce you to make it convenient for them to Soprano your money. If it is so much trouble, then stop taking the money!

You have no choice with those states.

So we have your bank information.

We now have additional “identity theft” safeguards. For example, some states require driver’s license information before you can file your return. Wow, I now have a copy of your driver’s license. And your spouse’s, if you are married.

Seems the government has shifted data protection responsibility to your friendly neighborhood tax preparer.

I did not want your data. I still don’t want it, but there it is - on my server.

Which can be carried away in an instant.

How hard would it be for someone to take down my office door, walk to the server, pull out all the wires and walk out with the thing?

And their goes your name, address, birth date, social security number, bank account information, driver’s license, those of your spouse and children, and who knows what else.

Identity thieves are spending way too much time hacking into Target and other major corporations.

It would be easier to break into CPA offices across the fruited plain. One person. One server. Repeat. You could probably knock out a dozen or two in a day.

Thank heavens our government is standing guard over all CPA firm servers in all the offices in all the cities across the land. 

Otherwise we would have reason to be concerned.

Diabetes, Disability And A Penalty

I have a friend who damaged his back, leading to nerve complications which have greatly affected his ability to work. Granted, he can still work, but not with the same intensity as before and certainly not for as many continuous hours. Sometimes by midday he has to take pain medications, which tend to knock him out. It is an unfortunate cycle, and the impact on his earning power is significant.

Let’s talk about disability. Then let’s talk about a disability exception to a penalty.

First, is disability income taxable or nontaxable?

Let’s confine this discussion to a disability policy purchased from an insurance company, omitting coverage from workers compensation and social security. There is a rule of thumb that is very important when thinking about disability insurance:

If you deducted the insurance, then payments under the insurance are taxable.

Let’s say that you purchased a short-term disability policy through your cafeteria plan. Amounts run through a cafeteria plan are generally not taxable to you. That is the point of the cafeteria, after all. Collect on the policy, however, and you trigger the above rule.

As a consequence, just about any financial or tax advisor will tell you to pay for disability insurance with after-tax dollars. The issue becomes even more important when purchasing long-term disability, as you would be permanently disabled (however defined) should you collect. You do not need the tax burden at the same time that your earning power is compromised.

You may recall that there is a 10% penalty if you take monies out of your 401(k) or IRA early. Early has different meanings, depending upon whether it is an IRA (or IRA-based) plan or a qualified plan. You can take money from a 401(k) at age 55 without penalty, for example, if you no longer work for the employer. An IRA does not care about your employer, but it does make you wait instead to age 59 ½. Take a distribution before those ages and you are likely facing a penalty.

But there is an exception to the 10% penalty if you get disabled.

Let’s say that you are injured enough to collect disability. Will that count for purposes of avoiding the 10% penalty?

You would think so, right?

Let’s talk about the Trainito case.

Trainito worked with the Boston Department of Environmental Health (DEH).  He was diagnosed with type 2 diabetes in 2005. He unfortunately did not take good care of himself, and he had continuous and increasing issues with neuropathy. He worked for DEH until October 2010, when he resigned due to the diabetes. He did not pursue disability benefits from DEH. Perhaps they did not offer such benefits.

Then he stopped taking his meds.

Fast forward six months. Trainito took a retirement distribution of over $22 thousand in April 2011.

Two months later he was found at his home in a diabetic coma. He was taken to a hospital where he spent more than a month recuperating, leaving the hospital in late July 2011. Damage was done, and he had reduced use of an arm and leg. He then applied for disability benefits with the state.

When preparing his return for 2011 he claimed the disability exception to the 10% penalty on the retirement distribution. The IRS disagreed, and the two found themselves in Tax Court.

The Code section at play is Sec 72(m)(7):

            (7) Meaning of disabled

For purposes of this section, an individual shall be considered to be disabled if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration. An individual shall not be considered to be disabled unless he furnishes proof of the existence thereof in such form and manner as the Secretary may require.

On first reading, it seems to make sense. Introduce an attorney and a couple of non-immediate points appear:

(1) The disability must be “total.”

This is a rewording of “unable to engage in any substantial gainful…” This is not an insignificant requirement, as it does not look to one’s regular and primary employment.

Many private disability policies will find you disabled if you are unable to perform your own occupation. The IRS definition is much stricter, requiring one to be unable to reasonably perform almost any occupation. As a consequence, it is possible that someone may be considered disabled by his/her insurance company but not considered so by this section.

(2) The distribution must be attributable to the disability.

The clearest way to show this is to take the distribution after being medically adjudged as disabled. Trainito did not do that. It is extremely likely that he knew he was seriously compromised by his diabetes, but he had not obtained a medical signoff to that effect.

The question before the Court was whether the absence of that medical signoff was fatal. 

The Court acknowledged that “substantial gainful activity” can be impaired by progressive diseases, such as diabetes. The Court further clarified that the presence of an impairment (such as diabetes) does not necessarily mean that an individual is disabled as intended under Sec 72(m)(7).

COMMENT: Makes sense. Odds are we each know someone who is diabetic but has it under medical control.

Trainito provided the Court with the record of his six weeks in the hospital, from June through July, 2011.  He was in a coma for most of it.

The Court wanted records back to April, 2011, when Trainito took the distribution.

Trainito testified that he saw a primary care doctor twice a month after being diagnosed in 2005. He stopped that when he was no longer working at DEH.

The Court sniffed:

Thus the fact that petitioner suffered a diabetic coma on June 12, 2011 does not indicate whether he was disabled on April 22, 2011. Petitioner undoubtedly suffered from diabetes on April 22, 2011 but he has not provided sufficient evidence to show that his diabetes caused him to be disabled within the meaning of section 72(m)(7).”

This seems a bit harsh. There is a “duh” element considering that he has a progressive disease. Perhaps if Trainito had his doctor testify, perhaps if he introduced his earlier medical records …

But Trainito did not have his doctor testify nor did he provide his earlier medical records. Why? Who knows. I suspect there may have been a financial consideration, but the Court did not say. It is also possible that he thought his testimony, accompanied by his shortly-thereafter month-long coma, would be sufficient proof to the Court.

The Court concluded that Trainito did not meet test (2) above: he did not show that the distribution was attributable to the disability. Trainito owed the penalty.

What are my thoughts?

Sometimes tax is not just about Code sections and Regulations. Sometimes it is about facts and – more importantly – being able to prove those facts. I believe you when you tell me that you donated multiple rooms of furniture to charity when you moved, but you still need receipts and documentation. I believe you when you explain how you supported your children from a previous marriage, but I still need to review the divorce decree and related legal paperwork to determine whether you can claim the children as dependents.

The IRS told Trainito to “prove it.”

He didn’t.

Pilgrim's Pride, A Senator And Tax Complexity

The Democratic staff of the Senate Finance Committee published a report last month titled “How Tax Pros Make the Code Less Fair and Efficient: Several New Strategies and Solutions.”

I set it aside, because it was March, I am a tax CPA and I was, you know, working. I apparently did not have the time liberties of Congressional staffers. You know the type: those who do not have to go in when it snows. When I was younger I wanted one of those jobs. Heck, I still do.

There was a statement from Senator Wyden, the ranking Democrat senator from Oregon:

Those without access to fancy tax planning tools shouldn’t feel like the system is rigged against them. 

Sophisticated taxpayers are able to hire lawyers and accountants to take advantage of … dodges, but hearing about these loopholes make middle-class taxpayers want to pull their hair out.”

There is some interesting stuff in here, albeit it is quite out of my day-to-day practice. The inclusion of derivatives caught my eye, as that of course was the technique by which the presumptive Democratic presidential nominee transmuted $1,000 into $100,000 over the span of ten months once her husband became governor of Arkansas. It must have taken courage for the staffers to have included that one.

Problem is, of course, that tax advisors do not write the law.  

There are complex business transactions taking place all the time, with any number of moving parts. Sometimes those parts raise tax issues, and many times those issues are unresolved. A stable body of tax law allows both the IRS and the courts to fill in the blanks, allowing practitioners to know what the law intended, what certain words mean, whether those words retain their same meaning as one travels throughout the Code and whether the monster comes to life after one stitches together a tax transaction incorporating dozens if not hundreds of Code sections. And that is “IF” the tax Code remains stable, which is of course a joke.

Let’s take an example.

Pilgrim’s Pride is one of the largest chicken producers in the world. In the late 1990s it acquired almost $100 million in preferred stock from Southern States Cooperative. The deal went bad.  Southern gave Pilgrim an out: it would redeem the stock for approximately $20 million.

I would leap at a $20 million, but then again I am not a multinational corporation. There was a tax consideration … and it was gigantic.

You see, if Pilgrim sold then stock, it would have an $80 million capital loss. Realistically, current tax law would never allow it to use up that much loss. What did it do instead? Pilgrim abandoned the stock, meaning that it put it outside on the curb for big trash pick-up day.

Sound insane?

Well, the tax Code considered a redemption to be a “sale or exchange,” meaning that any loss would be capital loss. Abandoning the stock meant that there was no sale or exchange and thus no mandatory capital loss.

Pilgrim took its ordinary loss and the IRS took Pilgrim to Court.

Tax law was on Pilgrim’s side, however. Presaging the present era of law being whatever Oz says for the day, the IRS conscripted an unusual Code section – Section 1234A – to argue its position.

Section 1234A came into existence to address options and futures, more specifically a combination of options and futures called a straddle. . What options and futures have in common is that one is not buying an underlying asset but rather is buying a right to said underlying asset. A straddle involves both a sale and a purchase of that underlying asset, and you can be certain that the tax planners wanted one side to be capital (probably the gain) and the other side to be ordinary (probably the loss). Congress wanted both sides to be capital transactions (hence capital gains and losses) even though the underlying capital asset was never bought or sold – only the right to it was bought or sold.

This is not one of the easiest Code sections to work with, truthfully, but you get an idea of what Congress was after.

Reflect for a moment. Did Pilgrim have (A) a capital asset or (B) a right to a capital asset?

Pilgrim owned stock – the textbook example of a capital asset.

Still, what is stock but the right to participate in the profits and management of a company? The IRS argued that – when Pilgrim gave up its stock – it also gave up its rights to participate in the profits and management of Southern. Its relinquishment of these rights pulled the transaction into the ambit of Section 1234A.

You have to admit, there are some creative minds at the IRS. Still, it feels … wrong, doesn’t it? It is like saying that a sandwich and a right to a sandwich are the same thing. One you can eat and the other you cannot, and we instead are being wound in a string ball of legal verbiage.

The Tax Court agreed with the IRS.  Pilgrim appealed, of course. It had to; this was a $80 million issue. The Appeals Court has now overturned the Tax Court.

The Appeal Court’s reasoning?

A “right” is a claim to something one does not presently have. Pilgrim already owned all the rights it was ever going to have, which means that it could not have had a right as envisioned under Section 1234A.

The tax law changed after Pilgrim went into this transaction, by the way.

Do I blame the attorneys and accountants for arguing the issue? No, of course not. The fact that an Appeals Court agreed with Pilgrim means the tax advisors were right. The fact that the law was later changed means the IRS also had a point.

And none of the parties involved  – Pilgrim and its attorneys and accountants, the IRS , the Tax Court and the Appeals Court wrote the law, did they?

Although the way Congress works nowadays, they may have been the first ones to actually read the bill-become-law. There perhaps is the real disgrace.

Does An LLC Member Pay Self-Employment Tax?

There is an issue concerning LLCs that has existed for approximately as long as I have been in the profession. I am thinking about it because I recently finished a research memo which included this issue.

This time we are talking about limited liability companies (LLCs) and self-employment income. One pays self-employment tax on self-employment income, and the dollars can add up rather quickly.

The offending party is the following enchanting prose from Code section 1402(a)(13) addressing self-employment income:

           

… there shall be excluded the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in … "

We do not need degrees in taxation to zero in on the term “limited partner” as being the key to this car. If you are a limited partner you get to exclude “the distributive share” of something. Since the IRS wants you to pay tax on something, the less of that something is probably a good thing.

So what is a limited partner in this conversation?

We don’t know.

The above wording came from an IRS proposed Regulation in 1977. The IRS stirred such a hornet’s nest that Congress put a hold on the Regulation. The hold has long since expired, but the IRS has not wanted to walk back onto that hill. It has been 37 years.

To be fair, the playing field changed on the IRS.

Have you ever heard of the Estate of Ellsasser? Don’t worry if you haven’t, as I suspect that many tax CPAs have not. Let’s time travel back to 1976. In addition to Bob Newhart and the Carol Burnett Show, people were buying tax shelters. The shelters worked pretty well back then, long before the passive activity rules entered the game. One of those shelters used to provide one with self-employment income, on which one would pay self-employment – also known as social security – tax.

Doesn’t sound like much of a shelter, doesn’t it?

The purpose was to get social security credits for someone who had not worked, had not earned enough credits, or had not earned enough to maximize their social security benefits.

The IRS did not like this at all, because at the time it was concerned with people taking advantage of social security. That was before our government decided to bankrupt us all, which act has now switched to the IRS demanding money from anyone foolish enough to make eye contact.

You see, in those days, there were entities known as “limited partnerships” in which a general partner made all the decisions and in return the limited partners got regular checks. A limited partner had little or no sway over the management of the place. It was an investment, like buying IBM or Xerox stock. There was no way the IRS was going to let a limited partner buy social security credits on the back of a limited partnership investment. No sir. Go get a job.

Fast forward about twenty years. There is a new sheriff in town, and that sheriff is the limited liability company (LLC). The states had created these new toys, and their claim to fame is that one could both work there and limit one’s liability at the same time. Unheard of! A limited partnership could not do that. In fact, if a limited partner started working at the place he/she would lose the protection from partnership liabilities. No limited partner was going to do that voluntarily.

And there you have a tax Regulation written in the 1970s referencing a “limited” partner. Twenty years later something new appears “limiting” one’s exposure to entity liabilities, but not being at all what the IRS had in mind two decades before.

And so the question became: does an LLC member have to pay self-employment tax?

And the issue has recently compounded, because there is also a new ObamaCare tax (the additional Medicare tax of 0.9%) which applies to …. wait on it… self-employment income. Yep, it applies to something the IRS cannot even define.

And then you have tax professionals trying to work with this nonsense. We do not have the option of putting the issue on the shelf until the baby is old enough to go to college. We have to prepare tax returns annually.

So I was looking at something titled “CCA 201436049.” It is nowhere as interesting as the final season of Sons of Anarchy, but it does touch upon our magic two words from the 1970s.

BTW, a “CCA” is a “Chief Counsel Advice” and represents an internal IRS document. It cannot be cited or used as precedence, but it gives you a VERY GOOD idea of what the IRS is thinking.

In our CCA, there is company that manages mutual funds. The management company used to be an S corporation and is now an LLC. The members of the management company pretty much do all the investment activity for the mutual funds, and the management company gets paid big bucks. The management company in turn pays its members via a W-2 and then “distributes” the remaining profit to them. The members pay social security on the W-2 (same as you or I) but not on the distributive share.

OBSERVATION: For the tax purist, a partnership is not allowed to pay its partner a W-2. The reason is that a partner in a partnership is considered to be self-employed, and self-employed people do not receive W-2s. LLCs have thrown a wrench into practice, however, and it is not uncommon to see an LLC member receive a W-2.

To get a CCA, the taxpayer has to be in examination. An IRS person in the field requests direction on how to handle an issue. The issue here is whether that distributive share should be subject to self-employment tax or not. A CCA is therefore like giving instructions to IRS examiners in the field.

The IRS goes through the same tax history we talked about above, and it is very skeptical that just “limiting” someone’s liability was the intent of the 1970s Regulation. It goes on to take a look at two recent cases.

In Renkemeyer, the Tax Court determined that lawyers within a law practice did not fit the “limited partner” exception, especially since they were actively working, something a 1970s “limited partner” could not do. They had to pay self-employment taxes on their distributive income.

In Reither the taxpayer issued W-2s and argued that that was sufficient to keep the rest of the distributive income from being subject to self-employment tax. The District Court made short work of the argument, primarily because there is no statutory support for it.

So … surprise, surprise… the CCA determined that the management company’s distributive share was subject to self-employment tax.

By itself, this is not surprising. What I did notice is that the IRS is paying more attention to this issue, and it is winning its cases. How much longer can it be before Congress finds this “new” source of tax revenue?

Granted, I think the odds of any meaningful tax legislation between Congress and this White House to be close to zero. There will be at least a couple of years.  That said, I suspect that tax planners have only so many years left to ramp this car onto the interstate before Congress takes our keys away.