No Tax On Social Security

 

Is not. 

For decades, social security benefits were not taxable at all. 

This changed with the Social Security Amendment of 1983, with the intent to shore up the social security trust fund. Beginning in 1984, if one’s income exceeded certain stairsteps ($25,000 for singles and $32,000 for marrieds), then benefits could be up to 50% taxable. 

Flip the calendar and The Omnibus Budget Reconciliation Act of 1993 raised the taxable portion up to 85% and added two more stairsteps ($34,000 for singles and $44,000 for marrieds). 

COMMENT: The taxation of social security is Congressional pratfall. There are two separate calculations here. The first calculation starts taxing benefits at $25,000 (for singles; $32,000 for marrieds) up to 50 percent. If your income keeps going, then you hit the second stairstep ($34,000 for singles; $44,000 for marrieds) up to 85%. Fall in between these two phaseout zones and you may want to use software to prepare your return. 

COMMENT: BTW, Congress has never inflation-adjusted those 1984 or 1993 dollars. 

No tax on social security became a political slogan during the presidential election. I have heard the phrase repeated since then, but it is not accurate. 

It would be more accurate to describe it as an age-based deduction. 

Take a look at the tax provision in its feral state:

 

SEC. 70103. TERMINATION OF DEDUCTION FOR PERSONAL EXEMPTIONS OTHER THAN TEMPORARY SENIOR DEDUCTION

 

(a)(3)(C) Deduction for seniors

 

(i)                   In general.—In the case of a taxable year beginning before January 1, 2029, there shall be allowed a deduction in an amount equal to $6,000 for each qualified individual with respect to the taxpayer.

(ii)                Qualified individual.—For purposes of clause (i), the term ‘qualified individual’ means—

(I)                  the taxpayer, if the taxpayer has attained age 65 before the close of the taxable year, and

(II)                in the case of a joint return, the taxpayer’s spouse, if such spouse has attained age 65 before the close of the taxable year.

(iii)               Limitation based on modified adjusted gross income.

(I)                  In general.—In the case of any taxpayer for any taxable year, the $6,000 amount in clause (i) shall be reduced (but not below zero) by 6 percent of so much of the taxpayer’s modified adjusted gross income as exceeds $75,000 ($150,000 in the case of a joint return).

(II)                (II) Modified adjusted gross income.—For purposes of this clause, the term ‘modified adjusted gross income’ means the adjusted gross income of the taxpayer for the taxable year increased by any amount excluded from gross income under section 911, 931, or 933.

(iv)               Social security number required.

(I)                  In general.—Clause (i) shall not apply with respect to a qualified individual unless the taxpayer includes such qualified individual’s social security number on the return of tax for the taxable year.

(II)                Social security number.—For purposes of subclause (I), the term ‘social security number’ has the meaning given such term in section 24(h)(7).

(v)                 Married individuals.—If the taxpayer is a married individual (within the meaning of section 139, this subparagraph shall apply only if the taxpayer and the taxpayer’s spouse file a joint return for the taxable year.”

What do I see? 

•  There is no mention of social security benefits.
•  There is no mention, in fact, of retirement income at all.
•  You do have to be at least age 65 to qualify.
•  The deduction is (up to) $6,000 per qualifying individual.
•   Make too much money ($75,000 for singles and $150,000 for marrieds) and you start losing the deduction. The deduction phases-out completely at $150,000 (singles) and $250,000 (marrieds).
•  If you are married, you must file jointly. Married filing separately will not work here.
• The only mention of social security is that one must include one’s social security number on the tax return, otherwise the IRS will consider it a math error and send you a bill for taxes due.

What do I not see?

• No tax on social security.

I get it: for many if not most people, social security benefits would not have been taxable anyway because of the stairsteps, the increased standard deduction and the additional standard deduction for taxpayers age 65 and over. I would prefer that we use the English language with more precision, but such is not our fate. 

We didn’t even mention the insolvency of the social security system itself. 

Take advantage if you can, as the deduction has a shelf life of only four years. Granted, a future Congress can extend (and re-extend) this deduction ad infinitum, but I suspect that will not happen here.

 

Losing A Tax Exemption

The taxation of tax-exempts can sometimes be tricky.

The reason is that a tax-exempt can – depending on the facts – owe income tax. This type of income is referred to as unrelated business income, and the tax issue developed because Congress did not want tax-exempts to mimic the activities of for-profit companies while not paying tax.

There are certain areas – such as permitting third-party use of membership data – that can trigger the unrelated business tax.

Another would be the rental of real estate with associated indebtedness.

The organization will owe tax on these activities.

Then there is the worst-case scenario: the revocation of the tax-exempt status itself. Think Elon Musk putting Tesla in a 501(c)(3) – the IRS is going to blow-up that arrangement.

Let’s discuss a recent case that walked the revocation ledge.

There is an organization in New York. It is open to seniors from age 55 to 90. To become a member a senior must submit an application and application fee. 

It appears to have four principal activities:

·      To provide burial benefits for members and assistance to surviving family

·      To provide information and referrals to seniors regarding burial as well as general concerns

·      To provide organized activities for senior citizens

·      To provide annual scholarships to needy, promising students

The organization charges fees as follows:

·      An application fee of $100 for seniors age 55 to 70

·      An application fee of $150 for seniors age 71 to 90

·      A $30 annual fee

·      A $10 fee every time a member dies

It doesn’t appear unreasonable to me.

There was an interesting and heartwarming twist to their activities: the organization would pay a separate amount directly to the family of a deceased member, pursuant to a Korean tradition. The organization paid, for example, $11 thousand directly to a funeral home and over $3,200 to the family of a deceased member.

Since we are talking about them, you know that the organization went to audit.

The IRS wanted to revoke their tax-exempt status.

Why?

The is an over-arching requirement that a tax-exempt be operated “exclusively” for an exempt purpose. There is some latitude in the “exclusive” requirement, otherwise de minimis and silly stuff could cost an organization its exemption.

Still, what did the IRS see here?

The first is that benefits were available only to members.

COMMENT: The organization had expressed an intent to include nonmembers, but as of the audit year that goal remained aspirational.

OBSERVATION: The organization had told the IRS of its intent to include nonmembers when it requested exempt status. Upon audit and failure to find nonmember benefits, the IRS argued that the organization had failed to operate in the manner it had previously represented to the IRS. 

Second is that a member was required to pay dues. In fact, if a member failed to pay dues for 90 days after receiving written notice, the organization could terminate the membership and – with it – the requirement to pay any burial benefits.

COMMENT: Sounds a bit like an insurance company, doesn’t it?

Third is that the amount of burial benefits was based on the number of years the deceased had been a member. A member of 12 years would receive more than a member of 5 years.

The IRS brought big heat. The organization was organized in 1996, applied for exempt status in 1998 and was being audited for 2013.

OK, a reasonable number of years had passed since receiving exempt status.

The organization had reported over $2.3 million in revenues on their Form 990.

Sounds to me like they were doing well.

In 2008 they bought a condominium, paying over $800 grand.

Oh, oh.

You can begin to understand where the IRS was coming from. As operated, the organization was looking like a small insurance company. It was accumulating a bank balance; it had bought real estate. The IRS wanted to see obvious charitable activities. If the organization could swing $800 grand on a condo, then they could shake loose a few dollars and waive dues for someone who was broke. They were operating dangerously close to a private club. That is fine, but do not ask for (c)(3) status.

The organization had a remaining argument: there was no diversion of earnings or money. There couldn’t be, as no benefits occurred until someone passed away.

The Court however separated this argument into two parts:

(1)  The earnings and assets of the organization cannot inure (that is, return to) to a member.

The organization successfully argued this point.

(2)  There must be no private benefit.

This makes more sense if one flips the wording: there must be a public benefit. The Court did not see a public benefit, as the organization was not providing benefits to nonmembers or allowing for reduction or abatement of dues for financial need. Not seeing a public benefit, the Court saw a private benefit.

The organization was operating in a manner too close to a for-profit business, and it lost its tax-exempt status.

I get the technical issues, but I do not agree as vigorously as the Court that there was that much private benefit here. Society has an interest in promoting the causes and issues of senior citizens, and the organization – in its own way – was helping. By aiding seniors with government agencies, it was reducing the strain on social services. By assisting seniors with planning and paying for funeral services, it was reducing costs otherwise defaulting to the municipality.

One would have preferred a warning, an opportunity for the organization to right its course, so to speak. What happened instead was akin to burning down the bridge.  

Still, that is how issues in this area go: one is working on a spectrum. The advisor has to judge whether one is on the safe or the non-safe side of the spectrum.

The Court decided the organization had wandered too far to the non-safe side.

Our case this time was The Korean-American Senior Mutual Association v Commissioner.