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.

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.

 

Creating A Tax Practice

 

It has been a couple of months on the blog.

I have been helping a friend and fellow CPA, at least as much as I could.

He is approaching retirement. He sold his practice to a larger firm. I remember talking with him about it:

Him:  What do you think?

CTG: I see the Federation and the Borg. What is your win condition here?

Him:  Yes, but ….

A rationalization that begins with “yes, but” should be a sign that you are about to buy real estate in the dark.

It has gone poorly. Zero surprise. The Borg are like that.

It was a clash of cultures: entrepreneurial versus bureaucratic, advisory versus compliance, real fees versus “valued added.”

He will survive. He may yet be able to retain several clients, reopen an office, and resume practice. He however will never be the same. 

His story has given me pause.

It also reminds me of someone who recently applied for tax-exempt status with the IRS.

More specifically, 501(c)(4) status.

As we have discussed before, Section 501 is the master key - so to speak – to tax-exempt status. The gold standard is 501(c)(3), which is both tax-exempt and contributions to which are tax deductible. That is about as good as it gets. The (c)(4) is a different beast: it is tax-exempt but contributions are not tax deductible. Why the difference? A (c)(4) frequently has an active advocacy role: think AARP, for example. That advocacy can rise to the level that it equals – or exceeds – the nonprofit motivation behind the organization.

Someone had the idea to form a tax practice as a nonprofit.

The nonprofit employs tax professionals licensed as attorneys, CPAs, enrolled agents and tax preparers with years of experience practicing worldwide taxation.”

How will it generate revenues?

The Corporation is a full-time tax service company supported by memberships and donations.”

How does this thing work?

There is a three-tier membership-based structure.

The first tier includes US taxpayers having hardship. The organization will charge per hour for complicated cases but not charge for simple cases.

The second tier is membership-based. One pays X dollars and receives comprehensive tax services.

The third tier is gauzy “feet on the ground” personnel including support volunteers.

I am not seeing it. Tier one is fee-based except for some pro bono work. Tier two is a flat-out copy of a boutique medical practice. I do not even know what tier three is, other than some filler when completing the tax-exempt application.

Why would someone go through this effort?

One of the main reasons for you to apply for the tax-exempt status is to meet the requirements established by TAS (Taxpayer Advocate Service) to be eligible for LITC (Low Income Tax Clinic) grants.”

Ahhh!

Along with one of your Board members personal investment and professional involvements, you have already generated the interest of several high-net-worth prospective donors.”

Methinks we found the motivation here.

The IRS saw it too:

The benefits provided by you are primarily for your paying members and you operate in a manner like organizations operated for profit. Thus, you are not operated exclusively for the promotion of social welfare within the meaning of Section 501(c)(4).”

BTW this is referred to as an “adverse determination” by the IRS. If a practitioner is aware that the IRS will come in adverse, it is not uncommon to withdraw the application. It allows the opportunity to fight another day.

The taxpayer did not withdraw in this case, and the adverse determination was issued as final.

Does this mean that the taxpayer cannot operate an organization with the pro bono and boutique fees and whatever feet-on-the-ground? Of course not. It just means that it will have to file and pay taxes – just like any other profit-seeking business.

What it cannot do is pretend to be tax-exempt.

This time we discussed IRS TEGE Release Number 202539014 dtd 9.26.25.