A Lesser Known Statute Of Limitations

The last time I checked, IRS Appeals personnel count was down by approximately 20% and – no surprise – getting a case through Appeals is taking over a year.

There is danger – and potentially an immediate one – to taxpayers and tax advisors.

Take a look at this cheerful composition:

26 U.S. Code § 6532 - Periods of limitation on suits

(1) General rule

No suit or proceeding under section 7422(a) for the recovery of any internal revenue tax, penalty, or other sum, shall be begun before the expiration of 6 months from the date of filing the claim required under such section unless the Secretary renders a decision thereon within that time, nor after the expiration of 2 years from the date of mailing by certified mail or registered mail by the Secretary to the taxpayer of a notice of the disallowance of the part of the claim to which the suit or proceeding relates.

(2) Extension of time

The 2-year period prescribed in paragraph (1) shall be extended for such period as may be agreed upon in writing between the taxpayer and the Secretary.

(3) Waiver of notice of disallowance

If any person files a written waiver of the requirement that he be mailed a notice of disallowance, the 2-year period prescribed in paragraph (1) shall begin on the date such waiver is filed.

(4) Reconsideration after mailing of notice

Any consideration, reconsideration, or action by the Secretary with respect to such claim following the mailing of a notice by certified mail or registered mail of disallowance shall not operate to extend the period within which suit may be begun.

We see the following:

The IRS has 6 months to respond to a claim for refund. If no response is forthcoming within that time, the taxpayer can sue for refund, as long as the suit or proceeding occurs within the two-year period beginning with the date the IRS formally disallowed the claim.

What if the IRS never responds to the claim? Your tax advisor (CPA or attorney) will likely recommend you file suit within 2 years from filing the claim. If you file, a tax CPA will hand you off to a tax attorney. A tax CPA can do a lot, but one must be a member of the bar to litigate.

What happens if you miss the Section 6532 deadline?

Let’s look at this next artful arrangement:

26 U.S. Code § 6514 - Credits or refunds after period of limitation

(a) Credits or refunds after period of limitation

A refund of any portion of an internal revenue tax shall be considered erroneous and a credit of any such portion shall be considered void—

(1) Expiration of period for filing claim

If made after the expiration of the period of limitation for filing claim therefor, unless within such period claim was filed; or

(2) Disallowance of claim and expiration of period for filing suit

In the case of a claim filed within the proper time and disallowed by the Secretary, if the credit or refund was made after the expiration of the period of limitation for filing suit, unless within such period suit was begun by the taxpayer.

(3) Recovery of erroneous refunds

For procedure by the United States to recover erroneous refunds, see sections 6532(b) and 7405.

(b) Credit after period of limitation

Any credit against a liability in respect of any taxable year shall be void if any payment in respect of such liability would be considered an overpayment under section 6401(a).

Section 6514(a)(2) can be brutal: the IRS is prohibited from issuing the refund unless within such period suit was begun by the taxpayer.

Oh, this is all big corporate tax stuff, you say. Unless your name is Apple or Nvidia, can this ever reach you?

Yepper.

What if you filed for an ERC (employee retention credit) and (1) have never heard back from the IRS or (2) did hear back but the IRS disallowed the claim? The IRS has been using Letter 105C (if they disallowed the ERC claim in full) or Letter 106C (if they partially disallowed the claim). A 105C letter will include language like this:

         

There is the disallowance language that Sections 6532 and 6514 allude to.

When was the IRS sending out these letters?

After running ERC claims through a risk-scoring algorithm, the IRS sent out approximately 28,000 letters 105C and 106C during the summer of 2024. If the taxpayer responded (to the 105C or 106C), the IRS would then conduct an mini-audit before sending the file to Appeals.

2024 plus 2 years equals 2026 – your two-year statute of limitations is coming up.

Is there a way to avoid filing in Court but still preserve your rights to a refund?

Yes. Let’s go back to Section 6532(a)(2).

There is a form that goes with it.

  

Here is the Internal Revenue Manual on Form 907:

On first impression, I like the Form 907 option. What more do we need to know about it?

(1)  First, you are still within Section 6532, so this must be done within the 2-year window.

(2)  Both parties – you and the IRS – must sign Form 907.

(3)  If the case is being actively worked, the Revenue Agent or Appeals Officer can hopefully help obtain the appropriate IRS signature.

But what if the case is not being actively worked?

There are several ways this can happen:

·      The file is lost (I had one lost in IRS Kansas City a few years ago; it held up a real estate closing).

·      You are waiting for the protest to be transferred to Appeals.

·      The protest has been transferred to Appeals but remains unassigned.

·      The protest was transferred and assigned but your AO is no longer working at the IRS. It again is … unassigned.

·      You never even filed a protest to either Letter 105C or 106C.

The IRS considers Form 907 to be an internal form, to be initiated by IRS employees. If you have settled on Form 907 and your back is to the wall on obtaining an IRS signature, consider the Taxpayer Advocate.

But give yourself breathing room. I suspect that trying to obtain an IRS signature on short notice – whether actively worked or not, assigned or unassigned – will prove futile.

You might have to file suit to preserve the claim.

 

Proving A Timely Tax Filing

 

I admit that I am biased, but I am not a fan of filing late tax returns.

Call it Murphy’s Law:

If anything can go wrong, it will.”

I am looking at a Tax Court order. An order takes place while the case is at trial. Somebody makes a motion, the Court reviews and decides. That decision is called an order, and they are common.

The IRS filed a motion that it sent a timely Notice of Deficiency to a taxpayer.

COMMENT: A Notice of Deficiency (also called a 90-day letter, a NOD or SNOD) is the IRS determining that you owe additional tax and wanting to reduce it to assessment. Why an assessment? For one thing, the IRS (usually) has 3 years to examine and adjust your return. It has 10 years to collect an assessment. That alone is a powerful incentive.

There are rules, of course. The IRS has only so much time to send the SNOD, and you have only so much time to respond to it. In general, the IRS has three years from when you filed the return or when the return was originally due, whichever is later. There are exceptions. A key one, and one will talk about today, is if you never file a tax return.

Milton Thomas Roberts failed to file a timely return for 2014. He received a notice from the IRS in 2015 asking about it. In February 2016 he went to the post office and mailed four packages: two to the IRS and two to New York state.

COMMENT: He was filing his 2013 and 2014 taxes with the IRS and New York – hence four packages. He did so correctly: he used certified mail. Yes, it costs a few dollars, but – if you ever must prove the mailing – those are the best dollars you ever spent.

About a week later the IRS acknowledged receiving his 2013 return.

COMMENT: Having the benefit of hindsight, one wonders why the IRS did not confirm 2014. To his credit, Roberts went online and confirmed that all four packages had been delivered.

For 2016 through 2019 Robers received notices from the IRS about this tax year or that, but he never received a notice about 2014.

That changed in October 2019, when the IRS sent a notice saying it never received a 2014 return.

Roberts did not immediately respond.

In February 2020, the IRS issued a SNOD showing over $275 grand of tax due.

That caught his attention.

Roberts (re)prepared his 2014 return and sent it to the IRS on or around June 2020. It showed adjusted gross income of $587 grand and a small refund of $804.

What happened to his copy of the original 2014 sent in 2016?

No idea.

Having attracted unwanted attention, Roberts was now audited for 2014. The IRS issued a second SNOD in January 2022 for $79 grand in additional tax, along with the usual interest and penalties.

You already know they are in Tax Court. Both sides agree that Roberts filed a 2014 return. Roberts argues that he filed twice – once in 2016 and again in 2020. The IRS says: nay, nay; he filed only once and that was in June 2020.

Does it matter?

Oh, yes it does.

Remember that the IRS has three years (barring oddities) to adjust his return and assess additional taxes. Roberts asserts that he filed 2014 in February 2016. Add three years and the IRS had until February 2019 to adjust and assess.

Roberts received nothing from the IRS in 2019.

Roberts says the IRS is too late. The second SNOD is incorrect and without effect.

The IRS disagrees. They say they never received the 2014 return until June 2020. Add three years and they had until June 2023 to adjust and assess. They were easily within the window.

The IRS just filed a motion requesting the Tax Court to determine that 2014 was within the window and they had filed a correct and effective SNOD.

Judge Toro denied the motion.

Why?

There is enough doubt as to what happened. Roberts had certified mail receipts, confirmation from New York of receiving 2013 and 2014 returns, confirmation from the delivery company that all four packages had been delivered, as well as a conspicuous absence by the IRS for three ½ years concerning the 2014 tax year.

Judge Toro was not going to say that the IRS had proved their case.

Mind you, that does not mean that Roberts proved his case either.

It does mean that the case revolves on whether there was a 2014 filing in 2016.

The IRS usually has the upper hand in such matters.

But Roberts brings the receipts.

You may wonder: does the IRS sometimes lose returns?

Oh yes. They have done so with me. I remember one client specifically because it impacted a scheduled real estate closing. We resolved the matter, but it involved considerable time and stress.

I will be keeping an eye out for the resolution of the Roberts story.

My hunch: he will win.

But he is in Tax Court. He is not pro se, so he is paying for an attorney. And he will keep paying, as a motion has been decided but the case itself marches on.

Which makes me wonder: could he have avoided this by simply filing a timely tax return?

As I said, I am biased.

Our case (or motion, actually) this time is from Milton Thomas Roberts v Commissioner, Tax Court docket 7011-22.

Keeping Records For More Than Three Years

 

How long should you keep tax records?

We have heard that one should keep records for at least three years, as the IRS has three years to examine your return.

There is a lot of wiggle room there, however.

Let’s look at a wiggle that repeats with some frequency: a net operating loss (NOL) carryover.

An NOL occurs when a business’ tax deductions exceed its tax revenues.

I include the word “business” intentionally. Nonbusiness income - think interest, dividends, royalties – will not generate NOLs, unless you happen to own a bank or something. That would be rare, but it could happen.

An NOL is a negative (net) number from a business.

How does this negative number get on your personal return?

Several ways. Here is one: you own a piece of a passthrough business and receive a Schedule K-1.  

A passthrough normally does not pay taxes on its own power. Its owners do. If that passthrough had a big enough loss, your share of its loss might wipe out all the other income on your personal return. It happens. I have seen it.

You would go negative. Bingo, you have an NOL.

But what do you do with it?

The tax law has varied all over the place on what to do with it. Sometimes you could take it back five years. Sometimes two. Sometimes you could not take it back at all. What you could not take back you could take forward to future years. How many future years? That too has varied. Sometimes it has been fifteen years. Sometimes twenty. Right now, it is to infinity and beyond.

Let’s introduce Betty Amos.

Betty was a Miami CPA and restaurateur.  In the early 1980s she teamed up with two retired NFL players to own and operate Fuddruckers restaurants in Florida.

She wound up running 15 restaurants over the next 27 years.

She was honored in 1993 by the National Association of Women Business Owners. She was named to the University of Miami board of trustees, where she served as chair of the audit and compliance committee.

I am seeing some professional chops.

In 1999 her share of Fudddruckers generated a taxable loss. She filed a joint tax return with her husband showing an NOL of approximately $1.5 million.

In 2000 she went negative again. Her combined NOL over the two years was pushing $1.9 million.

Let’s fast forward a bit.

On her 2014 tax return she showed an NOL carryforward of $4.2 million.

We have gone from $1.9 to $4.2 million. Something is sinking somewhere.

On her 2015 tax return she showed an NOL carryforward of $4.1 million.

That tells me there was a positive $100 grand in 2014, as the NOL carryforward went down by a hundred grand.

Sure enough, the IRS audited her 2014 and 2015 tax years.

More specifically, the IRS was looking at the big negative number on those returns.

Prove it, said the IRS.

Think about this for a moment. This thing started in 1999. We are now talking 2014 and 2015. We are well outside that three-year period, and the IRS wants us to prove … what, specifically?

Just showing the IRS a copy of your 1999 return will probably be insufficient. Yes, that would show you claiming the loss, but it would not prove that you were entitled to the loss. If a K-1 triggered the loss, then substantiation might be simple: just give the IRS a copy of the K-1. If the loss was elsewhere – maybe gig work reported on Schedule C, for example - then substantiation might be more challenging. Hopefully you kept a bankers box containing bank statements, invoices, and other records for that gig activity.

But this happened 15 years ago. Should you hold onto records for 15 years?

Yep, in this case that is the wise thing to do.

Let me bring up one more thing. In truth, I think it is the thing that got Betty in hot water.

When you have an NOL, you are supposed to attach a schedule to your tax return every year that NOL is alive. The schedule shows the year the NOL occurred, its starting amount, how much has been absorbed during intervening years, and its remaining amount. The IRS likes to see this schedule. Granted, one could fudge the numbers and lie, but the fact that a schedule exists gives hope that one is correctly accounting for the NOL.

Betty did not do this.

Betty knew better.

Betty was a CPA. 

The IRS holds tax professionals to a higher standard.

BTW, are you wondering how the IRS reconciles its Indiana-Jones-like stance on Betty’s NOL with a three-year-statute-of-limitations?

Easy. The IRS cannot reach back to 1999 or 2020; that is agreed.

Back it can reach 2014 and 2015.

The IRS will not permit an NOL deduction for 2014 or 2015. Same effect as reaching back to 1999 or 2000, but it gets around the pesky statute-of-limitations issue.

And in the spirit of bayoneting-the-dead, the IRS also wanted penalties.

Betty put up an immediate defense: she had reasonable cause. She had incurred those losses before Carter had liver pills. Things are lost to time. She was certain that she carried numbers correctly forward from year to year.

Remember what I said about tax professionals? Here is the Court:

More significantly, Ms. Amos is a longtime CPA who has worked for high-profile clients, owned her own accounting firm, and been involved with national and state CPA associations. It beggars belief that she would be unaware that each tax years stands alone and that it was her responsibility to demonstrate her entitlement to the deductions she claimed.”

Yep, she was liable for penalties too.

Our case this time was Betty Amos v Commissioner, T.C. Memo 2022-109.

Are Minimum Required Distribution Rules Changing Again?

I wonder what is going on at the IRS when it comes to IRA minimum required distributions.

You may recall that prior law allowed for something called a “stretch” IRA.  The idea was simple, but planners and advisors pushed on it so long and so hard that Congress changed the law.

An IRA (set aside Roth IRAs for this discussion) must start distributing at some point in time. The tax Code tells you the minimum you must distribute. If you want more, well, that is up to you and the tax Code has nothing further to say.  The minimum distribution uses actuarial life expectancies in its calculation. Here is an example:

                   Age of IRA Owner            Life Expectancy

                            72                                    27.4

                            73                                    26.5

                            74                                    25.5

                            75                                    24.6                                        

Let’s say that you are 75 years old, and you have a million dollars in your IRA. Your minimum required distribution (MRD) would be:

                  $1,000,000 divided by 24.6 = $40,650

There are all kinds of ancillary rules, but let’s stay with the big picture. You have to take out at least $40,650 from your IRA.

President Trump signed the SECURE Act in late 2019 and upset the apple cart. The new law changed the minimum distribution rules for everyone, except for special types of beneficiaries (such as a surviving spouse or a disabled person).

How did the rules change?

Everybody other than the specials has to empty the IRA in or by the 10^th year following the death.

OK.

Practitioners and advisors presumed that the 10-year rule meant that one could skip MRDs for years 1 through 9 and then drain the account in year 10. It might not be the most tax-efficient thing to do, but one could.

The IRS has a publication (Publication 590-B) that addresses IRA distributions. In March, 2021 it included an example of the new 10-year rule. The example had the beneficiary pulling MRDs in years 1 through 9 (just like before) and emptying the account in year 10.

Whoa! exclaimed the planners and advisors. It appeared that the IRS went a different direction than they expected. There was confusion, tension and likely some anger.

The IRS realized the firestorm it had created and revised Publication 590-B in May with a new example. Here is what it said:

For example, if the owner dies in 2020, the beneficiary would have to fully distribute the plan by December 31, 2030. The beneficiary is allowed, but not required, to take distributions prior to that date.”

The IRS, planners and advisors were back in accord.

Now I am skimming the new Proposed Regulations. Looks like the IRS is changing the rules again.

The Regs require one to separate the beneficiaries as before into two classes: those exempt from the 10-year rule (the surviving spouse, disabled individuals and so forth) and those subject to the 10-year rule.

Add a new step: for the subject-to group and divide them further by whether the deceased had started taking MRDs prior to death. If the decedent had, then there is one answer. If the decedent had not, then there is a different answer.

Let’s use an example to walk through this.

Clark (age 74) and Lois (age 69) are killed in an accident. Their only child (Jon) inherits their IRA accounts.

Jon is not a disabled individual or any of the other exceptions, so he will be subject to the 10-year rule.

One parent (Clark) was old enough to have started MRDs.

The other parent (Lois) was not old enough to have started MRDs.

Jon is going to see the effect of the proposed new rules.

Since Lois had not started MRDs, Jon can wait until the 10^th year before withdrawing any money. There is no need for MRDS because Lois herself had not started MRDs.

OK.

However, Clark had started MRDs. This means that Jon must take MRDs beginning the year following Clark’s death (the same rule as before the SECURE Act). The calculation is also the same as the old stretch IRA: Jon can use his life expectancy to slow down the required distributions – well, until year 10, of course.

Jon gets two layers of rules for Clark’s IRA:

·      He has to take MRDs every year, and

·      He has to empty the account on or by the 10^th year following death

There is a part of me that gets it: there is some underlying rhyme or reason to the proposed rules.

However, arbitrarily changing rules that affect literally millions of people is not effective tax administration.

Perhaps there is something technical in the statute or Code that mandates this result. As a tax practitioner in mid-March, this is not my time to investigate the issue.  

The IRS is accepting comments on the proposed Regulations until May 25.

I suspect they will hear some.

Section 1202 Stock And A House Tax Proposal

I am not a fan of fickleness and caprice in the tax law.

I am seeing a tax proposal in the House Ways and Means Committee that represents one.

It has been several years since we spoke about qualified small business stock (QSBS). Tax practice is acronym rich, and one of the reasons is to shortcut who qualifies – and does not qualify – for a certain tax provision. Section 1202 defines QSBS as stock:

·      issued by a C corporation,

·      with less than $50 million in assets at time of stock issuance,

·      engaged in an active trade or business,

·      acquired at original issuance by an eligible shareholder in exchange for either cash or services provided, and

·      held for at least five years.

The purpose of this provision is to encourage – supposedly – business start-ups.

How?

A portion of the gain is not taxed when one sells the stock.

This provision has been out there for approximately 30 years, and the portion not taxed has changed over time. Early on, one excluded 50% (up to a point); it then became 75% and is now 100% (again, up to a point).

What is that point?

The amount of gain that can be excluded is the greater of:

·      $10 million, or

·      10 times the taxpayer’s basis in the stock disposed

Sweet.

Does that mean I sell my tax practice for megabucks, all the while excluding $10 million of gain?

Well, no. Accounting practices do not qualify for Section 1202. Not to feel singled- out, law and medical practices do not qualify either.

I have seen very few Section 1202 transactions over the years. I believe there are two primary reasons for this:

                 

(a)  I came into the profession near the time of the 1986 Tax Reform Act, which single-handedly tilted choice-of-entity for entrepreneurial companies from C to S corporations. Without going into details, the issue with a C corporation is getting money out without paying double tax. It is not an issue if one is talking about paying salary or rent, as one side deducts and the other side reports income. It is however an issue when the business is sold. The S corporation allows one to mitigate (or altogether avoid) the double tax in this situation. Overnight the S corporation became the entity of choice for entrepreneurial and closely-held companies. There has been some change in recent years as LLCs have gained popularity, but the C corporation continues to be out-of-favor for non-Wall Street companies. 

 

(b)  The sale of entrepreneurial and closely-held companies is rarely done as a stock purchase, a requirement for Section 1202 stock. These companies sell their assets, not their stock. Stock acquisitions are more a Wall Street phenomenon.

So, who benefits from Section 1202?

A company that would be acquired via a stock purchase. Someone like … a tech start-up, for example. How sweet it would have been to be an early investor in Uber or Ring, for example. And remember: the $10 million cap is per investor. Take hundreds of qualifying investors and you can multiply that $10 million by hundreds.

You can see the loss to the Treasury.

Is it worth it?

There has been criticism that perhaps the real-world beneficiaries of Section 1202 are not what was intended many years ago when this provision entered the tax Code.

I get it.

So what is the House Ways and Means Committee proposing concerning Section 1202?

They propose to cut the exclusion to 50% from 100% for taxpayers with adjusted gross income (AGI) over $400 grand and for sales after September 13, 2021.

Set aside the $400 grand AGI. That sale might be the only time in life that someone ever got close to or exceeded $400 grand of income.

The issue is sales after September 13, 2021.

It takes at least five years to even qualify for Section 1202. This means that the tax planning for a 2021 sale was done on or before 2016, and now the House wants to retroactively nullify tax law that people relied upon years ago.

Nonsense like this is damaging to normal business. I have made a career representing entrepreneurs and their closely-held businesses. I have been there – first person singular - where business decisions have been modified or scrapped because of tax disincentives. Taxing someone to death clearly qualifies as a business disincentive. So does retroactively changing the rules on a decision that takes years to play out. Mind you – I say that not as a fan of Section 1202.

To me it would make more sense to change the rules only for stock issued after a certain date – say September 13, 2021 – and not for sales after that date. One at least would be forewarned.   

Should bad-faith tax proposals like this concern you?

Well, yes. If our current kakistocracy can do this, what keeps them from retroactively revoking the current tax benefits of your Roth IRA?  How would you feel if you have been following the rules for 20 years, contributing to your Roth, paying taxes currently, all with the understanding that future withdrawals would be tax-free, and meanwhile a future Congress decides to revoke that rule - retroactively?

I can tell you how I would feel.

Wiping Out An Inherited IRA

I came across an unfortunate tax situation this week.

It has to do with IRAs and trusts.

More specifically, naming a trust as a beneficiary of an IRA.

This carried a bit more punch before the tax law change of the SECURE Act, effective for 2020. Prior to the change, best planning for an inherited IRA frequently included a much younger beneficiary. This would reset the required distribution table, with the result that the monies could stay in the IRA for decades longer than if the original owner had lived. This was referred to as the “stretch” IRA. The SECURE Act changed that result for most beneficiaries, and now IRAs have to distribute – in general – over no longer than 10 years. 

Trusts created a problem for stretch IRAs, as trusts do not have an age or life expectancy like people do. This led to something called the “look-through” or “conduit” trust, allowing one to look-through the trust to its beneficiary in arriving at an age and life expectancy to make the stretch work.

The steam has gone out of the conduit trust.

One might still want to use a trust as an IRA beneficiary, though. Why? Here is an example:

The individual beneficiary has special needs. There may be income and/or asset restrictions in order to obtain government benefits.

What is the point, you ask? Doesn’t the IRA have to distribute to the individual over no more than 10 years?

Well … not quite. The IRA has to distribute to the trust (which is the IRA beneficiary) over no more than 10 years. The trust, in turn, does not have to distribute anything to its individual beneficiary.

This is referred to as an accumulation trust. Yes, it gets expensive because the trust tax rates are unreasonably compressed. Still, the nontax objectives may well outweigh the taxes involved in accumulating.

There is something about an inherited IRA that can go wrong, however. Do you remember something called a “60-day rollover?” This is when you receive a check from your IRA and put the money back within 60 days. I am not a fan, and I can think of very few cases where I would use or recommend it.

Why?

Because of Murphy’s Law, what I do and have done for over 35 years.

You know who can do a 60-day rollover?

Only a surviving spouse can use a 60-day rollover on an inherited IRA.  

You know who cannot do a 60-day rollover on an inherited IRA?

Anyone other than a surviving spouse.

It is pretty clear-cut.  

I am looking at someone who did not get the memo.

Here are the highlights:

·      Husband died.

·      The wife rolled the IRA into her own name (this is a special rule only for surviving spouses).

·      The wife died.

·      A trust for the kids inherited the IRA.

No harm, no foul so far.

·      The kids wanted to trade stocks within the IRA.

So it begins.

·      The IRA custodian told the kids that they would have to transfer the money someplace else if they wanted to trade.

No prob. The kids should have the IRA custodian transfer the money directly to the custodian of a new IRA that will let them trade to their heart’s content.

·      The kids had the IRA custodian transfer the money to a non-IRA account owned by the trust.

And so it ends.

The kids were hosed. They tried a Hail Mary by filing a private letter request with the IRS, asking for permission to put the money back in the IRA. The IRS looked at the tax law for a split second … and said “No.”

The IRS was right.

And, as usual, I wonder what happened with calling the tax advisor before moving around not-insignificant amounts of money.  

One can point out that taxes would have been payable as the kids withdrew money, and an inherited IRA has to distribute. If mom died in 2020 or later, the IRA would have to be distributed over no more than 10 years anyway.

Still, 10 years is 10 years. If nothing else, it would have given the kids the opportunity to avoid bunching all IRA income into one taxable year.

Not to mention paying for a private letter ruling, which is not cheap.

I hope they enjoy their stock trading.

The cite for the home gamers is PLR 202125007.

Happy New Year

 

Is It Income If You Pay It Back?

You receive unemployment benefits.

You repay unemployment benefits.

Do you have taxable income?

To start with: did you know that unemployment benefits are taxable? I have long considered this a dim bulb in taxation. Taxing the little you receive as unemployment seems cruel to me.

Back to our question: it depends.

It depends on when you pay it back.

Let’s look at the Yoklic case.

Yoklic applied for unemployment benefits in 2012.  He received $3,360, and then the state determined that he was not entitled to benefits. The state sent him a letter in October, 2012 requesting repayment.

Yoklic sent a check in September, 2013.

And he left the unemployment off of his 2012 return. How could it be income, he reasoned, if he had to pay it back. It was more of a loan, or alternatively monies that he received and to which he was not entitled.

Makes sense.

But tax theory does not look at it that way.

Enter the “claim of right” doctrine. It is an oldie, tracing back to a Supreme Court case in 1932.

The problem starts with accounting periods. You and I file taxes every year, so our accounting period is the calendar year. Sometimes something will start in one period (say October, 2012) but not resolve until another period (say September, 2013).

This creates a tax accounting issue: what do you do with that October, 2012 transaction? Do you wait until it resolves (in this case, until September, 2013) before you put it on a tax return? What if it doesn’t resolve for years? How many years do you wait? Does this transaction hang out there until the cows come home?

Enter the claim of right. If you receive monies – and you are not restricted in how you can use the monies – then you are taxable upon receipt. If it turns out that you are restricted – say by having to repay the monies - then you have a deduction in the year of repayment.

If you think about it, this is a reason that a bank loan is not income to you: you are immediately restricted by having to repay the bank. There is no need to wait until repayment, as the liability exists from the get go.

Find a bag of money in a Brooks Brothers parking lot, however, and you probably have a different answer.

Unless you repay it by the end of the year. Remember: you have a deduction in the year of repayment. If you find the bag of money and the police require you to return it, then the income and deduction happen in the same year and they fizzle out.

What if you promise to return the bag of money by year-end, but you do not get around to it until January 5^th? You may have an argument here, albeit a weak one. You could reduce your promise to writing, say by signing a contract. That seems a better argument.

What did Yoklic do wrong?

He repaid the monies in the following year.

He had income in 2012.

He had a deduction in 2013.

The problem, of course, is that the 2012 income may hurt more than the 2013 deduction may help.

There is – by the way - a Code section that addresses this situation: Section 1341, aptly described as the “claim of right” section. It allows an alternate calculation to mitigate the income-hurt-more-than-the-deduction-benefited-me issue. We have talked about Section 1341 before, but let me see if I can find a fresh story and we can revisit this area again.