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.

A Condo Association, Dogs Running Wild and An Office In Home

This time we are talking about an office-in-home. Many of us have one, but few of us can actually claim a tax deduction for it.

The office-in-home deduction has five main rules, two of which are highly specialized. The remaining three require one to:

1. Use the office exclusively and regularly as a principal place of business
2. Use the office exclusively and regularly as a place to meet or deal with patients, clients or customers in the normal course of business
3. Use the office in connection with a trade or business – but only if the office is a separate structure

If you are an employee, then you are in the trade or business of being an employee. If your office is in a separate structure, you are home-free under test (3). 

OBSERVATION: I suppose a converted, oversized shed could meet this test.   

I have a CPA friend who practices out of her basement. She would qualify under test (2), as she regularly meets with her clients there. I however almost always meet clients either at their office or mine, so I would not qualify.

That leaves us with test (1), which is an almost impossible standard to meet if one has an office elsewhere. Fortunately there was a Supreme Court decision a number of years ago (Soliman), which allowed one to consider administrative or management duties for purposes of this test.  

Soliman was an anesthesiologist, and the three hospitals where he worked did not provide him with an office. He used a spare bedroom for work-related activities, such as contacting patients and billing. The IRS had previously taken a very hard line with test (1) and denied the deduction. The IRS reasoned that Soliman’s job was to put people to sleep, and he did that job at the hospital. This meant that the hospital was his “principal” place of business.  The IRS was not going to be persuaded otherwise, at least until the Supreme Court told them to knock it off and allow Soliman his deduction.

Great. So I can do administrative work at home – such as scheduling or billing – and have my office qualify for a deduction, right?

Not so fast.

There are two more tests if one is an employee. The one that concerns us is the requirement that the office be for the convenience of the employer.

Those words sound innocuous, but they are not.

For most of us, having an office at home is for our convenience. In fact, the IRS takes this farther, arguing that – if your employer provides you with an office – then it is virtually impossible for the home office to be for the employer’s convenience.  The IRS reasons that the employer would not care if you showed up, as it had an office waiting. There are some exceptions, such as telecommuting or requiring work hours when the office is closed, but you get the idea. For the vast majority of employees, one cannot get past that convenience-of-employer test.

What if one is self-employed? Forget the convenience test. There is no employer.

Let’s look at McMillan v Commissioner. There will be a quiz at the end.

Denise McMillan had a couple of things going on, but what we are interested in is her home office. She was self-employed.

She claimed an office-in-home deduction on her 2009 return. I am not certain of her housing situation, but her office was 50% of her home. I cannot easily visualize how this is possible, especially given the requirement that the office space not be used for any other purpose. That is a lot of space that she is not using for another purpose – like living there.

She lived in a condo. She had gotten into it with the homeowners association over construction defects related to mold and noise, dogs running wild, dogs barking incessantly and leaving dog memorabilia as dogs will when running wild and barking nonstop.

The condo association would do nothing, so she sued them.

The condo association – highlighting the quality of its Board – sued her back.

Wow, send me a flyer so I can consider buying at this bus station to paradise.

All in all, she was out over $26 thousand in legal fees and expenses.

And she deducted 50% of them through her office-in-home deduction.

QUIZ: Is this a valid tax deduction?

She sued because of events which were interfering with her use and enjoyment of her property.  Had this property been exclusively her residence, the conversation would be over. But one-half of it was being used for business purposes.

She next had to show that the litigation also had an effect on her business activity.

 QUESTION: Have you decided yet?

The Court observed that she was suing over noise, animal waste and similar issues. She argued that they were affecting her ability to work. Makes sense to me.

The IRS did not challenge her argument. 

NOTE: My hunch is that the IRS was relying upon an origin-of-claim doctrine. The lawsuit originated from a personal asset – her residence – so the tax consequences therefrom should remain personal. In this case, personal means nondeductible.

Since the IRS did not challenge, the Court could not – or would not - conclude that there was no effect on her ability to work.

The IRS had not challenged the 50% percentage either.

So the Court decided that she was entitled to a tax deduction for 50% of her legal expenses.

By the way, how did you answer?

Deducting Something, On Some Lake, Somewhere

Someone asked me during the busy season how I came up with the topics for this tax blog. 

It is whatever catches the eye of a somewhat-ADD 30-year tax CPA.  We are a bit of a garage tax blog, I guess.

What caught my eye this week was another case concerning rental property. It gives us a chance to talk about the “vacation home” rules. If you have a second home, odds are good that you and your tax preparer have talked about these rules.

Let’s say that a person – let’s call him Steve – buys a second home. It is in Tennessee. Steve likes Tennessee.

There are three things that Steve can do with his home in Tennessee:

(1) It can be a true second home. Steve, Mrs. Steve and Steve-descendants use it whenever they can. No non-Steves use the home.

(2)  It can be rented. Steve never uses it, as it is being rented to non-Steves.

(3)  Steve uses it some and rents it some.

It is (3) that drags us into the vacation home rules.

Let’s recall what the tax difference is between owning a house as a primary residence and owning it as a rental:

(1) Primary residence – you can deduct…

a.     Mortgage interest

b.     Real estate taxes

(2) Rental – you can deduct…

a.     Mortgage interest

b.     Real estate taxes

c.      Operating costs, such as utilities and insurance

d.     Maintenance costs, such as mowing in the summer and snow removal in the winter

e.     Depreciation

As you can see, there is a wider range of potential tax deductions if only we can qualify Tennessee as a rental.

Congress and the IRS know this. That is how we got the vacation home rules to begin with. You cannot rent out the place one week out of year, use it personally the rest of the time and deduct everything that is not tied down.

Our Code section is 280A and it is a math quiz:

(1) Did you rent the place for less than 15 days during the year?

(2) If no …

a.     Did you use it personally less than 10% of the days it was rented out?

Let’s go through it.

 

(1) If you rent the place for two weeks or less, the rental income is not taxable. Mortgage interest and real estate taxes are deductible the same as a residence.

COMMENT: Makes no sense, right? The IRS is actually letting you NOT REPORT income? How did that get in there? I bet it has something to do with Augusta and the Masters. It helps to know people who know people. 

(2) You rent it out more than two weeks and use it more than 10% of the rental days.

Congratulations, you have a second home. You also have rental income. You have to report the rental income, but the IRS is kind enough to allow you to take rental deductions UP TO A POINT. You cannot claim so many deductions that you reach the point of a tax loss. You must stop at zero

The deductions get allocated between the personal use days and the rental use days. It’s only fair.

Since it is a second home, you get to deduct whatever interest and taxes were not allocated to the rental as personal mortgage interest and personal real estate taxes.

(3) You rent it out more than two weeks and use it less than 10% of the rental days.

You still have to allocate the expenses as we discussed in (2), but the IRS now allows you to claim a rental loss. Why? Because at less than 10% personal use the IRS does NOT consider this to be your second home. The IRS considers it a rental.

There is a downside, though. You know that mortgage interest allocated to the personal use? It is not deductible anymore. Why? Because the only thing that made it deductible before was that it was attached to your second home.  As we said, under scenario (3) the IRS considers this to be a rental, meaning it is not your second home.

You do get to deduct the real estate taxes allocated to the personal use.  Taxes have a different tax treatment.

There are some special rules on counting days. For example, days spent repairing or maintaining the property do not count, either as personal use or as rental. You might want to document these days well, though.

What if Steve wants to allow Steve-descendants to use the place?

Most of the time this will not work. The reason is that Steve-descendants are considered to be Steve, and that means personal use days.

But there is small exception…

Steve-descendants will not be considered to be Steve if:

·     They pay fair market rent, and

·     They use the place as their principal residence

It is the second requirement that causes the problem. Put the house in Hilton Head or Key West and odds are that no one is using the place as a principal residence.

However, put a Steve-descendant into medical school in Tennessee and you may have the beginnings of a tax plan.

Our case this week is Cheryl Savello v Commissioner. She had more than one thing going, but our interest is whether she got to treat a Nevada property where her daughters stayed as rental property.

Her daughters used the place as their principal residence.

The Court agreed that the rent appeared to be market value, citing offers to rent from third parties.

But the Court decided that there was no rental. The daughters’ use was attributable to their mother.

What happened?

Her daughters didn’t pay the rent.