Gambling As A Trade Or Business

 

The question came up recently:

How does one convince the IRS that they are a professional gambler?

The answer: it is tough. But not impossible. Here is a quote from a landmark case on the topic:

If one’s gambling activity is pursued full time, in good faith, and with regularity, to the production of income for a livelihood, and is not a mere hobby, it is a trade or business.” (Groetzinger)

First, one must establish that the gambling activity is an actual trade or business.  

Believe or not, the term “trade or business” is not precisely defined in the tax Code. This point drew attention when the Tax Cuts and Jobs Act of 2017 (TCJA) introduced the qualified business deduction for – you guessed it – a trade or business. Congress was stacking yet another Code section on top of one that remained undefined.

Court cases have defined a trade or business an activity conducted with the motive of making a profit and conducted with continuity and regularity.

That doesn’t really move the needle for me.

For example, I play fantasy football with the intention of winning the league. Does that mean that I have the requisite “profit motive?” I suppose one could reply that - even if there is a profit motive - there is no continuity or regularity as the league is not conducted year-round.

To which I would respond that it cannot be conducted year-round as the NFL is not played year-round. Compare it to a ski slope – which can only do business during the winter. There is no need for a ski slope during the summer. The slope does business during its natural business season, which is the best it can do. My fantasy football league does the same.

Perhaps you would switch arguments and say that playing in one league is not sufficient. Perhaps if I played in XX leagues, I could then argue that I was a fantasy football professional.

OK, IRS, what then is the number XX?

The tax nerds will recognize the IRS using that argument against stock traders to deny trade or business status. Unless your name rhymes with “Boldman Tacks,” the IRS is virtually predestined to deny you trade or business status. You trade 500 times a year? Not enough, says the IRS; maybe if you traded 1,000 times. The next guy trades 1,000 times. Not enough, says the IRS. Did we say 1,000?  We misspoke; we meant 2,000.

So the courts have gone to the Code section and cases for hobby losses. You may remember those: hobby losses are activities for which people try to deduct losses, arguing that they are in fact true-blue, pinky-swear, profit-seeking trades or businesses.

You want an example? I’ll give you one from Galactic Command: a wealthy person’s daughter is interested in horses and dressage. Mom and dad cannot refuse. At the end of the year, I am pulled into the daughter’s dressage activity because … well, you know why.

Here are additional factors to consider under the (Section 183) hobby loss rules:

1.  The activity is conducted in a business-like manner.
2.  The taxpayer’s expertise
3.  The taxpayer’s time and effort
4.  The expectation that any assets used in the activity will appreciate in value.
5.  The taxpayer’s history of success in other activities
6.  The taxpayer’s history of profitability
7.  The taxpayer’s financial status
8.  The presence of personal pleasure or recreation

I suspect factors (7) and (8) would pretty much shut down that dressage activity.

Let’s look at the Mercier case.

The Merciers lived in Nevada. During 2019 Mrs Mercier was an accountant at a charter school and Mr Mercier operated an appliance repair business. They played video poker almost exclusively, of which they had extensive knowledge. They gambled solely on days when they could earn extra players card points or receive some other advantage. They considered themselves professional gamblers.

Do you think they are?

I see (3), (7) and (8) as immediate concerns.

The Court never got past (1):

We find that although Petitioners are serious about gambling, they were not professional gamblers. Petitioners are both sophisticated in that they are an accountant and a previous business owner. Petitioner wife acknowledged that as an accountant, she would advise a taxpayer operating a business to keep records. Petitioner husband acknowledged that for his appliance repair business, he did keep records.”

COMMENT: In case you were wondering about the sentence structure, this was a bench opinion. The judge made a verbal rather than written decision.

Petitioners did not personally keep track of their gambling activity in 2019 choosing, instead, to rely on third-party information from casinos, even though they further acknowledged that the casino record may be incomplete, as only jackpot winnings, not smaller winnings, are reported. Petitioners also did not keep a separate bank account to manage gambling winnings and expenses, but used their personal account, which is further evidence of the casual nature of their gambling.”

My thoughts? The Merciers were not going to win. It was just a matter of where the Court was going to press on the hobby-loss checklist of factors. We have learned something, though. If you are arguing trade or business, you should – at a bare minimum – open a business account and have some kind of accounting system in place.  

Our case this time was Mercier v Commissioner, Tax Court docket number 7499-22S, June 6, 2023.

The Gallenstein Rule

 

It is a tax rule that will eventually go extinct.

It came to my attention recently that it can – however – still apply.

Let’s set it up.

(1)  You have a married couple.

(2)  The couple purchased real estate (say a residence) prior to 1977.

(3)  One spouse passes away.

(4)  The surviving spouse is now selling the residence.

Yeah, that 1977 date is going to eliminate most people.

We are talking Section 2040(b).

(b)  Certain joint interests of husband and wife.

(1)  Interests of spouse excluded from gross estate.

Notwithstanding subsection (a), in the case of any qualified joint interest, the value included in the gross estate with respect to such interest by reason of this section is one-half of the value of such qualified joint interest.

(2)  Qualified joint interest defined.

For purposes of paragraph (1), the term "qualified joint interest" means any interest in property held by the decedent and the decedent's spouse as-

(A)  tenants by the entirety, or

(B)  joint tenants with right of survivorship, but only if the decedent and the spouse of the decedent are the only joint tenants.

In 1955 Mr. and Mrs. G purchased land in Kentucky. Mr. G provided all the funds for the purchase. They owned the property as joint tenants with right of survivorship.

In 1987 Mr. G died.  

In 1988 Mrs. G sold 73 acres for $3.6 million. She calculated her basis in the land to be $103,000, meaning that she paid tax on gain of $3.5 million.

Someone pointed out to her that the $103,000 basis seemed low. There should have been a step-up in the land basis when her husband died. Since he owned one-half, one-half of the land should have received a step-up.

COMMENT: You may have heard that one’s “basis” is reset at death. Basis normally means purchase cost, but not always. This is one of those “not always.” The reset (with some exceptions, primarily retirement accounts) is whatever the asset was worth at the date of death or – if one elects – six months later.  Mind you, one does not have to file an estate tax return to trigger the reset; rather, it happens automatically. That is a good thing, as the lifetime estate tax exemption is approaching $13 million these days. Very few of us are punching in that weight class.

Someone looked into Mrs. G’s situation and agreed. In May 1989 Mrs. G filed an amended tax return showing basis in the land as $1.8 million. Since the basis went up, the taxable gain went down. She was entitled to a refund.

Three months later she filed a second amended return showing basis in the land as $3.6 million. She wanted another refund.

This time she caught the attention of the IRS. They could understand the first amended but not the second. Where were these numbers parachuting from?

I am going to spare us both a technical walkthrough through the history of Code section 2040.

There was a time when joint owners had to track their separate contributions to the purchase of property, meaning that each owner would have his/her own basis. I suppose there are some tax metaphysics at play here, but the rule did not work well in real life. Sales transactions often occur decades after the purchase, and people do not magically know that they need to start precise accounting as soon as they buy property together. Realistically, these numbers sometimes cannot be recreated decades after the fact. In 1976 Congress changed the rule, saying: forget tracking for joint interests created after 1976. From now on the Code will assume that each tenant contributed one-half.

That is how we get to today’s rule that one-half of a couple’s property is included in the estate of the first-to-die. By being included in an estate, the property is entitled to a step-up in basis. The surviving spouse gets a step-up in the inherited half of the property. The surviving spouse also keeps his/her “old” basis in his/her original one-half. The surviving spouse’s total basis is therefore the sum of the “old” basis plus the step-up basis.

Mr. G died before 1977.

Meaning that Mrs. G was not subject to the new rule.

She was subject to the old rule. Since Mr. G had put up all the money, all the property (yes, 100%) was subject to a step-up in basis when Mr. G died.

That was the reason for the second amended return.

The Court agreed with Mrs. G.

It was a quirk in tax law.

The IRS initially disagreed with the decision, but it finally capitulated in 2001 after losing in court numerous times.

Mind you, the quirk still exists. However, the population it might affect is dwindling, as this law change was 47 years ago. We only live for so long.

However, if you come across someone who owned property with a spouse before 1977, you might have something.

BTW this tax treatment has come to be known by the widow who litigated against the IRS: the tax-nerds sometimes call it “the Gallenstein rule.”

Substantially Disclosing A Gift To The IRS

Take a look at this memorable prose:

         Sec 6501(c) (9) Gift tax on certain gifts not shown on return.

If any gift of property the value of which (or any increase in taxable gifts required under section 2701(d) which) is required to be shown on a return of tax imposed by chapter 12 (without regard to section 2503(b) ), and is not shown on such return, any tax imposed by chapter 12 on such gift may be assessed, or a proceeding in court for the collection of such tax may be begun without assessment, at any time. The preceding sentence shall not apply to any item which is disclosed in such return, or in a statement attached to the return, in a manner adequate to apprise the Secretary of the nature of such item.

I get it: if you never disclose the gift, the IRS can come after you until the end of time. The reverse is what concerns us today: if you disclose the gift “in a manner adequate,” then the IRS does not have until the end of time.

Gift tax cases can be … idiosyncratic, to be diplomatic. All tax is personal, but gift tax can be Addams Family idiosyncratic.

Ronald Schlapfer (RS) was a Swiss-born businessman. He had ties to both Switzerland and the United States. He owned a life insurance policy issued in 2006.The policy in turn owned all the stock in EMG, a Panamanian company previously owned by RS.

It was 2006 and RS was a nonresident of the U.S. He gifted his interest in EMG to his mother, aunt and uncle.

He obtained U.S. citizenship in 2008.

Got it: he gifted before he became subject to U.S. gift tax.

In 2013 – and after obtaining his citizenship – RS decided to play it safe and submitted an offshore voluntary disclosure filing with the IRS. It included a gift tax return for 2006, which informed the IRS of the gift to his family. The return included the following:

“A protective filing is being submitted. On July 6, 2006, taxpayer made a gift of controlled foreign company stock valued at $6,056,686 per U.S. Treasury Regulation 25.2501-1(B). The taxpayer is not subject to U.S. gift tax as he did not intend to reside permanently in the United States until citizenship was obtained in 2008.”

COMMENT: In this situation, a protective filing means that the taxpayer is unsure if a filing is even required but is submitting one, nonetheless. It is an attempt to backstop penalties and other bad things that could happen from a failure to file.

COMMENT: International practice has become increasingly paranoid for many years now. The IRS seems convinced that every UBER driver has unreported foreign accounts, and one’s failure to follow arbitrary and obscure rules are a per se admission of culpability. In this case, for example, there was technical doubt whether the gift was reportable as the transfer of a life insurance policy or as the transfer of a company owned by that policy. Why was there doubt? Well, the IRS itself created it. Rest assured, whichever way you chose the IRS would fall the other way.

The IRS disagreed that the gift occurred in 2006. There was a hitch in the transfer, and the attorney did not resolve the matter until 2007. RS in turn argued that 2007 was but a scrivener’s error. According to well-trod ground, a scrivener’s error is considered administrative, not substantive, and does not mark the actual date of the underlying transaction.

Sometime in here RS agreed to extend the limitations period.

In 2019 the IRS issued the statutory notice of deficiency (SNOD). That is also called a 90-day letter, and it meant that the next step was Tax Court - if RS wanted to further pursue the matter.

Off to Tax Court they went.

RS’ argument was simple: the statute of limitations had expired.

The IRS argued that the gift was not adequately disclosed.

The IRS argued that disclosure requires the following:

·       Description of the property gifted, and any consideration received by the donor.

·       The identity and relationship between the parties.

·       There is additional disclosure for property is transferred in trust.

·       A detailed explanation of how one arrived at the fair market value of the property gifted.

·       Whether one has taken a position contrary to any Regulations or rulings

The IRS was trying to catch RS in the first requirement above: a description of the property gifted.

Was it an insurance policy, ownership in a company, or something else?

Here is the Court:

While Schlapfer may have failed to describe the gift in the correct way, he provided enough information to identify the underlying property that was transferred.”

RS won his case. The IRS had blown the statute of limitations.

Our case this time was Schlapfer v Commissioner, T.C. Memo 2023-65.

Tax Preparer Gives Gambler A Losing Hand

 

I am looking at a bench opinion.

The tax issue is relatively straightforward, so the case is about substantiation. To say that it went off the rails is an understatement.

Let us introduce Jacob Bright. Jacob is in his mid-thirties, works in storm restoration and spends way too much time and money gambling. The court notes that he “recognizes and regrets the negative effect that gambling has had on his life.”

He has three casinos he likes to visit: two are in Minnesota and one in Iowa. He does most of his sports betting in Iowa and plays slots and table games in Minnesota.

He reliably uses a player’s card, so the casinos do much of the accounting for him.

Got it. When he provides his paperwork to his tax preparer, I expect two things:

(1)  Forms W-2G for his winnings

(2)  His player’s card annual accountings

The tax preparer adds up the W-2Gs and shows the sum as gross gambling receipts. Then he/she will cross-check that gambling losses exceed winnings, enter losses as a miscellaneous itemized deduction and move on. It is so rare to see net winnings (at least meaningful winnings) that we won’t even talk about it.

COMMENT: Whereas the tax law changed in 2018 to do away with most miscellaneous itemized deductions, gambling losses survived. One will have to itemize, of course, to claim gambling losses.   

Here starts the downward cascade:

Mr. Bright hired a return preparer who was recommended to him, but he did not get what or whom he expected. Rather than the recommended preparer, the return preparer’s daughter actually prepared his return.”

OK. How did this go south, though?

The return preparer reported that Mr. Bright was a professional gambler ….”

Nope. Mind you, there are a few who will qualify as professionals, but we are talking the unicorns. Being a professional means that you can deduct losses in excess of winnings, thereby possibly creating a net operating loss (NOL). An NOL can offset other income (up to a point), income such as one’s W-2. The IRS is very, very reluctant to allow someone to claim professional gambler status, and the case history is decades long. Jacob’s preparer should have known this. It is not a professional secret.

Jacob did not review the return before signing. For some reason the preparer showed over $240 grand of gross gambling receipts. I added up the information available in the opinion and arrived at little more than $110 grand. I have no idea what she did, and Jacob did not even realize what she did. Perhaps she did not worry about it as she intended the math to zero-out.

She should not have done this.

The IRS adjusted the initial tax filing to disallow professional gambler status.

No surprise.

Jacob then filed an amended return to show his gambling losses as miscellaneous itemized deductions. He did not, however, correct his gross gambling winnings to the $110 grand.

The IRS did not allow the gambling losses on the amended return.

Off to Tax Court they went.

There are several things happening:

(1)  The IRS was arguing that Jacob did not have adequate documentation for his losses. Mind you, there is some truth to this. Casino reports showed gambling activity for months with no W-2Gs (I would presume that he had no winnings, but that is a presumption and not a fact). Slot winnings below $1,200 do not have to be reported, and he gambled on games other than slots. Still, the casino reports do provide some documentation. I would argue that they provide substantiation of his minimum losses.

(2)  Let’s say that the IRS behaved civilly and allowed all the losses on the casino reports. That is swell, but the tax return showed gambling receipts of $240 grand. Unless the casino reports showed losses of (at least) $240 grand, Jacob still had issues.

(3)  The Court disagreed with the IRS disallowing all gambling deductions. It looked at the casino reports, noting that each was prepared differently. Still, it did not require advanced degrees in mathematics to calculate the losses embedded in each report. The Court calculated total losses of slightly over $191 grand. That relieved a lot – but not all – of the pressure on Jacob.

(4)  Jacob did the obvious: he told the Court that the $240 grand of receipts was a bogus number. He did not even know where it came from.

(5)  The IRS immediately responded that it was being whipsawed. Jacob reported the $240 grand number, not the IRS. Now he wanted to change it. Fine, said the IRS: prove the new number. And don’t come back with just numbers reported on W-2Gs. What about smaller winnings? What about winnings from sports betting? If he wanted to change the number, he was also responsible for proving it.

The IRS had a point. It was being unfair and unreasonable but also technically correct.

Bottom line: the IRS was not going to permit Jacob to reduce his gross receipts number without some documentation. Since all he had was the casino reports, the result was that Jacob could not change the number.

Where does this leave us? I see $240 – $191 = $49 grand of bogus income.

My takeaway is that we have just discussed a case of tax malpractice. That is what lawyers are for, Jacob.

Our case this time was Jacob Bright v Commissioner, Docket No. 0794-22.

Backup Withholding On A Gig Worker

I am minding my own business when an IRS notice lands in my office. Here is a snip:

Question: is this bad?

Answer: it might be.

Let’s talk about it.

The IRS requires Form 1099-NEC be provided a nonemployee service provider paid over $600 over the course of a year. This is the tax form sent to self-employeds and gig workers.

The acronym “BWH” means backup withholding.

So, we are talking about withholding on nonemployees.

How can this be? Employee withholding is easy to understand: federal income tax, FICA, state income tax and whatnot. Anyone who is a W-2 has seen it – or is seeing it – every pay date. But there is no withholding on a nonemployee. A nonemployee is responsible for his/her own taxes. How do we even get here?

There are several ways. Let’s go through two.

Let’s say that I own a business called Galactic. Galactic hires someone to take care of our IT system. That someone is named Rick, and Rick does business as REM Consulting.

OK.

Rick does work. He sends an invoice for $750. Galactic pays him $750.

Here is our first way to backup withholding.

Rick immediately exceeded the $600 hurdle. He provided covered services, i.e., he is a gig worker. Galactic will send Rick a 1099-NEC at year-end. Presently, that 1099 is at $750. It will increase every time Rick does additional work.

Galactic needs some information from Rick to prepare that 1099: a name, an address, and a taxpayer identification number (TIN). I expect the name and address to be easy, as that would be on Rick’s business card or invoice. The TIN might not be so easy. A common TIN is a social security number. I guess Rick could provide Galactic his SSN, but then again, Rick might not be keen with passing-out his SSN all day every day.

Rick instead is thinking of making REM Consulting a single member LLC. Why? The default tax rule is to disregard a single member LLC as a separate entity. To the IRS, REM Consulting is just Rick (mind you, state rules may be different). Why bother, you wonder? Because REM Consulting can get its own employer identification number (EIN). If I were Rick, I would use that EIN instead of my SSN for all business purposes.

COMMENT: If you read the instructions, REM Consulting technically does not have to apply for an EIN until it has employees. That is true but beside the point. We automatically request an EIN for all new LLC’s – single member or not.

Back to the first way into backup withholding.

Galactic asks Rick for a TIN. Rick says “No.” Why? Because we need Rick to say “No” to continue our discussion.

Galactic is required to start backup withholding immediately, as Rick has already cleared the $600 floor. The withholding rate is 24%. Galactic will withhold $180 and send Rick a check for $570. Galactic will of course have to send that $180 to the IRS (it is withholding after all). Hopefully Rick relents and provides a TIN. If so, Galactic will include his TIN and withholding on the 1099-NEC, and Rick can get his withholding back when he files his personal return.

A second way is when the payor has the wrong TIN. Let’s say that Rick gave Galactic his EIN, but Galactic wrote it down incorrectly. Galactic and Rick are a year into their relationship, and everything is going well, except that Galactic receives a letter from the IRS saying that that Rick’s 1099-NEC is incorrect. The name and TIN do not match.

There is a short period of time allowed for Galactic to review its records and get with Rick if necessary. If the matter is resolved (someone wrote the TIN down incorrectly, for example), then Galactic corrects the matter going forward. That is that, and no backup withholding is required. Galactic does not even have to contact the IRS for permission.

However, say the matter is not resolved. Rick has no interest in helping. Galactic will have to start backup withholding on its next payment to Rick. Mind you, it can later stop withholding if Rick comes to his senses.

Withholding is a pain. There is additional accounting, then one must remit the money to the government and file additional tax returns. Every step has due dates and penalties for not meeting those dates.

Let’s say you receive that IRS notice and blow it off. After all, what is the worst the IRS can do, you ask.

Well, they can hold you responsible for the withholding.

But I didn’t withhold, you answer.

They don’t care. They want their money. You were supposed to withhold from Rick and remit. You chose not to withhold. You now have substitute liability and will have to reach into your own pocket and remit. Perhaps you can ask Rick for reimbursement, but you probably should not pack luggage for that trip.

A few more things about backup withholding:

• There is a form to provide your TIN (of course): Form W-9. It is extremely likely you filled one out when you started your job.
• You might be surprised how many different types of income are subject to backup: interest, dividends, rents and so on. It is not limited to gig income.
• A famous exception to backup is retirement income. Realistically, though, you won’t be able to even open an IRA account with the major players (Vanguard, Fidelity and so on) without providing a TIN upfront.
• It can apply to nonresident foreign nationals, although the withholding rate is different.
• The way to stop backup is to correct the situation that created it in the first place: that is, provide your TIN.

A difference between the two scenarios is when responsibility for withholding begins:

In scenario one, it begins with the first payment to Rick.

In scenario two, it begins more than a year later, upon receipt of a notice from the IRS.

Both scenarios can be bad, but scenario one especially so. At least scenario two is prospective (assuming you do not blow off the multiple notices the IRS will send).

Back to the start of this post. Which scenario do I have: scenario one or scenario two?

I do not know at this moment.

Let’s hope it is not bad. 

Penalty Abatement For Preparer Errors

 

I was looking over a law review article weighing the pros and cons of different types of Tax Court decisions.

Nerd train, I admit.

But there is something here to talk about.

There are several types of Tax Court opinions. Some have precedential value, and some do not. Precedence means that a Court applies the law in the same manner to cases with the same facts.

One type is a Memorandum opinion. These tend to be heavily factual, and they involve relatively well-settled law.

Another is the Summary (or S) opinion. These involve a relatively modest amount of tax (currently $50 grand) and use a streamlined set of procedures.

The reason for different types of opinion is grounded in practicality. Memo opinions allow the Court to process more clear-cut cases without worrying about establishing unanticipated precedent. The S opinions allow taxpayers a forum without having to hire an attorney to navigate cumbersome Tax Court procedural rules.

I am looking at a case decided as a bench opinion. 

Think about the judge issuing an oral opinion right there and then and you have a bench opinion.

And these types can be combined. A judge may, for example, issue a bench opinion in a memo or S case.

I am looking at something I know all too well.

Mr. Trammer was an IT consultant.

Mrs. Trammer was a social worker.

Mr. Trammer worked primarily from home. Depending upon, he was paid as a W-2 employee or as a 1099 gig worker. He had an office-in-home and all that.

Mrs. Trammer was a W-2 employee. She drove around Michigan visiting childcare and foster care locations. She at times would purchase gifts for the kids.

She sounds like a good person.

They reported all kinds of deductions on their 2019 and 2020 returns: business deductions for the gig, employee business deductions for the social work, charitable deductions for the church.

If you recall, many itemized deductions were reduced or eliminated altogether beginning in 2018.

No surprise, the IRS disallowed a swath of deductions. Some – like employee business deductions – simply did not exist for the tax year at issue. Others – like office-in-home for the gig – had calculation errors.

Got it. They need to dig up documentation. They should immediately concede on the calculation error and employee expenses. The matter should be resolved as routine in correspondence exam.

Off to Tax Court they went.

Huh?

Upon reflection, this makes sense. The IRS and Covid did not play well together. They were not answering the phones over there. Faxing supporting documentation to the AUR Unit was often a joke. I suspect this matter went to Court by default.

Here we go:

The Trammers relied on a paid return preparer to prepare their returns for the years at issue. Although the individual return preparers identified on the 2019 and 2020 returns differed, the Trammers used the same preparation firm for both years.”

That does not sound like a CPA firm. Granted, I prepare only a fraction of returns I sign - staff accountants generally prepare - but I do review all returns before signing. 

Each year, they brought their records … who decided what items to report on the Trammers’ return and where.”

Yep.

The returns contained obvious errors such as reporting the same expense in multiple places.”

The old list-the-same-thing-over-and-over routine. Often these returns are not complex, but the preparer must be diligent when moving numbers. It consequently is common to give these returns to more experienced staff. Ideal would be to give the return to the same experienced staff every year.

The Court made short work of the returns.

Schedule C/Gig work

They failed to demonstrate the amount of expenses that they incurred or the business purposes for those expense, and they did not provide sufficient evidence from which the Court could formulate an estimate.”

Form 2106/employee business expenses

… the Trammers failed to substantiate the expenses Mrs. Trammer incurred in the conduct of her social work.”

Schedule A/Itemized Deductions

The Trammers failed to substantiate itemized deductions in excess of the standard deduction amounts that the Commissioner allowed…”

The IRS wanted penalties. They always do.

Not his time. Here is the Court:

The Trammers relied on a return preparer to whom they had been referred. They supplied the return preparer with necessary and accurate information each year, and the return preparer decided what to do with that information. The Trammers reasonably relied in good faith on their return preparer’s judgement. Accordingly, the section 6662 accuracy-related penalty does not apply for the years in issue.”

I am impressed, as I was expecting a rubber stamp.

What was different this time?

For one thing, Mr. Trammer showed up for the trial, and Mrs. Trammer participated via conference call. This gave them a chance to humanize their situation. While not conceding the errors, the Court did believe them when they said they tried. The Court, however, was not as kind to the preparer.

And remember: the next person cannot use this case (technically) as precedent in a future penalty. The Court had room to be lenient.

Our case this time was Trammer v Commissioner, TC Bench Order March 14, 2023.

Do Not Do This When Buying Disability Insurance

 

It is a tax trap. An employer thinks that they are doing a boon for their employees by providing a tax-exempt fringe benefit.

Where is the trap?

CTG: it has to do with insurance.

I don’t get it, you say. My employer pays for some/most/all my health insurance. When I see a doctor, the insurance pays some, I pay some. Granted, some health insurances are better than others, but where is the trap?

CTG: it is not health insurance.

I get life insurance at work, you continue. It is equal to a year’s salary or something like that. I have noticed that they charge me something for this on my W-2 every year.

CTG: Life insurance has a split personality. An employer can offer you up to $50 thousand of life insurance as a nontaxable fringe. Any insurance above that amount (for example, if your annual salary is more than $50 grand) is taxable to you. Mind you, the charge tends to be minimal - as the IRS uses favorable rates - but you are charged something.  

It is not life insurance.

It is disability insurance.

Let’s look at John Linford.

John sold Medicare supplement and Medicare Advantage plans. His employer decided to do a nice, and in 2011 it purchased a group disability policy from Principal Life. On the plan’s first iteration, the company paid 100% of the premiums. In 2013 the plan was amended, giving the company the option to charge an employee 25% of the premiums. The company said “nah” to the option, choosing to continue paying 100% of the premiums.

At first blush, this sounds like a beneficent employer.

John incurred a disability in 2014. He filed a worker’s compensation claim in December 2014.

John was fired a year later, in November 2015.

This may still be a beneficent employer. They might have been assisting John in getting to that disability policy.

In May 2017 Principal Life approved his disability claim.

At that speed, one could be homeless before the insurance kicks-in.

Principal Life paid him a $105 grand in retroactive benefits.

John heard that disability is generally nontaxable.

Yep.

John left the $105 grand off his tax return.

Nope.

The IRS caught it, of course.

The IRS wanted almost $22 thousand in tax, as well as a penalty chop of over $4 grand.

Off to Tax Court they went.

There is a Code section for this type of employer-provided insurance: Section 105.

           § 105 Amounts received under accident & health plans.

(a)  Amounts attributable to employer contributions.

Except as otherwise provided in this section, amounts received by an employee through accident or health insurance for personal injuries or sickness shall be included in gross income to the extent such amounts (1) are attributable to contributions by the employer which were not includible in the gross income of the employee, or (2) are paid by the employer.

Read the verbiage at (a).

Except as otherwise provided, any accident or health insurance is taxable to the extent the employer provides the insurance as a tax-free benny. Wait, you say, what about health insurance? That is not taxable. True, but health insurance is nontaxable via the “except as otherwise provided” language. There is no such exception for disability insurance.

This stuff can be confusing.

John had one more swing at the plate. Remember that the company amended the plan allowing them to charge employees 25% of the cost. John wanted to know if there was some relief there. I get it: 25% nontaxable is not as good as 100% nontaxable, but it is better than 100% taxable.

The Court said no. Potential is not actuality, and John never paid any of the premiums.

What about the penalties? Did the Court cut John some slack? One can get confused here: one rule for health insurance, another rule for different insurance.

Based on the record the Court concludes that the petitioner husband did not have reasonable cause and did not act in good faith in not reporting the disability payments.”

The Court upheld the penalties. There went another $4-plus grand.

Some companies allow one to purchase short-term disability through their cafeteria plan. Mind you, this means that the premiums are paid with pre-tax money and will result in taxable income if benefits are ever collected. I tend to back-off on short-term disability, although I prefer that one pay with after-tax dollars for either short- or long-term disability.

I, however, feel strongly about paying after-tax for long-term disability. Those benefits may continue until you reach social security age, and you do not need to be dragging taxes behind you until then. The small rush of a tax-free benny is insignificant if you are ever – in fact – disabled.

Our case this time was Cynthia L Hailstone and John Linford v Commissioner, T.C. Summary Opinion 2023-17.