Owing Tax on Social Security Not Received

 

I am spending more time talking about social security.

The clients and I are aging. If it does not affect me, it affects them – and that affects me.

Social security has all manners of quirks.

For example, say that one worked for an employer which does not pay into social security. There are many - think teachers, who are covered instead by state plans. It is common enough to mix and match employers over the course of a career, meaning that some work may have been covered by social security and some was not. What does this mean when it comes time to claim benefits?

Well, if you are the employee in question, you are going to learn about the windfall elimination provision (WEP), which is a haircut to one’s social security for this very fact pattern.

What if this instead is your spouse and you are claiming spousal benefits? Well, you are going to learn about the “government pension offset,” which is the same fish but wrapped in different paper.

What if you are disabled?

Kristen Ecret was about to find out.

She worked a registered nurse until 2014, when she suffered an injury and became medically disabled. She started receiving New York workers compensation benefits.

Oh, she also applied for social security benefits in 2015.

In December 2017 (think about it) she heard back from the SSA. She was entitled to benefits, and those benefits were retroactive to 2015.

Should be a nice check.

In January 2018 she received a Form SSA-1099 for 14,392, meaning the SSA was reporting to the IRS that she received benefits of $14,332 during 2017.

But there was a bigger problem.

Kristen had received nothing – zippo, nada, emptitadad – from SSA. The SSA explained that her benefits had been hoovered by something called the “workers’ compensation offset.”

She filed a request for reconsideration of her benefits.

She got some relief.

It’s a year later and she received a Form SSA-1099 for 2018. It reported that she received benefits of $71,918, of which $19,322 was attributable to 2018. The balance – $52,596 – was for retroactive benefits.

Except ….

Only $20,749 had been deposited to her bank account. Another $5,375 was paid to an attorney or withheld as federal income tax. The difference ($45,794) was not paid on account of the workers’ compensation offset.

Something similar happened for 2019.

Let’s stay with 2019.

Instead of using the SSA-1099, Kristen reported taxable social security on her 2019 joint income tax return of $5,202, which is 85% of $6,120, the only benefits she received in cash.

I get it.

The IRS of course caught it, as this is basic computer matching.

The IRS had records of her “receiving” benefits of $55,428.

The difference? Yep: the “workers’ compensation offset.”

There was some chop in the water, as a portion of the benefits received in 2019 were for years 2016 through 2018, and both sides agreed that portion was not taxable. But that left $19,866 which the IRS went after with vigor.

The Court walked us through the life, times and humor of the workers’ compensation offset, including this little hummable ditty:

For purposes of this section, if, by reason of section 224 of the Social Security Act [i.e., 42 U.S.C. § 424a] . . . any social security benefit is reduced by reason of the receipt of a benefit under a workmen’s compensation act, the term ‘social security benefit’ includes that portion of such benefit received under the workmen’s compensation act which equals such reduction."

Maybe the Court will find a way ….

            Section 86(d) compels us to agree with respondent."

The “respondent” is the IRS. No help here from the Court.

Applying the 85% inclusion ratio, we conclude that petitioners for 2019 have taxable Social Security benefits of $16,886, viz, 85% of the $19,866 in benefits that were attributable to 2019. Because petitioners on their 2019 return reported only $5,202 in taxable Social Security benefits, they must include an additional $11,684 of such benefits ($16,886 − $5,202) in their gross income."

Kristen lost.

Oh, the IRS applied an accuracy-related penalty, just to make it perfect.

We know that tax law can be erratic, ungrounded, and nonsensical. But why did Congress years ago change the tax Code to convert nontaxable disability income into taxable social security income? Was there some great loophole here they felt compelled to squash?

Our case this time was Ecret v Commissioner, T.C. Memo 2024-23.

IRS Gets Called Out In Offer In Compromise Case

 

I am looking at an offer in compromise (OIC) case.

These cases are almost futile for a taxpayer, as the Tax Court extends broad deference to the IRS in its analysis of and determinations on OICs. To win requires one to show that the IRS acted in bad faith.

COMMENT: I have soured on OICs as the years have gone by. Those commercials for “pennies on the dollar” stir unreasonable expectations and do not help. OICs are designed for people who have experienced a reversal of fortune - illness, unemployment, disability, or whatnot – which affect their ability to pay their taxes. It is not meant for someone who is irresponsible or inexplicably unfettered by decency or the responsibilities of the human condition. Not too long ago, for example, one of the clients wanted us to pursue an OIC, as he has racked up impressive tax debt but has no cash. I refused to be involved. Why? Because his cash is going to construct a $2-plus million dollar home. I am very pro-taxpayer, but this is not that. Were it up to me, we would fire him as a client.

Let’s look at the Whittaker case.

Mr. W is a veteran and was a self-employed personal trainer. Mrs. W worked in a local school district and had a side gig as a mall security guard. They were also very close to retirement.

The Ws owed everybody, it seems: a mortgage, student loans, the IRS, the state of Minnesota and so on.

In 2018 the IRS sent a notice of intent to levy.

The Ws requested a collection due process (CDP) hearing.

COMMENT: The Ws were represented by the University of Minnesota tax clinic, giving students a chance to represent clients before the IRS and courts.

The IRS of course wanted numbers: the Form 433 paperwork detailing income, expenses, assets, debt and so forth.

The Ws owed the IRS approximately $33 grand. The clinic calculated their reasonable collection potential as $1,629. They submitted a 20% payment of $325.80, per the rules, along with their OIC.

In the offer, the Ws stressed that their age and difficult financial situation meant that soon they would have to rely on retirement savings as a source of income rather than as a nest egg. Their house was in disrepair and had an unusual mortgage, meaning that it was extremely unlikely it could be refinanced to free up cash.

The IRS has a unit - the Centralized Offer in Compromise unit – that stepped in next. Someone at the unit calculated the Ws’ RCP as $250,000, which is wildly different from $1,629. The unit spoke with representatives at the clinic about the bad news. The clinic in turn emphasized special circumstances that the Ws brought to the table.  

That impasse transferred the OIC file to Appeals.

It was now March 2020.

Remember what happened in March 2020?

COVID.

The two sides finally spoke in September.

Appeals agreed with an RCP of $250 grand. The Settlement Officer (SO) figured that the Ws could draw retirement monies to pay-off the IRS.

Meanwhile Mr. W had retired and Mrs. W was gigging at the mall only two weekends a month.

The SO was not changing her mind. She figured that Mrs. W must have a pension from the school. She also surmised that Mr. W’s military pension must be $2,253 per month rather than $1,394. How did she know all this? Magic, I guess.

The W’s argued that they could not borrow against the house. They had refinanced it under something called the Home Affordability Refinance Program, which helps homeowners owing more than their house is worth. A ballon payment was due in 2034, and refinancing a house that is underwater is nearly impossible.

This did not concern the SO. She saw an assessed value of $243,000 on the internet, subtracted an $85 thousand mortgage, which left plenty of cash. The W’s pointed out that there was deferred maintenance on the house – a LOT of deferred maintenance. Between the impossible mortgage and the deferred maintenance, the house should be valued – they argued – at zero.

Nope, said the SO. The Ws could access their retirement to pay the tax. They did not have to involve the house, so the mortgage and deferred maintenance was a nonfactor. She then cautioned the W’s not to withdraw retirement monies for any reason other than the IRS. If they did so, she would consider the assets as “dissipated.” That is a bad thing.

Off to Tax Court they went. Remember my comment earlier: low chance of success. What choice did the Ws have? At least they were well represented by the tax clinic.

The Court saw three key issues.

Retirement Account

The W’s led off with a great argument:

 

  

This is Internal Revenue Manual 5.8.5.10, which states that a taxpayer within one year of retirement may have his/her retirement account(s) treated as income rather than as an asset. This is critical, as it means the IRS should not force someone to empty their 401(k) to pay off tax debt.

The SO was unmoved. The IRM says that the IRS “may” but does not say “must.”

Yep, that is the warm and fuzzy we expect from the IRS.

The Court acknowledged:

We see no erroneous view of the law and no clearly erroneous assessment of facts.”

But the Court was not pleased with the IRS:

But there may be a problem for the Commissioner – this reasoning didn’t make it into the notice of determination …”

The “notice of determination” comment is the Court saying the files were sloppy. The IRS must do certain things in a certain order, especially with OICs. Sloppy won’t cut it.

Home Equity

The W’s had offered to provide additional information on the loan terms, the deferred repairs to the house, the unwillingness of the banks to refinance.

The IRS worked from assessed values.

It is like the two were talking past each other.

Here is the Court:

The IRS does need to take problems with possible refinancing a home seriously.”

The Whittakers have a point – there’s nothing in the administrative record that states or even suggests that the examiner at the Unit or the settlement officer during the CDP hearing asked for any information in addition to the appraised value.”

There is no evidence in the record of any consideration of the Whittakers’ arguments on this point.”

Oh, oh.

Here is the first slam:

We therefore find that the settlement officer’s conclusion about the Whittaker’s ability to tap the equity in their home was clearly erroneous on this record. This makes her reliance on that equity in her RCP calculations an abuse of discretion.”

COVID

The W’s had alerted the IRS that Mr. W had completely retired and Mrs. W was working only two weekends a month. The SO disregarded the matter, reasoning that the W’s had enough pension income to compensate.

Which pension, you ask? Would that include the pension the SO unilaterally increased from $1,394 to $2,253 monthly?

The Commissioner now concedes that the settlement officer was mistaken, and that Mr. Whittaker had a military pension of only $1,394 per month.”

Oops.

There was the second slam.

The IRS – perhaps embarrassed – went on to note that the Mall of America opened after being COVID-closed for three months. Speaking of COVID, the lockdown had inspired a nationwide surge in demand for fitness equipment. Say …, wasn’t Mr. W a personal fitness trainer?

The Court erupted:

Upholding the rejection of the Whittakers’ offer because Mrs. Whittaker’s mall job may have resumed or Mr. Whittaker might be able to run a training business using potential clients’ possible pandemic purchases is entirely speculative.”

True that.

The settlement officer ‘did not think that the loss of the Whittaker’s wage income or self-employment income … sufficiently mattered to justify reworking the Offer Worksheet.’”

The Court was getting heated.

The settlement officer’s explicit refusal to rework the worksheet despite the very considerable discrepancy in the calculation before and after the pandemic is a clear error and thus an abuse of discretion.”

The Court remanded the matter back to IRS Appeals with clear instructions to get it right. It explicitly told the IRS to consider the material change in the Ws’ circumstances – changes that happened during the CDP hearing itself - and their ability to pay.

We said earlier “almost futile.” We did not say futile. The Ws won and are headed back to IRS Appeals to revisit the OIC.

Our case this time was Whittaker v Commissioner, T.C. Memo 2023-59.

Can A Taxpayer Be Responsible For Tax Preparer Fraud?

 

We are familiar with the statute of limitations. In general, the SoL means that you have three years to file a return, information important to know if you are due a refund. Likewise, the IRS has three years to audit or otherwise adjust your return, important to them if you owe additional tax.

The reason for the SoL is simple: it has to end sometime, otherwise the system could not function.  Could it be four years instead of three? Of course, and some states use four years. Still, the concept stands: the ferris wheel must stop so all parties can dismount.

A huge exception to the SoL is fraud. File a fraudulent return and the SoL never starts.

Odds are, neither you nor I are too sympathetic to someone who files a fraudulent return. I will point out, however, that not all knuckleheaded returns are necessarily fraudulent. For example, I am representing an IRS audit of a 2020 Schedule C (think self-employed). It has been one of the most frustrating audits of my career, and much of it is self-inflicted. I know the examiner had wondered how close the client was to the f-word; I could hear it in her word selection, pausing and voice. We spoke again Friday, and I could tell that she had moved away from that thought. There is no need to look for fraud when being a knucklehead suffices.

Here is a question for you:

You do not commit fraud but your tax preparer does. It could be deductions or credits to which you are not entitled. You do not look at the return too closely; after all, that is why you pay someone. He/she however did manage to get you the refund he/she had promised. Can you be held liable for his/her fraud?

Let’s look at the Allen case.

Allen was a truck driver for UPS. He had timely filed his tax return for the years 1999 and 2000. He gave all his tax documents to his tax preparer (Goosby) and then filed the resulting return with the IRS.

Mr. Goosby however had been juicing Allen’s itemized deductions: contributions, meals, computer, and other expenses. He must have been doing quite a bit of this, as the Criminal Investigations Division (CID, pronounced “Sid”) got involved.

COMMENT: CID is the part of the IRS that carries a gun. You want nothing to do with those guys.

Allen was a good guy, and he agreed with the IRS that there were bogus numbers on his return.

He did not agree that the tax years were open, though. The IRS notice of deficiency was sent in 2005 – that is, outside the normal three years. Allen felt that the tax years had closed.

He had a point.

However, look at Section 6501(c):

§ 6501 Limitations on assessment and collection.

(c)  Exceptions.

(1)  False return.

In the case of a false or fraudulent return with the intent to evade tax, the tax may be assessed, or a proceeding in court for collection of such tax may be begun without assessment, at any time.

The Court pointed out that the law mentions a “false or fraudulent return.” It does not say that the fraud must be the taxpayer’s.

The year was open, and Allen owed the additional tax.

I get it. There is enough burden on the IRS when fraud is involved, and the Court was not going to add to the burden by reading into tax law that fraud be exclusively the taxpayer’s responsibility.

The IRS had helped its case, by the way, and the Court noticed.

How?

The IRS had not assessed penalties. All it wanted was additional tax plus interest.

I wish we could see more of that IRS and less of the automatic penalty dispenser that it has unfortunately become.

Allen reminds us to be careful when selecting a tax preparer. It is not always about getting the “largest” refund. Let’s be honest: for many if not most of us, there is a “correct” tax number. It is not as though we have teams of attorneys and CPAs sifting through vast amounts of transactions, all housed in different companies and travelling through numerous foreign countries and treaties before returning home to us. Anything other than that “correct” number is … well, a wrong number.  

Our case this time was Allen v Commissioner, 128 T.C. 4 (U.S.T.C. 2007).

The Consistent Basis Rule

 

I was talking to two brothers last week who are in a partnership with their two sisters. The partnership in turn owns undeveloped land, which it sold last year. The topic of the call was the partnership’s basis in the land, considering that land ownership had been divided in two and the partnership sold the property after the death of the two original owners. Oh, and there was a trust in there, just to add flavor to the stew.

Let’s talk about an issue concerning the basis of property inherited from an estate.

Normally basis means the same as cost, but not always. Say for example that you purchased a cabin in western North Carolina 25 years ago. You paid $250 grand for it. You have made no significant improvements to the cabin. At this moment your basis is your cost, which is $250 grand.

Let’s add something: you die. The cabin is worth $750 grand.

The basis in the cabin resets to $750 grand. That means – if your beneficiaries sell it right away – there should be no – or minimal – gain or loss from the sale. This is a case where basis does not equal cost, and practitioners refer to it as the “mark to market,” or just “mark” rule, for inherited assets.

There are, by the way, some assets that do not mark. A key one is retirement assets, such as 401(k)s and IRAs.

A possible first mark for the siblings’ land was in the 1980s.

A possible second mark was in the aughts.

And since the property was divided in half, a given half might not gone through both marks.

There is something in estate tax called the estate tax exemption. This is a threshold, and only decedents’ estates above that threshold are subject to tax. The threshold for 2024 is $13.6 million per person and is twice that if one is married.

That amount is scheduled to come down in 2026 unless Congress changes the law. I figure that the new amount will be about $7 million. And twice that, of course, if one is married.

COMMENT: I am a tax CPA, but I am not losing sleep over personal estate taxes.

However, the exemption thresholds have not always been so high. Here are selected thresholds early in my career: 

		Estate Tax
Year		Exclusion
1986		500,000
1987- 1997		600,000
1998		625,000

I would argue that those levels were ridiculously low, as just about anyone who was savings-minded could have been exposed to the estate tax. That is – to me, at least – absurd on its face.

One of our possible marks was in the 1980s, meaning that we could be dealing with that $500,000 or $600,000 estate threshold.

So what?

Look at the following gibberish from the tax Code. It is a bit obscure, even for tax practitioners.

Prop Reg 1.1014-10(c):

               (3) After-discovered or omitted property.

(i)  Return under section 6018 filed. In the event property described in paragraph (b)(1) of this section is discovered after the estate tax return under section 6018 has been filed or otherwise is omitted from that return (after-discovered or omitted property), the final value of that property is determined under section (c)(3)(i)(A) or (B) of this section.

(A) Reporting prior to expiration of period of limitation on assessment. The final value of the after-discovered or omitted property is determined in accordance with paragraph (c)(1) or (2) of this section if the executor, prior to the expiration of the period of limitation on assessment of the tax imposed on the estate by chapter 11, files with the IRS an initial or supplemental estate tax return under section 6018 reporting the property.

(B) No reporting prior to expiration of period of limitation on assessment. If the executor does not report the after-discovered or omitted property on an initial or supplemental Federal estate tax return filed prior to the expiration of the period of limitation on assessment of the tax imposed on the estate by chapter 11, the final value of that unreported property is zero. See Example 3 of paragraph (e) of this section.

(ii) No return under section 6018 filed. If no return described in section 6018 has been filed, and if the inclusion in the decedent's gross estate of the after-discovered or omitted property would have generated or increased the estate's tax liability under chapter 11, the final value, for purposes of section 1014(f), of all property described in paragraph (b) of this section is zero until the final value is determined under paragraph (c)(1) or (2) of this section. Specifically, if the executor files a return pursuant to section 6018(a) or (b) that includes this property or the IRS determines a value for the property, the final value of all property described in paragraph (b) of this section includible in the gross estate then is determined under paragraph (c)(1) or (2) of this section.

This word spill is referred to as the consistent basis rule.

An easy example is leaving an asset (intentionally or not) off the estate tax return.

Now there is a binary question:

Would have including the asset in the estate have caused – or increased – the estate tax?

If No, then no harm, no foul.

If Yes, then the rule starts to hurt.

Let’s remain with an easy example: you were already above the estate exemption threshold, so every additional dollar would have been subject to estate tax.

What is your basis as a beneficiary in that inherited property?

Zero. It would be zero. There is no mark as the asset was not reported on an estate tax return otherwise required to be filed.

If you are in an estate tax situation, the consistent basis rule makes clear the importance of identifying and reporting all assets of your estate. This becomes even more important when your estate is not yet at – but is approaching – the level where a return is required.

At $13.6 million per person, that situation is not going to affect many CPAs.

When the law changes again in a couple of years, it may affect some, but again not too many, CPAs.

But what if Congress returns the estate exemption to something ridiculous – perhaps levels like we saw in the 80s and 90s?

Well, the consistent basis rule could start to bite.

What are the odds?

Well, this past week I was discussing the basis of real estate inherited in the 1980s.

What are the odds?

Not Quite The Informal Claim Doctrine

 

I am looking at a district court opinion from Illinois.

I find the discussion of the numbers a bit confusing. It happens sometimes.

But there something here we should talk about.

We have recently discussed the tax concept of a “claim.” In normal-person-speak, it means you want the government to refund your money. The classic claim is an amended income tax return, but there can be claims for other-than-income taxes. It is its own niche, as using the wrong form can result in having your claim rejected.

Let’s look at the American Guardian Holdings case.

AGH filed its 2015 tax return on September 19, 2016.

Here are the numbers on the original tax return:     

	Original
Revenues	152,092,338
Taxable income	4,880,521
Tax	1,327,806

 The accountant found an error and amended the return on June 6, 2019.

			First
	Original		Original	Amended
Revenues	152,092,338		152,092,338	154,808,792
Taxable income	4,880,521		4,880,521	11,084,397
Tax	1,327,806		1,327,806	148,243
Refund				(1,179,563)

Let me see: The 2015 return would have been extended to October 15, 2016. The amended return was prepared June 6, 2019. Yep, we are within the statute of limitations.

Problem: AGH never sent the amended return.

Answer: AGH hired a new accountant.

The new accountant filed an amended return on September 19, 2019.

COMMENT: Still a few days left on the statute.

For some reason, the accountant incorporated the first amended (even though it had not been filed) into the second amended, resulting in the following hodgepodge:

		First		Second
		Original	Amended	Original	Amended
Revenues		154,808,792	141,773,572	154,808,792	?
Taxable income		11,084,397	7,446,746	11,084,397	?
Tax		1,327,806	148,243	1,327,806	0
Refund			(1,179,563)		(148,243)
Total refund					(1,327,806)

Huh? I would find that second amended confusing. On first impression it appears that AGH is filing a claim for $148,243, but that is incorrect. AGH was stacking the second amended on top of its first. AGH is filing a claim for $1,327,806, which is the entire tax on the original return.

Not surprisingly, the IRS also responded with “huh?” It could not process the second amended return because the “Original” numbers did not match its records.

AGH responded by filing yet another amended return (third amended). Mind you, at this point it was after October 15, 2019, and the statute of limitations was in the rear view mirror.

AGH did the following:

(1)  AGH explained that the new and shiny (third) amended return incorporated the previously (non-filed) first amended return and the second (actually filed) amended return. As a consequence, the “previously-filed amended return for 2015 should be discarded.”

COMMENT: NO! 

(2)  AGH further explained that it was filing Form 1120-PC (a specialized tax form for property and casualty insurance companies) as its third amended return rather than the Form 1120 originally filed because it had received permission to change its method of accounting.

COMMENT: NO!!

I am somewhat shocked at how deep a hole AGH had dug, and more shocked that it kept digging.

Let’s go through the wreckage:

(1)  AGH filed its (second) amended return/claim within the statute of limitations.

(2)  This creates an issue if the claim is imperfect, as one would be perfecting the claim AFTER the statute expires. Fortunately, there is a way (called the informal claim doctrine) that allows one to perfect a claim after the original filing date and still retain the benefit of that original date. 

(3)  The IRS immediately seized on the “previously-filed amended return for 2015 should be discarded” statement to argue that AGH had violated the informal claim doctrine.  If the second amended return was discarded, there was no timely-filed return to which the informal claim doctrine could attach. Fortunately, the Court decided that the use of the word “discard” did not actually mean what it sounded like. AGH dodged a bullet, but it should never have fired.

(4)  That leaves the third amended return, which was filed after the statute expired. AGH of course argued informal claim, but it had committed a fatal act by changing its method of accounting. You see, the informal claim allows one to clarify, document and explain whatever issue is vague or in dispute within the claim at issue. What one is not allowed to do is to change the facts. AGH had changed the facts by changing its method of accounting, meaning its third amended return could not be linked to the second via the informal claim doctrine.

(5)  Standing on its own, the third amended of course failed as it was filed after the statute had expired.    

This case is a nightmare. I am curious whether there was a CPA or law firm involved; if so, a malpractice suit is almost a given. If the work was done in-house, then … AGH needs to tighten up its hiring standards. The case reads like there were no adults in the room.

All is not lost for AGH, however.

Remember that AGH filed its second amended return within the statute of limitations.  The matter then went off the rails and the Court booted the third amended return.

But that leaves the second amended. Can AGH resuscitate it, as technically the Court dismissed the third claim but not necessarily the second?  It would likely require additional litigation and associated legal fees, and I would expect the IRS to fight tooth and nail. AGH would have to weigh the cost-benefit.

Our case this time was American Guardian Holdings, Inc v United States of America, No. 1:2023cv 01482, Northern District of Illinois.