Income And Cancellation of Indebtedness

 

I am reading a case about cancellation of indebtedness income. 

Let’s take a moment to discuss the concept of income in the tax Code. 

The 16^th amendment, passed in 1913 and authorizing a federal income tax, reads as follows: 

The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.

Needless to say, the definition of “incomes, from whatever source” became immediately contentious. 

Ask a tax practitioner for a definition of income, and it is likely that he/she will respond with “an accession to wealth.” 

That phrase comes from a 1955 Supreme Court case (Commissioner v Glenshaw Glass) which included the following: 

Here, we have instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion." 

I am seeing three conditions, of which “accession to wealth” is but one. 

Let’s circle back to indebtedness and income.

Can one have income by borrowing money? 

Unless there is something extraordinarily odd about the loan, I would say “no.” The reason is that any increase in wealth (by receipt of the loan proceeds) is immediately offset by the requirement to repay the loan. 

Let’s say you buy a house. You take out a mortgage. 

What if you are in financial distress and mail the keys back to the mortgage company? 

Granted, the house secures the debt, but surrendering the house does not automatically release the debt. It however will likely result in your receiving the following 1099:

Like any 1099, there is a presumption of income. In this instance, there has been an exchange in the ownership of the house. There is another way to say this: the tax Code sees a sale of the property. 

It seems odd that tax sees potential income here. It is unlikely to happen if the surrendered asset is one’s principal residence, as one would have access to the $250,000/$500,000 gain exclusion. It could happen if the surrendered asset is rental or investment property, though. 

What about the debt on the property? 

Tax considers that a separate transaction. 

When the debt is discharged, the IRS has yet another form: 

Yes, it gets confusing. The system works much better when the two steps happen concurrently – such as in a short sale. In that case, it is common to skip the 1099-A altogether and just issue the 1099-C. 

NOTE: There is a twist in the straw depending upon whether the debt is recourse or nonrecourse. Believe it or not, there are about a dozen states where you can buy your principal residence with nonrecourse debt. You will not be surprised to learn that California is one of them. The upside is that you can return the keys to the bank and no longer be responsible for the mortgage. The downside is this policy was a major contributor to the burst of the housing bubble in the late aughts.

It is common for the 1099-C to be issued three years after the 1099-A. Why? The Code requires the reporting of cancellation of indebtedness on or before an “identifiable event” happens. 

An identifiable event in turn is defined as: 

1.  bankruptcy
2.  expiration of statute of limitations for collection
3.  cancellation of debt that renders it unenforceable in a receivership, foreclosure, or similar proceeding
4.  creditor's election of foreclosure remedies that statutorily bars recovery
5.  cancelation of debt due to probate proceedings
6.  creditor's discharge pursuant to an agreement
7.  discharge of indebtedness pursuant to a decision by the creditor, or the application of a defined policy of the creditor, to discontinue collection activity and discharge debt
8.  in specific cases, the expiration of a non-payment testing period [presumption of 36 months of no payment to the creditor]    

The three years is number (8). 

The income type we are discussing with the 1099-C is cancellation of indebtedness income. As discussed, just borrowing money does not create income. Whereas your assets may go up (you have cash from the loan or bought something with the cash), that amount is offset by the loan itself. The scales are balanced, and there is no accession to income. 

However, cancel the debt. 

The scale is no longer balanced. 

Meaning you have potential income. 

But the Code allows for exceptions. Here is Section 108: 

                (a) Exclusion from gross income

(1) In general Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if—

(A) the discharge occurs in a title 11 case,

(B) the discharge occurs when the taxpayer is insolvent,

(C) the indebtedness discharged is qualified farm indebtedness,

(D) in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness, or

(E) the indebtedness discharged is qualified principal residence indebtedness which is discharged—

(i) before January 1, 2026, or

(ii) subject to an arrangement that is entered into and evidenced in writing before January 1, 2026. 

The common ones are (a)(1)(A) for bankruptcy and (a)(1)B) for insolvency. 

Bankruptcy is self-explanatory. 

Solvency is not self-explanatory. You can think of insolvency as being bankrupt but not filing for formal bankruptcy. You owe more than you own. Let’s call the difference between the two the “hole.” To the extent that that cancelled debt is less than the “hole,” there is no cancellation of indebtedness income. Once the cancelled debt equals the “hole,” the exclusion ends. At that point, your net worth is zero (-0-). Technically the next dollar is an “accession to wealth” and therefore income. 

In our case this week Ilana Jivago borrowed from Citibank. She defaulted and was eventually foreclosed on in 2009. Citibank sent her a 1099-C. Jivago argued that it was nontaxable because it was qualified principal residence indebtedness per (a)(1)(E) above. 

Qualified principal residence indebtedness is defined as:         

Indebtedness incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer.

The Court looked at photographs of and admired the renovations she made in 2005 and 2006. The Court noted that Jivago did not use an interior designer, and she did much of the work herself.

The problem is that 2005 and 2006 were before she borrowed from Citibank. 

Easy win for the IRS.

Our case this time was Jivago v Commissioner, Docket No. 5411-21.

The Skip Tax - Part Two

 

How does one work with the skip?

In my experience, the skip is usually the realm of the tax attorneys, although that is not to say the tax CPA does not have a role. The reason is that most skips involve trusts, and trusts are legal documents. CPAs cannot create legal documents. However, let that trust age a few decades, and it is possible that the next set of eyes to notice a technical termination or taxable distribution will be the CPA.

Let’s pause for a moment and talk about the annual exclusion and lifetime exemption.

The gift tax has an annual exclusion of $18,000 per donee per year. There is also a (combined gift and estate tax) lifetime exemption of $13.6 million per person. If you gift more than $18 grand to someone, you start carving into that $13.6 million lifetime exemption.

The skip tax has the same exclusion and exemption limits as the gift tax.

The problem is that a gift and a skip may not happen at the same time.

Let’s take two examples.

(1)  A direct skip

That is the proverbial gift to the grandchild. Let’s say that it well over $18 grand, so you must file a return with the IRS.

You gift her a $100 grand.

The gift is complete, so you file Form 709 (the gift tax return) with your individual tax return next year.

The transfer immediately dropped at least two generations, so the skip is complete. You complete the additional sections in Form 709 relating to skips. You claim the annual exclusion of $18 grand, and you apply some of the $13.6 million exemption to cover the remaining $82 grand.

Done. Directs skips are easy.

(2)  An indirect skip

Indirects are another way of saying trusts.

Remember we discussed that there is a scenario (the taxable termination) where the trust itself is responsible for the skip tax. However, there is no skip tax until the exemption is exhausted. The skip may not occur for years, even decades, down the road. How is one to know if any exemption remains?

Enter something called the “inclusion ratio.”

Let’s use an example.

(1)  You fund a trust with $16 million, and you have $4 million of (skip) lifetime exemption remaining. 

(2)  The skip calculates a ratio for this trust.

4 divided by 16 is 25%.

Seems to me that you have inoculated 25% of that trust against GST tax.

(3)  Let’s calculate another ratio.

1 minus 25% is 75%.

This is called the inclusion ratio.

It tells you how much of that trust will be exposed to the skip tax someday.

(4)  Calculate the tax. 

Let’s say that the there is a taxable termination when the trust is worth $20 million.

$20 million times 75% equals $15 million.

$15 million is exposed to the skip tax.

Let’s say the skip tax rate is 40% for the year the taxable termination occurs.

The skip tax is $6 million.

That trust is permanently tainted by that inclusion ratio.

Now, in practice this is unlikely to happen. The attorney or CPA would instead create two trusts: one for $4 million and another for $11 million. The $4 million trust would be allocated the entire remaining $4 million exemption. The ratio for this trust would be as follows:

                       4 divided by 4 equals 1

                       1 minus 1 equals -0-.

                       The inclusion ratio is zero.

                       This trust will never have skip tax.

What about the second trust with $11 million?

You have no remaining lifetime exemption.

The second trust will have an inclusion ratio of one.

There will be skip tax on 100% of something in the future.

Expensive?

Yep, but what are you going to do?

In practice, these are sometimes called Exempt and Nonexempt trusts, for the obvious reason.

Reflecting, you will see that a direct skip does not have an equivalent to the “inclusion ratio.” The direct skip is easier to work with.

A significant issue involved with allocating is missing the issue and not allocating at all.

Does it happen?

Yes, and a lot. In fact, it happens often enough that the Code has default allocations, so that one does not automatically wind up having trusts with inclusion ratios of one.

But the default may not be what you intended. Say you have $5 million in lifetime exemption remaining. You simultaneously create two trusts, each for $5 million. What is that default going to do? Will it allocate the $5 million across both trusts, meaning that both trusts have an inclusion ratio of 50%? That is probably not what you intended. It is much more likely that you intend to allocate to only one trust, giving it an inclusion ratio of zero.

There is another potential problem.

The default does not allocate until it sees a “GST trust.”

What is a GST trust?

It is a trust that can have a skip with respect to the transferor unless one or more of six exceptions apply.

OK, exceptions like what?

Exception #1 – “25/46” exception. The trust instrument provides that more than twenty-five percent (25%) of the trust principal must be distributed (or may be withdrawn) by one or more persons who are non-skip persons before that individual reaches age forty-six (46) (or by a date that will occur or under other circumstances that are likely to occur before that individual reaches age forty-six (46)) (IRC §2632(c)(3)(B)(i)).”

Here is another:

Exception #2 – “25/10” exception. The trust instrument provides that more than twenty-five percent (25%) of the trust principal must be distributed (or may be withdrawn) by one or more persons who are non-skip persons and who are living on the date of the death of another person identified in the instrument who is more than ten (10) years older than such individual (IRC §2632(c)(3)(B)(ii)).”

Folks, this is hard terrain to navigate. Get it wrong and the Code does not automatically allocate any exemption until … well, who knows when?

Fortunately, the Code does allow you to override the default and hard allocate the exemption. You must remember to do so, of course.

There is another potential problem, and this one is abstruse.

One must be the “transferor” to allocate the exemption.

So what, you say? It makes sense that my neighbor cannot allocate my exemption.

There are ways in trust planning to change the “transferor.”

You want an example?

You set up a dynasty trust for your child and grandchildren. You give your child a testamentary general power of appointment over trust assets.

A general power of appointment means that the child can redirect the assets to anyone he/she wishes.

Here is a question: who is the ultimate transferor of trust assets – you or your child?

It is your child, as he/she has last control.

You create and fund the trust. You file a gift tax return. You hard allocate the skip exemption. You are feeling pretty good about your estate planning.

But you have allocated skip exemption to a trust for which you are not the “transferor.” Your child is the transferor. The allocation fizzles.

Can you imagine being the attorney, CPA, or trustee decades later when your child dies and discovering this? That is a tough day at the office.

I will add one more comment about working in this area: you would be surprised how legal documents and tax returns disappear over the years. People move. Documents are misplaced or inadvertently thrown out. The attorney has long since retired. The law firm itself may no longer exist or has been acquired by another firm. There is a good chance that your present attorney or CPA has no idea how – or if – anything was allocated many years ago. Granted, that is not a concern for average folks who will never approach the $13.6 million threshold for the skip, but it could be a valid concern for someone who hires the attorney or CPA in the first place. Or if Congress dramatically lowers the exemption amount in their relentless chase for the last quarter or dollar rolling free in the economy.

With that, let’s conclude our talk about skipping.

 

Spotting The Skip Tax - Part One

I was reviewing something this week we may not have discussed before. Mind you, there is a reason we haven’t: it is a high-rent problem, not easy to understand or likely to ever apply to us normals. If you work or advise in this area (as attorney, CPA, trustee or so on), however, it can wreck you if you miss it.

Let’s talk a bit about the generation skipping tax. It sometimes abbreviated “GST,” and I generally refer to it as the “skip.”

Why does this thing even exist?

It has to do with gift and estate taxes.

You know the gift tax: you are allowed to make annual gifts up to a certain amount per donee before having to report the gifts to the IRS. Even then, you are spotted an allowance for lifetime gifts. While there may be paperwork, you do not actually pay gift tax until you exhaust that lifetime allowance.

You know the estate tax: die with enough assets and you may have a death tax. Once again, there is an allowance, and no tax is due until you exceed that allowance. The 2024 lifetime exemption is $13.6 million per person, so you can be wealthy and still avoid this tax.

As I said, we are discussing high-end tax problems.

Then there is the third in this group of taxes: the generation skipping tax. It is there as a backstop. Without it, gift and estate taxes would lose a significant amount of their bite.

Why Does the Skip Exist?

Let go through an example.

When does the estate tax apply (setting aside that super-high lifetime exemption for this discussion)?

It applies when (a) someone with a certain level of assets (b) dies.

How would a planner work with this?

Here is an idea: what if one transfers assets to something that itself cannot die? Without a second death, the estate tax is not triggered again.

What cannot die, without going all Lovecraftian?

How about a corporation?

Or – more likely – a trust?

When Does The Skip Apply?

It applies when someone transfers assets to a skip person.

Let’s keep this understandable and not go through every exception or exception to the exception.

A skip person is someone two or more generations below the transferor.

          EXAMPLE:

·       A transfer to my kid would not be a skip.

·       A transfer to my grandchild would be a skip.

What Constitutes a Transfer?

There are two main types:

·       I simply transfer assets to my grandchild. Perhaps she finishes her medical degree, and I buy and deed her first house.

·       I transfer assets through a trust.

The first type is called a direct skip. Those are relatively easy to spot, trigger the skip immediately and require a tax filing.

You already know the form on which the skip is reported: the gift tax return itself (Form 709). The form has additional sections when the skip tax applies.

          EXAMPLE:

·       I give my son a hundred grand. This is over the annual dollar limit, so a gift tax return is required. My son is not a skip person, so I need not concern myself with the skip tax sections of Form 709.

·       I give my grandson a hundred grand. This is over the annual limit, so a gift tax return is required. My grandson is also a skip person, so I need to complete the skip tax sections of Form 709.

What Is the Second Type of Transfer?

Use a trust.

Here is an example:

• Create a trust in a state that has relaxed its rule against perpetuities (RAP).

a.     This rule comes from English common law, and its intent was to limit how long a person can control the ownership and transfer of property after his/her death.

• Fund the trust at the settlor’s death.

a.     If that someone is Jeff Bezos or Elon Musk, there could be some serious money involved here.

•   The settlor’s children receive distributions from the trust. When they die, the settlor’s grandchildren take their place.

• When the grandchildren die, the great grandchildren take their place, and so on.

What we described above BTW is a dynasty trust.

The key here is - before the skip tax entered the Code in the 1970s - the then-existing gift and estate tax rules would NOT pull that trust back onto anyone’s estate return for another round of taxation.

Congress was not amused.

And you can see why a skip is defined as two generations below the transferor. Congress wanted a bite into that apple every generation, if possible.

How Does Skipping Through A Trust Work?

There are two main ways: 

EXAMPLE ONE: Say the trust has a mix of skip and nonskip beneficiaries, say children (nonskip) and grandchildren (skip). The IRS chills, because the trust might yet be includable in the taxable estate of a nonskip person. Say the last nonskip person dies (leaving only skips as beneficiaries) AND nothing is includable in an estate return somewhere. Yeah, no: this will trigger the skip tax. To make things confusing, the skip refers to this as a “termination,” even though nothing has actually terminated.   

EXAMPLE TWO: The trust again has a mix of skip and nonskip beneficiaries. This just like the preceding, except we will not kill-off the nonskip beneficiary. Instead, the trust simply distributes to a skip or skips (say the grandchildren or great-grandchildren). This triggers the skip tax and is easier to identify and understand.

If Skipping Through A Trust, When Is the Tax Due?

Look at Example One above. This could be years – or decades – after the creation of the trust.  

The trustee is supposed to recognize that there has been a skip “termination” of the trust. The trustee would file the (Form 709) tax return, and the trust would pay the skip tax.

And – yes – in the real world it is a problem. What if the trustee (or attorney or CPA) misses the termination as a taxable event?

Malpractice, that’s what. An insurance company will probably be involved.

What About Example Two?

This is a backstop to the first type of transfer. In the second type there is still a nonskip beneficiary, meaning that the trust has not “terminated” for skip purposes. The trust distributes, but the distribution goes to a skip.

Say the trust distributes a 1965 Shelby Mustang GT350 R.

First, nice.

Second, the skip tax is paid by the beneficiary receiving the distribution. The trust does not pay this one.

Third, the trustee may want to warn the beneficiary that he/she owes skip tax on a car worth at least $3.5 million.

Fourth, realistically the trust is going to pay, whether upfront or as a reimbursement to the beneficiary. The tax paid is itself subject to the skip tax if it comes out of the trust.

How Much Is the Skip Tax?

Right now, it is 40 percent.

It changes with changes to the gift and estate tax rates.

That 1965 Shelby GT 350R comes with a skip tax of at least $1.4 million. It takes a lot of green to ride mean.

How Do You Plan for This Tax?

The skip is very much a function of using trusts in estate planning.

Trust taxation can be oddball on its own.

Introduce skip tax and you can go near hallucinatory.

This is a good spot for us to break.

We will return next post to continue our skip talk.

The Change-Of-Address Rules Matter

 

The IRS requests that one alert them of change-of-address when one moves. There is even a form, but I do not often see the form used in practice. Normally the IRS is alerted when one files the next tax return with the new address.

It is, by the way, a good idea to alert the IRS of a change of address in case you have the misfortune of tax notices. There is a clock for certain tax notices, and once they start it can be difficult to reverse the clock.

I will give you one, as it has become more repetitive in practice than I would have liked: the notice of deficiency, also called a “statutory” notice of deficiency. I generally refer to it as the SNOD.

We have talked about the SNOD before. The IRS wants to reduce its tax assessment to a judgement. That requires the intervention of a court - the Tax Court in this case - and the IRS sends out a multipage, impressive, imposing if not intimidating notice to the taxpayer.

Who in turn collects it with other tax documents - unread - and drops the bundle off a-half-year later (or more) when it is time to meet with the CPA.

There is a problem here: one has 90 days to respond to a SNOD.

Which has passed. The level of difficulty has increased. The matter has already defaulted in favor of the IRS, of course, as the taxpayer never responded. The IRS has unleashed its Collections berserkers, who have little interest whether you actually owe the tax or not.

Here is a Collections story from several years ago. The IRS proposed changes to a client’s tax return. Sure enough, the SNOD got lost in the mail, was stolen from the mailbox, was thrown in the trash, whatever. The IRS changed numbers here and there. Some numbers were small and of minor import. Others were 1099s issued to our client but belonging elsewhere among related taxpayers. Then there was the big number: the rollover of a 401(k) or IRA. A 1099 is issued for a rollover, although it is normally a nontaxable event. The 1099 has a unique code for a rollover. The IRS, the taxpayer and accountant see the code, and everybody moves on.

Not this time.

The IRS did not see the code. Underreported income! Fair share! Tax the rich! The IRS went through its dunning notice series, eventually its SNOD, and then Collections activity. They filed a lien. They were irate, as they thought the taxpayer was ignoring them.

The taxpayer had no idea. It was only when trying to sell some real estate that the lien – and the rest of the story - came to light.

We went all Sherlock on what had happened.

We filed an amended return to reverse the IRS adjustment. We had Collections hold back the war dogs to allow the IRS time to process the amended return.

Which never happened. Collections came back more frenzied than before.

The system had failed. We wanted to know where that amended return was. The IRS is not built for self-reflection, BTW, but we eventually found the return. Someone in Kansas City had started to work the file, I presume quitting time arrived and – as an example of why people hate government unions – never got back to our client. Never. As in ever.

Yeah, the matter eventually got resolved, but it had become a sinkhole of professional time. I did talk with a very pleasant IRS attorney from Nashville, who - once the matter got to her - moved heaven and earth to reverse the lien.

And there you have an example of how not responding to a SNOD can sour someone’s life.

And an example of why I believe that the IRS should be required to reimburse a tax professional’s time when the IRS fails to follow procedures or otherwise just do their job.

Let’s look at Keith Phillips.

Phillips went to prison in 2010.

Somewhere in there something else bad happened: he was injured and lost almost all vision in his right eye. He filed a civil lawsuit against the prison and received a $201 thousand settlement in 2014. He did not file a tax return for 2014.

Nor would I. Damages for physical injuries are nontaxable, and this sounds very physical to me.

The IRS thought otherwise and wanted almost $52 grand in tax, plus penalties, interest, a safe room, coloring books and a binkie while they worked through the microaggression.

They sent a SNOD.

Phillips had no idea. He was in prison.

The Tax Court rubber-stamped the assessment. The IRS began collection activity. They sent letters to the same address as the SNOD but heard nothing back. They filed a tax lien. They notified the State Department that Phillips was seriously delinquent, and State should begin revoking his passport. That State Department matter was fortunately sent to Phillip’s correct address.

Now Phillips was wondering what had happened, although he had no plans to travel overseas in the near future. He filed with the Tax Court.

IRS:            More than 90 days have passed. We win, you lose. Why? Because you are a loser, you big loser you.  

Phillips:       Hey, IRS, you sent the SNOD to the wrong address.

IRS:            Nope, we sent it to the right address.

Phillips:       I never lived at this address.

IRS:             You did. We have a USPS notice for change of address.

Phillips:       Let me see it.

IRS:             Knock yourself out, loser.

Phillips:       This is my son. We have the same name. He was living with his mom. I had been here … in prison … years before this change of address was sent.

IRS:             Oops.

If the SNOD is sent to the wrong address, then the SNOD is not valid. To the IRS’ credit, this error is not common, but it happens.

Mind you, this does not technically mean that the matter is over. Phillips never filed a return for 2014, so the statute of limitations has never started for that year. On the other hand, now that the IRS is aware that the settlement was for personal injury – and thus nontaxable – what is the point?

Our case this time was Phillips v Commissioner, T.C. Memo 2024-44.

Embezzlement And A Payroll Tax Penalty

It has been about a month since I last posted.

To (re)introduce myself, I am a practicing tax CPA. I like to think practice allows a certain reality check on topics we discuss here. I am hesitant to discuss topics I do not work with or have not worked with for a long time. On the other hand, I can be acerbic while bloviating within my wheelhouse. I have strong opinions, for example, with IRS administration of “reasonable cause” relief for certain penalties. Here is one: work someone 80, 90 or more hours per week, deprive him/her of adequate rest, maintain the stress meter at redline, and ... stuff ... just ... happens. Maybe - if we had a government union to drag high achievers down to the level of the common spongers - then stuff would stop happening.

The downside is that this blog is maintained by a practicing CPA, and we just finished busy season.

Let’s ease back into it.

Let’s talk about the big boy penalty - the BBP.

There are penalties when someone fails to remit withheld payroll taxes to the IRS. It makes sense when you think about it. Your employer withholds 6.2% of your gross paycheck for social security and another 1.45% for Medicare. Your employer is also withholding federal income tax. All that is your money - your employer is acting only as a go-between - and not remitting the tax to the IRS is tantamount to stealing from you. And from the IRS.

I have seen it many times over the years. Sometimes still do. Not grievous stuff like Madoff, but nonetheless happening when a business is laboring.

I get it: the business is doing the best it can. I am not saying it is right, but growing up includes acknowledging that a lot of things are not right.

The BBP is a 100% penalty on the withheld employee taxes.

You read that right: 100 percent.

It applies if you are a “responsible person.” That makes sense to me if you are the big cheese at the Provolone factory, but the IRS has been known to consider ordinary Joe’s – somebody stuck at a miserable job for a needed paycheck before another job allows an escape – to be responsible persons. A common thread is that someone has the authority to write checks, meaning the person can decide where the money (however limited) goes. Sounds great in a classroom, but it can lead to stupid in the real world.

Let’s look at Rodney Taylor.

He has degrees in political science, speech, and theater. He is multilingual. He has worked domestically and internationally. He now owns a management company called Taylor & Co.

He says that he suffers from a limited learning disability, one involving mathematics.

Couldn’t tell, but I believe him.

Over the years he delegated much of his financial stuff to professionals such as Robert Gard, his CPA.

OK.

Gard embezzled between one and two million dollars from Taylor. Some of those monies were earmarked as payroll tax deposits.

Gard had a heart attack during a meeting when his fraud was unearthed. It appears that Taylor is a good sort, as Gard survived and attributed his survival to actions Taylor immediately took in response to the heart attack.

And next we read about the lawsuits. And the insurance companies. And banks. And insurance reimbursements. You know the storyline.

While all of this was happening, Taylor paid himself a $77 thousand bonus.

STOP! Pay it back. Immediately. Not Kidding.

Taylor transferred funds from the company’s bank account to a new something he was launching.

DID YOU NOT HEAR STOP???

You know the IRS had a BBP issue here.

Taylor argued that he could not be a responsible person, as he was embezzled. He had difficulties with mathematical concepts. He hired people to do stuff.

I do not know who was advising Taylor - if anyone - but he lost the plot.

• Taylor owed the IRS.
• Taylor was CEO, hired and fired, controlled the financial affairs of the company, and made the decision to sue Gard. He couldn’t be any more responsible if he tried.
• Meanwhile, Taylor diverted money to himself while still owing the IRS.

The IRS gets snarky when you prioritize yourself when you still owe back payroll taxes.

Bam! Big boy penalty.

Yeah, and rain is wet.

Sometimes it … is … just … obvious.

Our case this time was Taylor v Commissioner, T.C. Memo 2024-33.

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.