When The IRS Does Not Believe You Filed An Extension

I have a certain amount of concern whenever we approach a major due date. Let’s use your personal tax return as an example. It is due on April 15; an extension stretches that out to October 15. 

What is the big deal?

Penalties. Fail to extend the return, for example.

How does this happen?

A client moves to another city. A client was unhappy with your fees last year, and you are uncertain if the client is staying with you. A client’s kid starts working, prompting a tax return for the first time. A client gets involved with some business, and the first time you hear about it is when his/her information comes in. A client does business in a new state.

Or – let’s be frank here – you just miss it.

There are two common penalties; think of them as the salt and pepper of penalties:

·      Failure to file

·      Failure to pay

We associate the IRS with taking our money, so one would easily assume that the more onerous penalty is failure to pay. It is not. Owe money past April 15 and the IRS will charge a penalty of ½% per month.

Fail to file, however, and the penalty is 5% per month.

Yep, 10 times as much.

And when does the penalty start?

Miss that extension and it starts April 16.

Huh? Don’t you have until October 15 to file that thing?

Yes, IF you file an extension.

You do not want to miss that extension.

I was reading a case about the Laidlaw brothers. They sold Harley Davidson motorcycles, and they got pulled into Court for a welfare benefit plan that went awry.

There was one issue left: did their accountant file extensions for the two brothers by April 15? If not, those penalties included 5 zeroes. We are talking enough-to-buy-a-house money.

To add to the stress, the trial occurred about a decade after the tax year in question.

The accountant’s name was Morgan, and he presented extensions showing zero tax due for each brother. The IRS said it never received any extensions. Morgan did not send the extensions certified mail, but he recalled sending both extensions in the same envelope. He remembered taking the envelope to the post office and checking for proper postage. He took pride that the Post Office had never returned an extension request for insufficient postage.

He pointed out that there was no question about an extension for the year before, and the year before that, and so forth. The brothers were significant clients to his firm, and he went the extra mile.

The IRS was having none of it. They pointed out that Morgan had many clients, and the likelihood that he could remember something that specific from a decade ago was dubious. Additionally, any memory was suspect as self-serving.

Sounds like Morgan needed to present well in front of the Court.

And there is the rub. The Laidlaw case went Rule 122, meaning that depositions were submitted to the Court, but there was no opportunity for face-to-face questioning.

Here is the Court:

… we had no opportunity to observe Mr. Morgan’s credibility as a witness. The reliability of a witness’ testimony hinges on his credibility. We were not provided a full opportunity – so critical to our being able to find the witness reliable – to evaluate Mr. Morgan’s credibility on the issue of timely filing because petitioners never offered his live testimony in a trial setting. While we can learn much from reading the testimony, it is not the same as a firsthand observation of the witness’ demeanor and sincerity, both essential aspects of credibility and reliability.

The brothers lost, and the IRS collected a sizeable penalty amount.

Back in the day, we used to log all extensions going to the IRS. We would certify each envelope and then attach the receipt to a log detailing each envelope’s contents. Granted, that log could not prove that a given envelope contained a given extension, but it did show our attention to policies and procedures. I recall getting out of at least one sizeable penalty by arguing that point to the IRS.

Those were different times, and many (including me) would say that today’s IRS is less forgiving of basic human error

And, to some extent, we are talking ancient history with extension procedure. Today’s practices, our included, has moved to electronic filing. Our software tracks and records our extensions and returns and their receipt by the IRS. I do not need to keep a mail log as my software does it for me.

Morgan needed something like a log. It would have given the Court confidence in and support for his recollection of acts occurring a decade earlier, even without him being present to testify in person.

Can You Depreciate a Battle Axe?

Mr. and Mrs. Eotvos (Eotvos) ran a day care out of their house.

There are special tax rules for a day care provider.

(1) For example, how would you depreciate your personal house for the day care activity?

The first rule that comes to mind is the office-in-home, but that rule doesn’t work for a provider. The office-in-home requires “exclusive” use in order to claim a deduction. By that standard a provider wouldn’t be able to claim any depreciation, unless one had a room used only for the day care.

In response, the IRS loosened that rule from “exclusive” to “regular” use. For example, a provider would use the kitchen, dining room and bathrooms regularly, making them eligible for depreciation.

Can you claim 100% of the cost of your house?

You already know the answer is “no.” That is what the shift from “exclusive use” to “regular use” means.

But what percentage do you use?

You probably use hours.

Let’s say you have kids in your house 45 hours a week.

You still spend time cleaning, lesson planning, preparing meals and so on. Say that it comes to another 14 hours per week.

There are 168 hours in a week. You spend 59 hours on daycare activities. Seems to me that 35% (59/168) would be reasonable.

(2) If you travel, you likely know about the per diem rate. This is something the IRS publishes annually, and – in general – you can deduct this rate for each day you are away-from-home for business purposes. You do not have to. You can claim actual expenses if you wish, but you will need to step-up your document retention procedures if you go that route.

Did you know that there are per diem rates for a day care provider? Yep, there is a rate for breakfast, lunch and snack. You can claim the per diem and skip the hassle of segregating how much of your grocery bill was for the day care and how much was personal.

The IRS looked at Eotvos’ 2012 through 2014 tax returns. They claimed depreciation on their house. The Court wanted to see the calculation.

Eotvos photographed numerous pieces of furniture and furnishings and estimated what they were worth.

COMMENT: We will not get into Accounting 101 here, but this is not the way it is done.

The furnishings they were depreciating – best the Court could tell - included a battle axe and jewelry.

Folks, there has to be some connection to a business activity to even start this conversation. You cannot bring home a pair of Nike sneakers and claim that 35% of the cost is deductible because you brought them inside the house.

Here is the Court:

Battle axes were not used as children’s playthings, and their acquisition and maintenance was not in furtherance of the day care business.”

What happens when you tell the Court silly stuff?

And a witness who can testify with a straight face about the nexus between a battle axe and a day care business earns no credibility.”

This is going south.

The IRS had calculated some depreciation, as there was no question that there was a day care there. Eotvos very much disagreed with the calculation, arguing – among other things – that the allowable business-use percentage should be 100%.

This blanket assertion, like the battle axe, strains credulity.”

They hit south and just kept going.

The Court allowed the IRS-calculated depreciation. The Court however slapped an accuracy-related penalty on the excess of their depreciation over the IRS number.

They sort of brought that upon themselves.

Owing A Million Dollar Penalty

What caught my attention was the size of the penalty.

The story involves Letantia Russell, a dermatologist from California who has been in the professional literature way too much over too many years. The story started with her attorneys reorganizing her medical practice into a three-tiered structure and concealing ownership through use of nominees. Then there was the offshore bank account.

Let’s talk about that offshore account.

Back when I came out of school, one had to report foreign accounts above a certain dollar balance. The form was called the “TD 90-22.1.” I remember accountants who had never heard of it. It just wasn’t a thing.

The requirement hasn’t changed, but the times have.

If you have an overseas bank account, you are supposed to disclose it. The IRS has a question on Schedule B (where you report interest and dividends) whether you have a foreign bank account. If you answer yes, you are required to file that TD 90-22.1. The form does not go to the IRS; it instead goes to the Treasury Department. Mind you, the IRS is part of Treasury, but there are arcane rules about information sharing between government agencies and whatnot. Send to Treasury: good. Send to IRS: bad.

The rules were fairly straightforward: bank account, balance over $10 grand, own or able to sign on the account, required to file. There was no rocket science here.

Don’t play games with account types, either. A checking account is the same as a savings account which is the same as a money market and so on. Leave that hair-splitting stuff to the lawyers.

About a decade or so ago, the government decided to pursue people who were hiding money overseas. Think the traditional Swiss bank account, where the banker would risk jail rather than provide information on the ownership of an account. That Swiss quirk developed before the Second World War and was in response to the unstable Third Republic of France and Weimar government of Germany. Monies were moving fast and furious to Switzerland, and Swiss bankers made it a criminal offense to break a strict confidentiality requirement.

Thurston Howell III joked about it on Gilligan’s Island.

Travel forward to the aughts and the UBS scandal and the U.S. government was not laughing.

Swiss banks eventually agreed to disclose.

The IRS thundered that those who had … ahem, “underreported” … their foreign income in the past might want to clean-up their affairs.

The government dusted-off that old 90-22.1 and gave it a new name: FinCen 114 Report of Foreign Bank and Financial Accounts.

The IRS was still miffed about that government-agency-sharing thing, so it came up with its own form: Form 8938 Statement of Foreign Financial Assets.

So you had to report that bank account to Treasury on the FinCen and to the IRS on Form 8938.  Trust me, even the accountants were trying to understand that curveball.

Resistance is futile, roared the IRS.

Many practitioners, me included, believed then and now that the IRS went fishing with dynamite. The IRS seemed unwilling to distinguish someone who inherited his/her mom’s bank account in India from a gazillionaire hedge-fund manager who knew exactly what he/she was doing when hiding the money overseas.

And you always have … those people.

Letantia Russell is one of those people.

The penalties can hurt. Fail to fail by mistake and the penalty begins at $10,000. Willfully fail to file and the penalty can be the greater of

·      $100,000 or

·      ½ the balance in the account

Letantia dew a $1.2 million penalty on her 2006 tax return. I normally sympathize with the taxpayer, but I do not here. One has to be a taxpayer before we can have that conversation.

It went to District Court. It then went to Appeals, where her attorneys lobbed every possible objection, including the unfortunate trade of Jimmy Garappolo from the New England Patriots to the San Francisco 49ers.

It was to no avail. She gets to pay a penalty that would make a nice retirement account for many of us.

An Update Concerning the Blog

CTG has not been posting recently due to a death in the family. CTG is hoping to resume posting next week.

Can The IRS Reduce Your Refund for Other Debt?

You file a tax return showing tax due (before withholdings) of $503.

You have withholdings of $1,214.

You therefore have a refund of $711 ($1,214 - $711).

The IRS takes your refund because you owe taxes for another year.

The IRS later audits your return. It turns out that you owe another $1,403.

Question:  Can you get back the $711 that went who-knows-where?

The tax lingo is the “right of offset.”

Here is Code section 6402(a):

(a)       General rule

In the case of any overpayment, the Secretary, within the applicable period of limitations, may credit the amount of such overpayment, including any interest allowed thereon, against any liability in respect of an internal revenue tax on the part of the person who made the overpayment and shall, subject to … refund any balance to such person.

The pace car in this area was Pacific Gas & Electric Co v U.S.

Pacific Gas & Electric had an overpayment for 1982 of almost $37 million. It filed for a refund, and the IRS included interest for sitting on PG&E’s money well into 1988. However, the IRS miscalculated and overpaid interest by approximately $3.3 million.

The IRS wanted its money back, but what to do?

In 1992 PG&E filed another refund on the same tax year!

So the IRS lopped-off $3.3 million as an “offset” for the earlier interest overpayment.

On to Court they went. There were tax-nerd issues, such as the tax years under dispute having closed under the statute of limitations. That issue did not concern the Court. What did concern the Court was whether the IRS was correct in shorting a tax refund by its previous overpayment of interest.

The IRS can clearly offset for a tax.

But was the interest paid PG&E the equivalent of a tax?

And the Court decided it was not:

·      Interest you (as a taxpayer) owe the IRS is considered a “deemed” tax thanks to Section 6601(e).

Any reference to this title (except subchapter B of chapter 63, relating to deficiency procedures) to any tax imposed by this title shall be deemed also to refer to interest imposed by this section on such tax.”

·      But there is no Code section going the other way - that is, when the IRS pays you interest.

PG&E won its case and kept the interest.

Back to our taxpayer.

He did not have a chance of having the IRS return the $711 it had previously applied to another tax year. What made his case interesting is that his offset year was audited, resulting in an addition to his tax.  It made sense that he would want his withholding to be applied to its proper tax year before the IRS went offsetting everything in sight.

It made sense but it was not the correct answer. The IRS’ authority to offset is quite broad.

BTW, the offset is not just for taxes. It can be for student loans or monies owed to state agencies (think child support).  The offset is not limited to your tax refund either: your federal retirement and social security can also be offset.

Is It Income If You Pay It Back?

You receive unemployment benefits.

You repay unemployment benefits.

Do you have taxable income?

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

Back to our question: it depends.

It depends on when you pay it back.

Let’s look at the Yoklic case.

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

Yoklic sent a check in September, 2013.

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

Makes sense.

But tax theory does not look at it that way.

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

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

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

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

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

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

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

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

What did Yoklic do wrong?

He repaid the monies in the following year.

He had income in 2012.

He had a deduction in 2013.

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

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

A CPA Goes Into Personal Audit

Folks, if you wind up before the Tax Court, please do not say the following:

… petitioner testified that allocating some of the expenses between his personal and business use required more time than he was willing to spend on the activity.”

Our protagonist this time is Ivan Levine, a retired CPA who was trying to get a financial service as well as a marketing business going. He worked from home. He used personal credit cards and bank accounts, as well as a family cellular plan. He also drove two vehicles – a Porsche 911 and a Chevrolet Suburban – for both personal and business reasons. All pretty standard stuff.

The IRS came down like a sack of bricks on his 2011 return. They challenged the following:

(1) Advertising

(2) Vehicle expenses

(3) Depreciation, including the vehicles

(4) Insurance (other than health)

(5) Professional fees

(6) Office expenses

(7) Supplies

(8) Utilities

(9) Cell phone

(10)       Office-in-home

Whoa! It seems to me that some of these expenses are straight-forward – advertising, for example. You show a check, hopefully an invoice and you are done. Same for professional fees, office expenses and supplies. How hard can it be?

It turns out that he was deducting the same expense in two categories. He was also confusing tax years – currently deducting payments made in the preceding year.

The office-in-home brings some strict requirements. One of them is that an office-in-home deduction cannot cause or increase an operating loss. If that happens, the offending deductions carryover to the subsequent year. It happens a lot.

It happened to Mr. Irvine. He had a carryover from 2010 to 2011, the year under audit. The IRS requested a copy of Form 8829 (that is, the office-in-home form) from 2010. They also requested documentation for the 2010 expenses.

COMMENT: Why would the IRS request a copy of a form? They have your complete tax return already, right? This occurs because the IRS machinery is awkward and cumbersome and it is easier for the revenue agent to get a copy from you.

Mr. Irvine refused to do either. The decision does not state why, but I suspect he thought the carryover was safe, as the IRS was auditing 2011 and not 2010. That is not so. Since the carryover is “live” in 2011, the IRS can lookback to the year the carryover was created. Dig in your heels and the IRS will disallow the carryover altogether.

The vehicles introduce a different tax technicality. There are certain expenses that Congress felt were too easily subject to abuse. For those, Congress required a certain level of documentation before allowing any deduction. Meals and entertainment are one of those, as are vehicle expenses.

Trust me on this, go into audit without backup for vehicle expenses and the IRS will just goose-egg you. You do not need to keep a meticulous log, but you need something. I have gotten the IRS to allow vehicle expenses when the taxpayer drives a repeating route; all we had to do was document one route. I have gotten the IRS to accept reconstructions from Outlook or Google calendar. The calendar itself is “contemporaneous,” a requirement for this type of deduction.

BTW the tricky thing about using Outlook this way is remembering to back-up Outlook at year-end. I am just saying.

You know Mr. Irvine did not do any of this.

Why?

Because it would have required “… more time than he was willing to spend on the activity.”

This from a CPA?

Being a CPA does not mean that one practices tax, or practices it extensively. I work tax exclusively, but down the hall is a CPA who has careered in auditing. He can exclaim about myriad issues surrounding financial statements, but do not ask him to do a tax return. There are also nouveau practice niches, such as forensic accountants or valuation specialists. One is still within the CPA tent, but likely far away from its tax corner.

Although a CPA, Mr. Irvine could have used a good tax practitioner. 

Paying Back The ObamaCare Subsidy

I do not see many tax returns with the ObamaCare health exchange subsidy.

Our fees make it unlikely.

However, take an ongoing client with variable income or business losses and we do see some.

I saw one this busy season that gave me pause.

Let’s discuss the McGuire case to set up the issue.

Mr. McGuire was working and Mrs. McGuire was not. In 2013, they applied with the Covered California and qualified for a monthly subsidy of $591, or $7,092 per year. They enrolled in a plan that cost $1,182 monthly. After the subsidy, their cost was (coincidentally) $591 monthly.

Mrs. McGuire started a job that paid $600 per week. She contacted Covered California, as she realized that her paycheck would affect that subsidy.

This being a government agency, you can anticipate the importance they gave Mrs. McGuire.

That would be “none.”

Several months later they did send a letter stating that the McGuires did not qualify for a subsidy.

The letter did not talk about switching to a lower cost plan. Or dropping the plan altogether. Or – be still my heart - provide a phone number to speak with an actual government bureaucrat.

It did not matter.

The McGuires had moved. They tried to get Covered California to update their address, but it was the same story as getting Covered California to update their premium subsidy for her new job.

The McGuires never received the letter.

It goes without saying that they never received Form 1095-A in 2014 either. This is the tax form for reporting an Exchange subsidy.

There are two main individual penalties under the Affordable Care Act:

(1) There is a penalty for not having “qualified” insurance. This is not the same as being uninsured. Have insurance that the government disapproves of and you are treated as having no insurance at all. 

(2) Subsidies received have to be reconciled to your actual household income. Make less that you thought and you may get a few bucks back. Make more and you may have to repay your subsidy. While technically not a “penalty,” it certainly acts like one.

The McGuires indicated on their tax return that they had health insurance (thereby avoiding penalty (1), but they did not complete the subsidy reconciliation (which is penalty (2)).

The IRS did, however.

Sure enough, the McGuires did not qualify for a subsidy. The IRS wanted its money back. All of it.

The McGuires fired back:

We would never have committed to paying for medical coverage in excess of $14,000 per year.”

True that.

We cannot afford it and would have continued to shop in the private sector to purchase the minimal, least expensive coverage or gone without coverage completely and suffered the penalties.”

That is, they would have avoided penalty (2) by not accepting subsidies and instead paid penalty (1), which would have been cheaper.

If we are deemed responsible for paying back this deficiency, it would be devastating and completely unjust. ….  The whole purpose of the Affordable Care Act was to provide citizens with just that, affordable healthcare. This has been an absolute nightmare and we hope that you will rule fairly and justly today.”

Here is the Tax Court:

But we are not a court of equity, and we cannot ignore the law to achieve an equitable end.”

Equity means fairness, so the Court is saying that – if the law is otherwise bright-line – they cannot decide on the grounds of fairness. 

Although we are sympathetic to the McGuires’ situation, the statute is clear; excess advance premium tax credits are treated as an increase in the tax imposed. The McGuires received an advance of a credit to which they were ultimately not entitled.”

The McGuires had to pay back $7 grand, despite the incompetence of Covered California.

Ouch.

Let’s return to CTG Galactic Command. How did my client get into a subsidy-repayment situation?

Gambling.

The tax Code is odd about gambling. It forces you to take gambling winnings into income. The subsidy calculation keys-off that income number.

Wait, you say. What about gambling losses?

The tax Code requires you to take gambling losses as an itemized deduction.

The subsidy calculation pays no attention to itemized deductions.

Win $40 grand and the subsidy calculation includes it. Your household income just went up.

Say that you also lost $40 grand. You netted nothing in real life.

Tough. The subsidy calculation does not care about your losses.

Heads you lose. Tails you lose. 

That was my client’s story.

Your Child Wins A Beauty Pageant

We are in a mini “tax season” here at Galactic Command, with September 15 being the deadline for business returns. Next month is the extended due date for the individual returns.

I wanted to find something light-hearted to discuss. Call it a salve to my sanity.

Let’s talk about your kid. Yes, the one who will soon be discovered on America’s Got Talent. It could happen. He could be the next Jonathan, or she the next Charlotte.

COMMENT: Jonathan and Charlotte were discovered on Britain’s Got Talent. It is worth watching their first appearance, if only for Simon’s reaction.

Say your kid wins prize money.

This being a tax blog: who pays tax on the money – the kid or you? After all, the kid is your dependent. He/she is nowhere near emancipated.

Here is a Code section one could spend a career in practice and not see:

 § 73 Services of child.

(a)  Treatment of amounts received.

Amounts received in respect of the services of a child shall be included in his gross income and not in the gross income of the parent, even though such amounts are not received by the child.

(b)  Treatment of expenditures.

All expenditures by the parent or the child attributable to amounts which are includible in the gross income of the child (and not of the parent) solely by reason of subsection (a) shall be treated as paid or incurred by the child.

The daughter of our protagonists (Lopez) started competing in beauty pageants at age nine. There were expenses involved with this, such as travel, outfits, cosmetics and so on. In 2011 and 2012 she won a couple of dollars, approximately $3,200 to pin it down.

Which was nowhere near the expenses of over $37 grand across the two years.

They used an Enrolled Agent with over 40-years’ experience to prepare their return.

COMMENT: An E.A. is an IRS-administered exam on tax proficiency. While perhaps not as well-known as the CPA, it is a substantial credential. There are many CPAs who practice outside tax, for example, but all E.A.’s practice tax.

The E.A. decided to put the daughter’s income on the parent’s return. He arrived at that conclusion by reviewing state child labor laws. He gave it a lot of thought, but he missed Code Section 73.

As I said, it is rare that one would blow dust off that section.

He prepared the parent’s return, including the daughter’s prize money.

That part was only $3 grand or so. The sweet part was the $37 grand in expenses. The parents took a BIG tax loss.

And the IRS tagged the return.

The Lopez’s fought the IRS. There was also a second IRS adjustment, so I presume they decided that fighting one was the same effort as fighting both.

The kid’s income and expenses, however, was a clear loser.  

The IRS adjusted their income by over $30 grand, so they came in with a souped-up penalty – the “accuracy related” penalty. That bad boy parachutes in at 20%. The IRS likes to toss that one out like hot-sauce packets at Gold Star.

Remember the E.A.?

The Court pointed out that the Lopez’s hired a tax professional. He researched the issue. Granted, he arrived at the wrong answer, but that was not the Lopez’s fault. They hired a professional, and they reasonably relied upon the advice of the professional.

The Court dismissed the penalties.

Small consolation, but something.

When Your Employer Bungles Your Retirement Plan Loan

I admit that I am not a fan of borrowing from an employer retirement plan, except perhaps as a next-to-last step before being evicted.

Things go wrong.

Lose your job, for example, and not only are you looking for work but you also have a tax bill on a loan you cannot pay back.

You do not even have to lose your job.

Ms. Frias participated in her company’s retirement plan. She was getting ready to go on maternity leave when she borrowed $40,000 from her 401(k). Her employer was to withhold from her paycheck (to be paid biweekly), and there was a make-up provision allowing her to correct any shortfall by the end of the following month.

COMMENT: Retirement plan proceeds are normally tax-free if repaid over a period of five years or less.

She went on leave on or around August 1^st.  She was drawing on her accumulated vacation and sick time.  Sounds pretty routine.

She returned to work October 12th.

In November, she learned that her employer had failed to withhold any monies for her 401(k) loan.

She immediately wrote a $1,000 check and increased her withholding to get caught-up.

Nonetheless, at the end of the year the plan administrator (Mutual of America Life) sent her a $40,000 Form 1099R on the loan.

They however sent it to her electronically. Having no reason to expect one, she did not realize that she had even received a 1099. Goes without saying it was not on her tax return.

You know the IRS matched this up and sent her a notice.

What do you think: does she have a tax issue?

No question her employer messed up.

And that she tried to correct it.

However, the law is strict:

Although a loan may satisfy the section 72(p) requirements, “a deemed distribution occurs at the first time that the requirements … of this section are not satisfied, in form or operation.”

Her first payment was due in August, the month following the loan. If she had a deemed distribution, it would have occurred then. A distribution – even a “deemed” one – would be taxable.

There remained hope, though:

The plan administrator may provide the plan participant with an opportunity to cure the failure, and a deemed distribution does not occur unless the participant fails to pay the delinquent payment within the cure period.”

This is a nice safety valve. If the employer gives you a “cure” period, you can still avoid having the fail and its associated tax.

What was her cure period?

The end of the following month: September.

When did she write a check?

November, when she realized that there was a problem.

Too late.

She had one last long shot: a “leave of absence” exception.

Which is Code section 72(p)(2)(C), and it provides for interruption in a loan repayment schedule if one is not drawing a paycheck or not drawing enough to meet the minimum loan payment.

Her argument? She was not receiving her “regular” paycheck. She instead was drawing on her vacation and sick time bank.

Problem: she nonetheless received a check, and the Court was unwilling to part-and-parcel its source. She was collecting enough to make the loan payments.

She was hosed.

She did nothing wrong, but her employer’s negligence cost her somewhere near $15 grand in unnecessary taxes.