Originally published on Forbes.com July 22nd, 2014
The treatment of social security disability payments is probably one of the more unfair aspects of the Internal Revenue Code. Every once in a while you will see it sneak up on somebody, which highlights the unfairness. The Tax Court might express sympathy, but they can’t help much. The most recent victims were Arthur and Cheryl English.
Cheryl English became disabled and began collecting on her policy from Hartford Insurance Company. Under the terms of the policy, her benefits would be reduced by any social security disability payments that she received. She applied for social security benefits in 2007, but did not receive anything in 2007. Or 2008. Or 2009. Finally, in 2010 she received a lump sum of $49,610. She had to pay $48,144 to Hartford under the terms of the disability policy. Less than fifteen hundred bucks net, but better than getting poked in the eye with a sharp stick, I guess.
Then the IRS came along with the sharp stick. Unlike the disability payments from Hartford, the social security benefits are taxable (85% of them anyway). The couple was assessed $10,559 in income tax. On the net amount that Ms. English received that works out to a marginal rate over 800%. To add insult to injury, there was an accuracy penalty of $2,112 tacked on.
On The Assessment
The Tax Court provided a pretty lengthy explanation that pretty much can be summed up as “It is what it is. Deal with it.” Here are some of the high points.
We are sympathetic to petitioners’ position. However, under existing law, we are required to reach a different result.
Section 86 provides that a taxpayer’s gross income includes up to 85% of Social Security benefits, including disability benefits, received during the taxable year. However, for purposes of that section, taxpayers may reduce Social Security benefits by repayments of other Social Security benefits previously received. Sec. 86(d)(2)(A). A Social Securitybenefit is defined as “any amount received by the taxpayer by reason of entitlement to—(A) a monthly benefit under title II of the Social Security Act, or (B) a tier 1 railroad retirement benefit.” Benefits received from private insurers, such as Hartford, do not satisfy this definition.
Although these laws result in differing treatment for certain disability benefits, we are not at liberty to carve out other exceptions to section 86 where Congress has not expressly done so. Accordingly, petitioners are not entitled to exclude from gross income the $49,610 Social Security payment received in 2010.
Some Help On The Penalty
If you are going to be mad at somebody about Ms. English’s 800% tax, you should be mad at Congress not the IRS. The penalty is another matter. Based on the Tax Court decisions I read, it seems that the IRS more or less automatically asserts the accuracy penalty whenever the threshold is met. The Tax Court could not do anything about the unfair assessment, but at least it could make the penalty go away.
This case involves a technical confluence of the taxability of Social Security disability benefits and the general nontaxability of private insurance disability benefits. There is no question that petitioner was disabled and entitled to disability benefits. She first received them from Hartford and, in accord with the tax law, did not include them in her income. When she became entitled to Social Security benefits with regard to the same disability, under her contract with Hartford, she was required to repay the Hartford benefits she had previously received.
Congress saw fit to make a certain percentage of Social Security benefits taxable, even if the payments are for a disability. Congress also provided that in circumstances where Social Security benefits had to be repaid, the initial receipt of the benefits would not be taxable. The disparate treatment of private and public disability benefits for tax purposes is curious and somewhat confusing. Under these circumstances, petitioners, who do not have tax expertise, sought the advice of two certified public accountants who counseled them that their benefits were not taxable.
Petitioners contend that their reliance on their tax professional for the 2010 tax status of their disability benefits was reasonable. Reliance on the advice of a tax professional may constitute reasonable cause and good faith if under all the facts and circumstances the reliance is reasonable and in good faith.
Curious and confusing – yah think? Two CPAs getting it wrong is a little embarrassing. That cackling sound you hear coming from Pennsylvania is Robert Flach, The Wandering Tax Pro, chortling about another instance of CPAs proving they are not 1040 experts.
On the other hand, if someone had just entered the SSA-1099 into the expensive software most of the rest of the tax preparation industry uses, they probably would have come up with the right answer and a WTF? from the taxpayer. The thing to do then would be to back the income out someplace else on the return and attach an explanatory statement, which might have avoided the penalty right out of the box. If luck was running strong, the whole thing might have slid by, since there would not have been a document mismatch, but I would never give advice like that being a CPA and all.
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