Originally published on Forbes.com.
Disability income is one of those things that creates knotty tax problems for regular people. Often the results are unfair. That is the way it seemed in the recent Tax Court decision in the case of Michael Nordloh. He had to litigate in order to qualify for social security disability benefits and ended up getting a pretty severe tax hosing out of his victory. The IRS tried to add insult to injury with an accuracy penalty, but the Tax Court was able to cut him a break on that. The facts are a little confusing, but I will do my best to help you follow along.
The Basic Story
The transactions are not that complicated. In 2007 Mr. Nordloh and his doctors became convinced that he could no longer work due to back pain. Social Security denied his disability claim and he appealed. In the meantime, he collected taxable disability income from MetLife under an employer-provided plan. He understood that if his social security claim was approved retroactively, he would have to pay back MetLife to that extent.
An administrative law judge approved Mr. Nordloh’s appeal in 2009. He received a lump-sum Social Security check for $87,004 in 2010. On January 5, 2011 he paid MetLife $83,233. So the retroactive net on the appeal was less than four grand, but then there is the matter of federal tax. That must be around a grand give or take. Right?
How It Looked To The Enrolled Agent
Mr. Norloh could not figure out what his tax was for 2010 so he went to an enrolled agent, who came up with a pretty reasonable answer. She claimed:
….the amount repaid to MetLife in 2011, $83,233, as a deduction in computing petitioners’ adjusted gross income. See generally sec. 62. The same deduction was carried over to modified adjusted gross income (MAGI), as defined by section 86(b)(2), and it was used in computing the amount of taxable SSD benefits under the formula set forth in section 86. See sec. 86(b)(1)(A)(i). Petitioners’ return reported receiving total SSD benefits of $87,004, of which $19,826 was taxable.
The MetLife payments were fully taxable, but Social Security is only partially taxable, so besides netting four grand, Mr. Norloh has a tax boon under this scenario.
How It Looked To The CPA
In April 2012, Mr. Norloh received a notice from the IRS indicating a deficiency of $7,822 and a penalty of $1,564. This time he went to a CPA who prepared amended returns for 2010 and 2011. The CPA noted that the repayment was in 2011. He came up with $26,991 due for 2010 and an overpayment of $21,750 in 2011 making for a net due of $5,169.
The IRS liked the CPA number better when it came to 2010, but somehow managed to tweak them to come to $27,532. That of course raises the stakes for the accuracy penalty.
What The Tax Court Ruled
Judge Whalen had to decide whether the $83,233 paid to MetLife could be deducted in 2010. That did not go well for the taxpayer:
We agree with petitioners that petitioner’s receipt of SSD benefits in 2010 triggered his contractual obligation to MetLife to repay the disability payments that MetLife had advanced under his long-term disability policy. We also agree that it was financially prudent for petitioner to keep the SSD benefits intact so that he could use those funds to repay MetLife. However, there is no evidence to show that petitioner’s contractual obligation to MetLife imposed a legal restriction on his use or disposition of the SSD benefits.
On the penalty, Judge Whalen went with the taxpayer.
After receiving the SSD benefits from SSA and issuing a check to MetLife, petitioners knew that they would need help filing their return for 2010. Accordingly, they requested an extended filing deadline, and they retained a tax professional from a reputable firm to prepare the return. They provided the necessary information to the adviser, and they filed the return as prepared by the adviser. Taking into account all of the circumstances, including their experience, knowledge, and education, it was reasonable for them to rely on the adviser.
After receiving a notice from the IRS raising a question about the return, petitioners retained a different tax adviser to give them further advice regarding their proper tax liability. The second adviser prepared amended returns for 2010 and 2011. Petitioners accepted the advice of the second adviser, and they filed those amended returns. In these proceedings, respondent has accepted the amended return for 2010 as essentially correct. Taking all of the facts and circumstances into consideration, we find that petitioners acted with reasonable cause and in good faith in an effort to assess their proper tax liability, and they are not liable for an accuracy-related penalty under section 6662(a) for a substantial understatement of income tax
Lessons
I’m still scratching my head about the CPA. He may have been technically right, but I think my approach would have been to have my client pay the original deficiency, wait a while and then file the amended return for 2011. Of course, Mr. Nordloh’s attorney probably should have encouraged him to pay back MetLife in the same year that he received the retroactive check, which would have avoided most of these problems. He missed by less than a week.
We don’t know how Mr. Nordloh actually made out on his 2011 refund claim, so we can’t determine how much he was net out of pocket. It is worth noting that the CPA computation was $5,169. That was on a net from the settlement of $3,771. That works out to a federal income tax rate of 137%. Congress should really do something about this, but I am not holding my breath. I’ve seen worse.
The other thing that is absurd about this case is the way the IRS vigorously went after the accuracy penalty. The Enrolled Agent, the IRS and the CPA came up with three different answers and then the IRS came up with a fourth answer. And the IRS wants to charge an accuracy penalty. Go figure.