Friday, October 26, 2018

Taxability of Long-Term Disability Benefits and Social Security Disability Benefits

William Delaney, EA
Westwood, MA
Your Editor rarely sees this issue, so I thought that this case and fact pattern would be useful to our membership.

Catherine Clay (petitioner) was employed as a teacher by the School District of the City of Saginaw, MI.  Her employer provided long-term disability insurance as part of her benefits package.  The benefit was equal to 2/3 of pre-disability compensation, less deductible income.  For this purpose, deductible income included any entitlement under  Social Security Disability.

If a long-term disability benefit were paid without an offset, and the recipient later received a Social Security Disability benefit, this deemed “overpayment” was required to be refunded to the disability insurance carrier.

Under the terms of the contract, disability benefits ceased at age 65 (subject to certain limited exceptions – see following paragraph). 

 On October 8, 2009, Ms. Clay, at age 49, was involved in an automobile accident.  She received sick pay from her employer through January 5, 2010.  After applying for long-term disability benefits, her claim was approved retroactive to January 6, 2010.  In September 2010, Ms. Clark received a lump-sum payment of $29,245 (8 months of benefits – 1/6/2010 thru 9/5/2010).  She continued to receive monthly payments until December 2011, when they ceased.  The insurance carrier relied upon an exception in  the contract which limited the payments to a maximum of 24 months if the disability was due to a “mental disorder.” 

On October 6, 2010, Ms. Clark had signed an agreement expressing her understanding that receipt of deductible income (such as a Social Security Disability benefit) was to be immediately repaid to the insurance carrier.  It was left unsaid how someone with a “mental disorder” could execute a valid agreement, but that is probably a story for another day.

The carrier issued W-2 forms for wages paid - $43,868 – for both 2010 and 2011.

Ms. Clay disputed the mental disorder determination; the carrier disagreed.  This dispute was ongoing as the tax dispute (below) went to trial.

Ms. Clay filed for Social Security Disability (SSD) benefits and her claim was denied (sound familiar?).  She engaged an attorney and her application was approved retroactive to April 2010.  She was advised, by letter, that there would be a retroactive benefit of $32,965, less $6,000 to be paid to her attorney for legal services.

When she received her adjustment check it also included one month of ongoing benefits, for a gross amount of $34,700.  Of the amount received in 2011, $13,880 was attributable to 2010 and the balance was attributable to 2011.

The carrier then invoked the repayment provision of its policy and issued a demand for immediate payment of $36,694.  Ms. Clay took the position that she need not repay anything at that time, since the carrier could recover the overpayment from subsequent benefits which were due (the non-continued payments, as you will recall, which were in dispute).  Instead, she used the SSD money to pay off an old tax debt and travel out of state for physical therapy.

Taxpayer (Ms. Clay) did not report her W-2 disability wages from the carrier on her 2011 federal income tax return.  She did report $34,700 of Social Security benefits (line 20a) and zero as taxable (line 20b).  On Schedule A. taxpayer deducted $6,000 (attorney fee) as a misc. itemized deduction not subject to the 2% floor (against zero taxable income – line 20b – as you may remember).

The IRS asserted on audit that…

1.  Taxpayer failed to report W-2 wages - $43,867.
2.  Taxable Social Security (line 20b) was under-reported by $27,634.
3.  A 2% floor applied to the itemized deduction, so it was overstated by $1,430.

In court, the taxpayer argued that she was required to repay the carrier for deductible income within 30 days of receipt (immediate), so she had restricted use of the money.  Therefore, the W-2 amount was not income.  Not mentioned was the fact that she disputed this and had repaid zero.  (how could she have missed that?)  The IRS countered and asserted that the Claim of Right doctrine applied---she had the right to receive it (and she did receive it), even though it might have to be repaid at a later date.

The Court then discussed at some length the limited exceptions to the Claim of Right doctrine and cited cases on point.  It’s a worthwhile read (pages 12 through 18).  However, the taxpayer failed to qualify and the Court ruled for the government.  Not surprising.  How does one claim an offset when there is no offset?

As to taxable Social Security (line 20b), it was obvious that the change in reported income, and the adjustment to itemized deductions, would also change this line from zero to something more than zero - $27,634 as calculated by the IRS.  The Court did, however, allow the taxpayer to apportion her Social Security income (received in a 2011 lump sum payment), between 2010 and 2011 [IRC Sec. 86(c)], which was also agreeable to the government, so some of it was transferred to 2010 income.

Although the petitioner argued that she could double dip---exclude the $6,000 attorney fee from her 2011 income when allocating under Sec. 86(a),  (and also deduct it, in full, on Schedule A), the Court was not persuaded and allowed only an itemized deduction, subject to the 2% floor.

See Catherine J. Clay v. Comm. of Internal Revenue, T.C. Memo 2018-145 (9/10/18).

COMMENTS:  The Doctrine of Claim-of Right stands for the concept that taxable income which is subsequently repaid deserves an offset for tax purposes.  If the amount eventually repaid exceeds $3,000, the taxpayer has two options:  A deduction in the year repaid, or a recovery of the tax paid on that amount in the year when it was reported.  For sums less than $3,000, a deduction in the year repaid is the only option.

In our fact pattern, the taxpayer wished to have it both ways.  Allow me an offset, but don’t require me to repay because I dispute the claim!

Taxable Social Security adjustment, i.e. “back payments.”  From the Frequently Asked Questions IRS web site:

“You may make an election to figure the taxable part of a lump-sum payment for an earlier year separately, using your income for the earlier year.”  “Then you subtract any taxable benefit for that (earlier) year which you previously reported.”  “The remainder is the taxable part of the (prior year or years) lump-sum payment.  Add it to the taxable part of your benefits for the current year (figured without the lump-sum payment for the earlier year).”

This allows the taxpayer (using the Clay fact pattern), to split the Social Security benefit into two years.  First, she would add the 2011 portion to her income and calculate the taxable portion.  Next, she would recalculate her 2010 return by adding the 2010 portion and determining how much (if any) of the 2010 benefit would be taxable.  This taxable amount (if any) would be added to her 2011 taxable portion and reported on line 20b.  On line 20a for 2011, the entire Social Security payment would be reported (now the return will tie-into what the IRS expects to see reported.  An attached “election” statement would support the line 20b calculation.

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