Taxing Lessons From Court Decisions

Decisions — Dueling rules

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En garde! When provisions in the internal revenue code appear to conflict, taxpayers and the IRS face off in court. Here are two cases from this week involving disputes over dueling code sections.

1.

In Docket No. 2103-17S (Palsgaard), the dueling internal revenue code sections are 86 and 104. The question is which section applies to disability benefits received from the social security administration.

In 2009, the taxpayer qualified for and began to receive benefits under a disability insurance policy provided by her employer. The benefits were not subject to federal income tax. In accordance with the employer’s policy, the taxpayer was required to apply for social security disability benefits. She began receiving those benefits in 2010, and the social security benefits offset the benefits she had been receiving under her employer’s policy.

The taxpayer was disabled during 2015 and received $31,247 of social security disability benefits. She says the disability benefits are not taxable under internal revenue code section 104, compensation for injuries or sickness, which excludes from income damages received due to personal physical injuries.

The IRS says social security disability benefits are taxable the same as other social security benefits. Specifically, the IRS says code section 86, social security and tier 1 railroad retirement benefits, provides a detailed formula for determining the taxable portion of social security benefits and defines the term “social security benefit.” The IRS says that term includes disability benefits.

Here are the relevant code sections.

From internal revenue code section 86(d)(1): (1) In general, for purposes of this section, the term “social security benefit” means 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.

From internal revenue code section 104(a): (a) In general, except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include—…(2) the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness.

 

WHAT WOULD YOU DECIDE?

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THE DECISION

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2.

 

In 150 T.C. No. 1 (Rafizadeh), the dueling code sections were 6038D and 6501. Both code sections became law on March 18, 2010. Section 6038D requires taxpayers to report certain foreign financial assets. Code section 6501 says the IRS has six years, rather than the usual three years, to assess a penalty for failing to report the income from those foreign financial assets.

The problem? The reporting requirement (section 6038D) took effect for tax years after March 18, 2010. The expanded statute of limitations (section 6501) applied to assets for which a taxpayer had to file the section 6038D report.

The taxpayer filed his federal income tax returns for 2006, 2007, 2008, and 2009 on time, but did not report income earned on a foreign account he held during those years.

On December 8, 2014, the IRS issued a notice assessing penalties on underpayments for 2006, 2007, 2008, and 2009.

The taxpayer agrees that the foreign account would be subject to the filing requirements of section 6038D. However, he says the six year statute of limitations does not apply. His argument is that the wording of the code section says the expanded limitations period only applies to assets for which he had to file a report. Since three of the years in question (2006-2008) are before the beginning date of “taxable years after March 18, 2010,” the longer statute can’t be used.

The IRS agrees that the notice was issued after the general three-year period of limitations had expired for each year. However, the IRS says the six year statute applies because at the time the six year statute provision was added, congress also modified an existing part of section 6501 to extend the statute of limitations for failures to comply with the foreign reporting requirements. The IRS says making this change at the same time meant congress did not intend for the separate six-year statute of limitations to be dependent on a taxpayer’s failure to file the new foreign asset reporting forms.

Here are the relevant code sections.

From internal revenue code section 6038D: – Information with respect to foreign financial assets –(a) In general–Any individual who, during any taxable year, holds any interest in a specified foreign financial asset shall attach to such person’s return of tax imposed by subtitle A for such taxable year the information described in subsection (c) with respect to each such asset if the aggregate value of all such assets exceeds $50,000 (or such higher dollar amount as the Secretary may prescribe). “The amendments made by this section [enacting this section] shall apply to taxable years beginning after the date of the enactment of this Act [Mar. 18, 2010].”

From internal revenue code section 6501: (e) Substantial omission of items–Except as otherwise provided in subsection (c)—

(1) Income taxes In the case of any tax imposed by subtitle A—

(A) General rule If the taxpayer omits from gross income an amount properly includible therein and—

(i) such amount is in excess of 25 percent of the amount of gross income stated in the return, or

(ii) such amount—

(I) is attributable to one or more assets with respect to which information is required to be reported under section 6038D (or would be so required if such section were applied without regard to the dollar threshold specified in subsection (a) thereof and without regard to any exceptions provided pursuant to subsection (h)(1) thereof), and

(II) is in excess of $5,000,

the tax may be assessed, or a proceeding in court for collection of such tax may be begun without assessment, at any time within 6 years after the return was filed.

 

WHAT WOULD YOU DECIDE?

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or

 

THE DECISION

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Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided in the post to read the entire case.

This information should not be considered legal, investment, or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment, or tax advice. Always consult your legal, investment, and/or tax advisor regarding your personal situation.

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Right answer!
Sorry, wrong answer :(

Code section 86 applies (decision for the IRS; the benefits are taxable).

Before 1984, social security benefits were excludable from the recipient’s gross income. However, this treatment was repealed in the Social Security Act Amendments of 1983, and beginning with the taxable year 1984, social security benefits, including disability benefits, have been subject to federal income tax.

As is relevant here, section 86(d)(1)(A) defines the term “social security benefit” to mean any amount received by a taxpayer by reason of entitlement to a monthly benefit under Title II of the social security act. The court notes that Title II of the social security act provides for old-age, survivors, and disability benefits.

The taxpayer’s argument that her social security disability benefits are excludable from taxable income under section 104(a) (2) is incorrect.

The specific provisions of section 86, and particularly subsection (d) (1) of that section, which set forth the statutory scheme for the taxation of social security benefits, override the general provisions of section 104(a) which exclude certain types of compensation (other than social security benefits) from gross income.

Sorry, wrong answer :(
Right answer!

The six year statute does not apply (for the taxpayer).

We conclude that the wording of the effective date for section 6501(e)(1)(A)(ii) limits its application to years for which the reporting requirement of section 6038D also is effective.

We must give effect to all of the words in the key phrase before us–“assets with respect to which information is required to be reported under section 6038D.”
We conclude that the most natural reading of this phrase is that the six-year statute of limitations applies only when there is a section 6038D reporting requirement (or would be barring an exception that is to be disregarded).

Section 6501(e)(1)(A)(ii) does not simply incorporate the definition of assets in section 6038D; it also specifies that the assets are subject to the reporting requirement (or would be but for an exception that is disregarded). We agree with the taxpayer that had congress intended simply to incorporate the definition in section 6038D of the assets to be covered, congress could have used other more straightforward wording, such as the defined term itself.

The IRS stretches to argue that the incorporation of that reporting requirement into section 6501(c)(8) shows that congress did not intend to make the separate six-year statute of limitations in section 6501(e)(1)(A)(ii) dependent on a taxpayer’s failure to satisfy section 6038D.

The trigger in section 6501(c)(8) is the failure to report, and that failure results in a different limitations period. By contrast the trigger for the six-year limitations period in section 6501(e)(1)(A)(ii) is the omission of gross income from assets that are subject to the section 6038D reporting requirement (or would be but for an exception thereto), and it extends the period to six years.

We conclude that the six-year limitations period under section 6501(e)(1)(A)(ii) does not apply for 2006, 2007, and 2008.

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