Social Security Fraud

My client's spouse had been receiving disability social security benefits for years. My client is in business and files a yearly tax return and joint return with his spouse. It turns out that my client's wife has received these funds improperly and after an investigation by the Social Security Administration was forced to pay back the amount of benefits received in the past to the tune of 105k. My client paid back the SSA. The benefits previously received were included in the income of the taxpayers.

The SSA issued a 1099 for 2017: negative or -120000.

This is not taxable income. However I do have an occasion where this should offset the income previously reported in earlier years or show it as a deduction against ordinary income in the current year and carry forward any unused portion of the amount reflected on the issued 1099?

Any thoughts on the best way to handle this to avoid or minimize the possibility of any further scrutiny such as audit?

This is an IRC 1341 situation. You have the choice of (1) claiming the amounts previously included in income as an itemized deduction on line 28 of Schedule A, or (2) recomputing the tax liability for each affected year as if the Social Security income had not been received and claiming the tax difference as a credit on Form 1040 line 73.

Setting aside whether the payback included just the amount incorrectly received or also interest and/or penalties, did client know she was not entitled to the benefits? If so, for starters I'd say client has no right to use the claim of right provisions of section 1341 because there was no way

it appeared that the taxpayer had an unrestricted right to such item;

. But if benefits were not knowingly and intentionally wrongly claimed, i.e., she really thought she was entitled, follow the rules of section 1341. Here's a simplified discussion of your issue, from Pub 17.

Repayments More Than Gross Benefits

In some situations, your Form SSA-1099 or Form RRB-1099 will show that the total benefits you repaid (box 4) are more than the gross benefits (box 3) you received. If this occurred, your net benefits in box 5 will be a negative figure (a figure in parentheses) and none of your benefits will be taxable. Don’t use a worksheet in this case. If you receive more than one form, a negative figure in box 5 of one form is used to offset a positive figure in box 5 of another form for that same year.

If you have any questions about this negative figure, contact your local SSA office or your local RRB field office.

Joint return.
If you and your spouse file a joint return, and your Form SSA-1099 or RRB-1099 has a negative figure in box 5, but your spouse's doesn’t, subtract the amount in box 5 of your form from the amount in box 5 of your spouse's form. You do this to get your net benefits when figuring if your combined benefits are taxable.

Example.

John and Mary file a joint return for 2017. John received Form SSA-1099 showing $3,000 in box 5. Mary also received Form SSA-1099 and the amount in box 5 was ($500). John and Mary will use $2,500 ($3,000 minus $500) as the amount of their net benefits when figuring if any of their combined benefits are taxable.

Repayment of benefits received in an earlier year. If the total amount shown in box 5 of all of your Forms SSA-1099 and RRB-1099 is a negative figure, you can take an itemized deduction for the part of this negative figure that represents benefits you included in gross income in an earlier year.
Deduction $3,000 or less. If this deduction is $3,000 or less, it is subject to the 2%-of-adjusted-gross-income limit that applies to certain miscellaneous itemized deductions. Claim it on Schedule A (Form 1040), line 23.
Deduction more than $3,000. If this deduction is more than $3,000, you should figure your tax two ways.
Figure your tax for 2017 with the itemized deduction included on Schedule A, line 28.
Figure your tax for 2017 in the following steps.
Figure the tax without the itemized deduction included on Schedule A, line 28.
For each year after 1983 for which part of the negative figure represents a repayment of benefits, refigure your taxable benefits as if your total benefits for the year were reduced by that part of the negative figure. Then refigure the tax for that year.
Subtract the total of the refigured tax amounts in (b) from the total of your actual tax amounts.
Subtract the result in (c) from the result in (a).
Compare the tax figured in methods 1 and 2. Your tax for 2017 is the smaller of the two amounts. If method 1 results in less tax, take the itemized deduction on Schedule A (Form 1040), line 28. If method 2 results in less tax, claim a credit for the amount from step 2c above on Form 1040, line 73. Check box d and enter "I.R.C. 1341" in the space next to that box. If both methods produce the same tax, deduct the repayment on Schedule A (Form 1040), line 28.

The way to report it is as a negative amount on line 20a and b. Unless someone else knows why it's an itemized deduction.

As to a carryover (or back), I'm guessing that section 172(d) will not allow this repayment to be part of an NOL, unless your client has lots of nonbusiness income.

Setting aside whether the payback included just the amount incorrectly received or also interest and/or penalties, did client know she was not entitled to the benefits? If so, for starters I'd say client has no right to use the claim of right provisions of section 1341 because there was no way it appeared that the taxpayer had an unrestricted right to such item.

Totally agree…we wonder because the word “Fraud” was used in the title of this post. Was this a criminal matter wherein the repayment was part of a plea deal? Does 165(c)(2) perhaps apply, leaving us with a jinormous 2% deduction [and a super-sized AMT add-back]? Or, did it appear that the taxpayer had an unrestricted right to such item?

Usually it is disability fraud...

the taxpayer knew full well not to take the disability benefit and did so anyway. the taxpayer was warned that that receiving the benefit when not entitled to it could be construed as fraud; but she took the money yearly anyway. the investigation that commenced would have resulted in criminal action if the funds were not paid back; it was the deal the taxpayer made to avoid further scrutiny and penalty.

I have checked with the taxpayer's lawyer and this was not treated as fraud or a criminal matter and no plea deal was made.

it was an overpayment in the past and has been paid back.

How many years back can I go? Can I go to 2011? calculate the difference in taxes paid if the overpayment had not been received and take that total amount as a credit pursuant to irc 1341?

It's not so much that it has to be fraud or criminal. It's whether it appeared that the recipient had an unrestricted right to the dough. Did it?

he did have an unrestricted right to the income and it was included on the tax return. Going back to 2011 he paid the difference of 21k in taxes on those benefits that were repaid in 2017. since the amount repaid exceeded 3k I believe I am right to take the difference in tax paid, the 21k as a credit on the 2017 return, line 73 and indicate "irc 1341" and have the entire amount refunded to the taxpayer?

That's not mechanically how 1341 works, but more importantly, I think you are still missing its concept. First you said the taxpayer knew full well not to take the disability benefit and did so anyway., Now you say he did have an unrestricted right to the income and it was included on the tax return.. Actually, neither of those is the test. Again, here is part of the law, with emphasis by me.

(a) General rule If—
(1) an item was included in gross income for a prior taxable year (or years) because it appeared that the taxpayer had an unrestricted right to such item;
(2) a deduction is allowable for the taxable year because it was established after the close of such prior taxable year (or years) that the taxpayer did not have an unrestricted right to such item or to a portion of such item; and ...

. (You also refer to "he" but you said it's his wife, right?).

The wife knew she was cheating or stealing or pushing beyond the allowable rules, right? Therefore, it did not appear (to her, and probably to hubby) that she had an unrestricted right to the money. I'm vaguely remembering a case that's very much on point - you are required to take it into income, but if it did not appear that your right was unrestricted, you don't get the benefit of section 1341. Maybe someone can find that case. I don't think it was in Tax Court, but I'm not sure.

let's make the assumption he did have an unrestricted right. let's forget that fraud was involved and just look at the following question:

Can I: Going back to 2011 he paid the difference of 21k in taxes on those benefits that were repaid in 2017. since the amount repaid exceeded 3k I believe I am right to take the difference in tax paid, the 21k as a credit on the 2017 return, line 73 and indicate "irc 1341" and have the entire amount refunded to the taxpayer?

Can I: [do some stuff] and have the entire amount refunded to the taxpayer?

Regarding all the specifics posted by Nilodop regarding the actual law, I'd say It comes down to your taxpayer taking a position on a tax return, that you will also be signing. I use Form 8275 if I think certain types of penalties might be in play to a significant extent. I've never used Form 8275-R, but check that one too.

Take a look at this case:

PARKS v. U.S., 78 AFTR 2d 96-7173 (945 F Supp 865, 96-2 USTC P 50645)

Any thoughts on the best way to handle this to avoid or minimize the possibility of any further scrutiny such as audit?

If you are subject to Circular 230, you are not allowed to use the likelihood of an audit in evaluating a Federal tax matter.

If you are subject to Circular 230, you are not allowed to use the likelihood of an audit in evaluating a Federal tax matter.. So very true, and an important point. However, there is probably nothing wrong with wanting to know that likelihood as just a matter of informing the client of it. FWIW, asserting 1341 in a fairly large dollar amount is probably rather likely to attract an audit.

PARKS v. U.S., 78 AFTR 2d 96-7173 (945 F Supp 865, 96-2 USTC P 50645). Yes, Jeff-Ohio, thank you for finding that for us! Not to be ungrateful, but a link would have been nice. Here it is. https://law.justia.com/cases/federal/di ... 5/1457809/

The case is worth reading. It cites another case raised by the taxpayer, Barrett, but makes this crucial point in disagreeing with it.

We disagree with Barrett's approach to section 1341(a) (1), which effectively reads the "appeared that the taxpayer had an unrestricted right" language out of the statute. This particular language is unusual and must be examined closely. Of course it is true, as the Tax Court observed, that the law favors settlements. Enforcement of this principle cannot be achieved at the expense of over-looking an integral element of the statute, however: the element of proof underlying the conclusion that it appeared that the taxpayer had an unrestricted right to the item at the time it was received.

. That says way better than I did above, what I was trying to say. I noticed too that IRS Chief Counsel, in Action on Decision 1992-008, recommended "Nonacquiescence."

OP keeps asking about the mechanics of 1341 (which does give me the impression he plans to claim its benefits). I'd say he has the general idea of the mechanics right, if 1341(a)(5)(A) and (B) are met.

I noticed too that IRS Chief Counsel, in Action on Decision 1992-008, recommended "Nonacquiescence."

Yes. Facts of OP are still a bit hazy. Not sure if the SSA just asked for the money back and that was that or if there was some type of threat of prosecution if the money wasn’t paid back. If the latter, not sure if there was some type of verbal or written agreement. On the one hand, under Parks, none of this really matters. Under that decision, even if there is some type of agreement, if liability/wrongdoing is not admitted to by the taxpayer as part of that agreement, that doesn’t end the tax consequence inquiry. In other words, the court is allowed to look at things beyond the agreement. This makes a lot of sense. The Tax Court, though, in Barrett, basically said that if there’s an agreement wherein wrongdoing was not admitted to by the taxpayer, then wrongdoing hasn’t been shown, meaning there was an apparent right to the income by the taxpayer when the taxpayer collected it.

Even though the District Court decision in James Parks, I think, is the more well-reasoned opinion, that doesn’t sink Szoboszlay’s client - at least in terms of said client being able to file a return/claim the credit without fear of repercussion. In other words, Szboszlay could rely on the Tax Court decision even though the client might lose at the end of the day, based on the better reasoning we see in James Parks [which is a 3rd Circuit case]. But what is the harm in trying? Not much. IRS would just deny the credit, as an initial matter. (And like Nilodop, a large 1341 credit might very well attract an audit). At that point, you’d have to decide it you wanted to fight the denial or not

(And like Nilodop, a large 1341 credit might very well attract an audit). Nilodop does not attract audits. Last one I had was around the early '60s, and I still remember it.

Here's the Supreme Court decision in James. I had to look it up. https://supreme.justia.com/cases/federal/us/366/213/ But it's an appeal from the 7th Circuit, not the 3rd, so maybe Jeff-Ohio has a different case in mind. And, seeing that it's a Supreme decision, I did not read the District or Circuit decisions. (Spell, should or be nor?)

This Tax Adviser article https://www.thetaxadviser.com/issues/20 ... rules.html discusses a point that also could be clearer in the law. To whom must there have been an appearance of a claim of right? The taxpayer? The IRS? The court? And when? When the income was received, or later, when the issue is raised? (It also discusses James). It also touches on the professional responsibility issue.

I read neither the one nor the other.

so maybe Jeff-Ohio has a different case in mind.

I don’t know why I kept saying “James” in my Post #16, other than I must have been thinking of the seminal case in the general area of embezzlement as I was writing. I meant to say “Parks.” I’ll fix it.

Thank you for that correction. And I too have corrected my post by adding a link to James that I had inadvertently omitted. Even if it isn't the one you meant to say.