Lesson From The Tax Court: It’s Not Income If You Pay It Back In Time

We all know that taxpayers do not have to report loans as income.  But it's not clear why.  It has something to do with the obligation to repay.  It might be the obligation to repay burdens other assets so the loan does not represent an actual increase in wealth.  Or it might be the obligation to repay creates an open transaction that crosses tax years and, for good administrative reasons, we simply presume the loan amount will be repaid in full.  For more details, see Lesson From The Tax Court: The Phantom Of The Tax Code—Discharge Of Indebtedness, TaxProf Blog (Feb. 19, 2018).

But what about when a taxpayer simply receives a payment that is not a loan, but appears to be a payment the taxpayer has a right to keep?  When it later turns out to be erroneous, and the taxpayer repays it, was it even income to start with?  Today we learn that if repayment of an erroneous distribution occurs in the same tax year as the distribution, there is no income to report.  That was good news for the taxpayers in Elijah Servance and Corliss Severance v. Commissioner, T.C. Summ. Op. 2022-23 (Nov. 21, 2022) (Judge Copeland), who received disability payments from Hartford Life Insurance Co. that they repaid in the same year.  The IRS said the payments were income.  The Tax Court held for the taxpayers.  Sure, the taxpayer lost the other, bigger, issue in the case—the one that got the Tax Analyst Headline of “Couple Could Not Exclude Retirement Benefits From Income.”  But this smaller issue about their disability insurance payments gives us two great lessons: one in tax law and one in tax procedure.  Details below the fold.

Facts
In 2012 Mr. Severance retired from 33 years with his employer, a railroad company.  He had received a diagnosis of colon cancer.  At that time he was covered by a long-term disability policy from Hartford Life Insurance Company.  His employer had paid his premiums, which meant that any disability payments he received from Hartford had to be reported as income since for many years he had been able to exclude the employer-paid premiums from income.  See §106(a).

The tax year at issue was 2015.  In that year Hartford sent the IRS (and the Severances) a W-2 reporting disability payments to Mr. Severance of $4,406.  They did not report that as income.  On audit, the IRS determined that amount should have been reported.

In Tax Court, Mr. Severance testified that he had been required to repay all of that amount to Hartford and in fact had repaid it all in 2015.  He supported his testimony with an email chain he had with a third-party recovery agent.  The last email was dated February 5, 2015.  Judge Copeland finds that: “The email indicates that Mr. Severance was repaying the ‘Hartford Life Debt’ at $1,000 per month beginning on February 3, 2015.”  Op. at 6.  That email, coupled with Mr. Severance’s testimony, led Judge Copeland to conclude that Mr. Severance “reimbursed Hartford in 2015 for any payments he might have received.”  Id.  That is a crucial finding of fact.  Let's see why.

Lesson 1: The Rescission Rule: It’s Not Income If You Pay It Back In Same Year
Taxpayers report and pay tax on a yearly basis.  §441(a).  That’s why “moneys received by a taxpayer as his own under a claim of right and without restriction as to their disposition are taxable for the year in which they are received and retained even though in a later year the taxpayer is obliged to refund them in whole or in part, in which event he would have a claim for deduction in the later year.” Penn v. Robertson, 115 F.2d 167, 175 (4th Cir. 1940).  Thus, in Blagaich v. Commissioner, T.C. Memo. 2016-2, the taxpayer who received $400,000 in 2010 was required to report that as income even though she was required to repay it, and in fact repaid it, in 2014.

If, however, taxpayers return the money they receive in the same year because they acknowledge they have no right to it, that action rescinds the prior receipt and courts apply equity to permit the taxpayer to ignore the prior receipt.  See Penn v. Robertson, supra, at 175 (cash payment to taxpayer that was repaid in the same year “extinguished what otherwise would have been taxable income...for that year”).

After explaining this rule, Judge Copeland applies it, declaring: “Thus, if the Severances’ repayments to Hartford in 2015 were of funds received in 2015, the rescission doctrine would demand an offset of the gross income dollar-for-dollar by the amount of repayment.”

Alert readers will quickly spot the problem here: even if one accepts that the Severances repaid Hartford for something in 2015, was that for amounts Hartford sent them in 2015 or for amounts Hartford sent them in earlier years?  What was this mysterious “Hartford Life Debt” referenced in the email?  Was the $4,406 reported on the W-2 the amount net of repayments, or did the W-2 simply fail to count repayments?  The puzzle pieces do not form a clear picture.  After all, an email that sets a repayment amount of an even $1,000 per month does not connect up neatly with a payback of a precise amount like $4,406.

That takes us to the procedural lesson.

Lesson 2: It Takes More than W-2 For IRS To Win Unreported Income Issue
Information reported by third parties on W-2’s, 1099’s, etc., is not always accurate.  That is why the courts have long held that while W-2’s are sufficient to support a determination of unreported income when the taxpayer files no return, they are not sufficient by themselves when the IRS is auditing a filed return.  See e.g. Portillo v. Commissioner, 932 F.2d 1128 (5th Cir. 1991).  See also  Lesson From The Tax Court: Naked Assessments!, TaxProf Blog (July 9, 2018).

When a taxpayer has filed a return and the IRS believes the taxpayer failed to report some amount of income the IRS cannot simply base its decision on a third party information return.  instead, the IRS has the burden to supply some “ligaments of fact” to tie the alleged unreported income to the taxpayer.  See Carson v. Commissioner, 560 F.2d 693, 696 (5th Cir. 1977) ("The tax collector's presumption of correctness has a herculean muscularity of Goliath-like reach, but we strike an Achilles' heel when we find no muscles, no tendons, no ligaments of fact.").

Congress pretty much codified that judicial doctrine in the Taxpayer Bill of Right 2, 110 Stat. 1452 (1996) when it added subsection (d) to §6201(d).  That subsection provides that if the taxpayer disputes the accuracy of a third party information form and has cooperated with the IRS’s reasonable requests during audit, then the IRS “shall have the burden of producing reasonable and probative information concerning such deficiency in additional to such information return.”  The IRS can meet its burden if the taxpayer admits or stipulates to the receipt of the unreported income.  See e.g. Nelson v. Commissioner, T.C. Memo. 2018-95 (taxpayer admitted in testimony to receipt of funds).

Judge Copeland relies heavily on that procedural doctrine in this case to resolve the factual ambiguities in favor of the taxpayer.  Here, Mr. Severance did not admit to the receipt of the $4,406 reported on the W-2.  He instead insisted that he did not receive it because he paid it back.  And the IRS “did not provide any substantive evidence of such receipt.” Op. at 5.  Heck, it appears that the IRS was not even able to produce either a copy of the W-2 or “any account transcripts or other evidence to that effect.” Id.

Bottom line: The IRS failed to meet its burden.  While the taxpayer’s evidence was pretty weak to support his claim of repayment, he did not need to do much here because the burden was on the IRS to actually show that he received the $4,406 reported on the W-2.  I suspect it could have done that with a bank deposit analysis or through a summons to Hartford for the payment records.  Realistically, however, that audit effort was probably not worth the resources, given the small amount at issue (small, at least, as to the government).

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.  He invites readers to return every Monday (or Tuesday when Monday is a federal holiday) for another Lesson From The Tax Court.