Adventures in Taxland, Part V

Last week I had a tax client that was a real success story. They went from a starting point of owing the IRS over $6000 to receiving a $175 refund. There were several twists and turns in the story, but by the proper application of tax law I was able to help the couple avert what would have been a calamity for their personal finances.


The first question is how they got into the position of having to pay in so much in the first place. The answer is that they made a lot of money. Sort of.

The wife worked a full time job, and made about $30,000 for 2012. She had taken out enough withholding to more than cover the taxes on that income, if that had been the couple’s only income.

The next piece of the puzzle was the husband. In 2012 his request for disability was approved. With social security disability, benefits accrue from the date you apply for disability. If and when you are finally approved, the accrued benefits are paid, up to the date of approval. In essence, you get back pay. The husband received a lump sum payment for 2010, 2011, and 2012, totaling $30,000. The worksheet for calculating the taxability of social security benefits is complicated, but the bottom line is that about $13,000 of the lump sum was taxable income. So now they were up to $43,000 in taxable income.

Then came a twist. Qualifying for disability is one of the few ways you can discharge federally guaranteed student loan debt. Death is about the only other way you can get out from under. You can’t even drop student loans debt through bankruptcy. The husband had old student loan debt that was written off. This one of those good news, bad news situations. The good news is that the bill collectors stop calling, trying to collect on the debt. The bad news is that cancelled debt is income. If you negotiate to close a credit card for less than the balance due, the amount written off is considered income. If your house is foreclosed on, and the bank sells it for less than the loan, the difference is income. More people are getting caught up in this since the Great Recession began in 2008.

With unpaid interest charges tacked on, the cancelled debt came to $21,000. So the couple’s income now included wages of $30,000, taxable social security of $13,000, and cancelled debt income of $21,000. Total income of $64,000. After taking the standard deduction and two personal exemptions, taxes due were over $6000. They sure didn’t take enough withholding to cover that.

From this starting point I sprang into action. Well, I didn’t actually spring. It was more of a tap, tap, tap on the keyboard, along with some filling out worksheets by hand.

First, we went to work on the cancelled debt income. Cancelled debt can be excluded from income to the extent that you are insolvent. You add up all your debts, including the student loan. Then you add all your assets, including your 401K, car, and personal possessions. To the extent your liabilities exceed your assets, you are insolvent. We went through the IRS approved worksheet, and determined that the couple was insolvent to well over the amount of the student loan debt. So we filed a Form 982 to exclude the income. That took care of that part of the problem.

The next step was to tackle the lump sum disability payment. The IRS allows what is called a Lump Sum Election (LSE). You go back through every year of the disability payments, and calculate how much of the Social Security would have been taxable under each year’s situation. In this case it required going over the couple’s tax returns for 2010 and 2011, as well as 2012, and figuring out how much of the Social Security was taxable in each year. Then that was lumped together and entered on their Form 1040, with a special notation. That reduced the taxable portion from $13,000 down to $5000. The bottom line of these machinations was to bring their reported income down from $64,000 to $35,000. And they had taken enough withholding to cover the tax bill on that, with $175 left over as a refund.

This case shows the benefit of training, experience, and cooperation among tax professionals can make a difference over just trying to use the software. The use of knowledge and judgment in applying the software made the difference between a big pay in and getting a refund for this client.

Not bad for a plumber who only does taxes part time.