Paying for but not Receiving Your Social Security Benefits – The Consequence of Filing Late

We have had many posts on the myriad of consequences of filing late tax returns. One we have not discussed results when a self-employed taxpayer files more than three years late. In that situation, the individual must still pay the self-employment tax; however, the individual receives no social security benefits as a result of those payments. As the economy drives more and more individuals into jobs in which they have independent contractor status, the importance of filing on time increases in order to preserve future benefits available to those who qualify for social security.

When a non-filer shows up, sometimes we triage their return for the year in which the refund statute of limitations will soon expire. If it appears that the taxpayer will receive a refund, a last minute push occurs to send that return in before the expiration of the statute of limitations which is generally three years from the due date of the return. If it appears that the taxpayer owes money, the same last minute push may not occur. Because filing the return before three years from the original due date could preserve for the individual the ability to get credit for self-employment earnings for purposes of calculating the amount of social security they will receive, or even whether they will qualify for social security, the practitioner who has the chance to file the return before three years from the due date of the original return should make every effort to do so.

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In order to receive social security benefits based on age, an individual must accumulate 40 quarters of earnings. To receive social security disability benefits, the individuals needs 32 quarters.   In 2017, an individual receives credit for a quarter of social security earnings if they have $1,300 of qualified earnings. Anyone earning more than $5,200 in 2017 will receive four quarters of credit – the most quarters it is possible to earn in a single year. In addition to meeting the number of quarters necessary to obtain benefits, an individual receives social security benefits based on the amount of their earnings. While the formula skews towards individuals at the lower end of the earnings spectrum by giving a higher return on those earnings in calculating the benefits, the more a person earns the higher their social security benefits.

Here are the directions from Social Security on how to calculate your projected benefit. You can find Column A and B here. I include this primarily to show how valuable the lower earnings are to someone compared to the earnings over $5,336 and how the benefit skews to provide the greatest assistance to those who will likely have the greatest need. 

Step 1: your earnings in Column B, but not more than the amount shown in Column A. If you have no earnings, enter “0.”

Step 2: Multiply the amounts in Column B by the index factors in Column C, and enter the results in Column D. This gives you your indexed earnings, or the estimated value of your earnings in current dollars.

Step 3: Choose from Column D the 35 years with the highest amounts. Add these amounts. $_________

Step 4: Divide the result from Step 3 by 420 (the number of months in 35 years). Round down to the next lowest dollar. This will give you your average indexed monthly earnings. $_________

Step 5:

  1. Multiply the first $885 in Step 4 by 90%. $_________
  2. Multiply the amount in Step 4 over $885, and less than or equal to $5,336, by 32%. $_________
  3. Multiply the amount in Step 4 over $5,336 by 15%. $_________

Step 6: Add a, b, and c from Step 5. Round down to the next lowest dollar. This is your estimated monthly retirement benefit at … your full retirement age. $_________

The aged based benefit is calculated based on the highest 35 years of earnings. Some of my earnings from the 1960s and 1970s when I worked summer jobs while going to school and a quarter of earnings could accumulate for $250 will not do much to push up my high 35 years of earnings, but these quarters did provide a benefit to me in reaching the 40 quarters because all of my earnings when working for the federal government involved no social security taxation and therefore no buildup of earnings or quarters. Federal employees hired starting in the mid-1980s do pay social security, but some state and local government employees may still be outside of the social security system from their primary earnings. Some of my clients have not yet earned enough quarters to receive any social security benefits. Making sure that they understand the importance of earning enough quarters and the link between filing their tax return and earning quarters is something we try to impart.

What can you do if your client has failed to file their return within the normal time period for having their earnings count toward social security? Several exceptions apply to individuals in these circumstances; however, the exceptions are narrow:

After the time limit has passed, earnings records can only be revised under the conditions described below and in §1425:

1. To correct an entry established through fraud;

2. To correct a mechanical, clerical, or other obvious error;

3. To correct errors in crediting earnings to the wrong person or to the wrong period;

4. To transfer items to or from the Railroad Retirement Board (if reported to the wrong agency), or to add railroad earnings to Social Security earnings records when the law permits;

5. To add wages paid in a period by an employer who made no report of any wages paid to the worker in that period, or if the employer is increasing the originally reported amount for the period;

6. To add or remove wages in accordance with a wage report filed by the employer with IRS; or, if a State or local governmental employer, with SSA if the report is filed within the time limitation specified for assessment, refund, or credit under a State’s coverage agreement;

7. To add self-employment income in a taxable year if an individual or the individual’s survivor establishes that:

(1) A self-employment tax return for that year was filed before the time limit ran out; and

(2) Either no self-employment income for that year has been recorded in the individual’s earnings record, or the recorded self-employment income for that year is less than the amount reported on the self-employment tax return; or

8. To add self-employment income for any taxable year up to the amount of earnings that were wrongly recorded as wages and later deleted. This can be done only if a tax return reporting such self-employment income is filed within three years, three months, and 15 days after the taxable year in which the earnings wrongly recorded as wages were deleted. The self-employment income must:

(1) Be for the same taxable year as the year in which the wages were removed; and

(2) Have already been included on the individual’s Social Security record.

9. Prior to the expiration of the time limit the worker or the worker’s survivor has:

(1) Applied for benefits and stated that the earnings for a year(s) were incorrect; or

(2) Requested a revision of his or her earnings record for a year(s).

The time limit can also be extended if an investigation was in progress. Because of the manner in which social security benefits work, it may not be the taxpayer who wants or needs to correct the social security records. It could be a spouse or a child or someone else who can obtain benefits derivatively from the individual with the earnings.

Some sources for correcting the social security statement can be found here, here and here.

 

 

 

 

Promoting, Not Discouraging, Tax Compliance

Imagine you are Jane or Michael, a 14 year old who just entered the work force for the first time. In 2014 you earn $1,000 babysitting for your neighbor or cutting the grass.  You are proud of your earnings and newfound financial independence.  Like most of your friends you open a bank account and you decide to start saving your earnings for college, or maybe law school, or even retirement.

While thinking about your earnings and plans to save, you research the tax aspects of your employment as well as aspects of retirement planning, including Social Security benefits. At first after going to the library and checking out books on the tax law, you are surprised to learn that your self-employment earnings are subject to self-employment tax, but you are somewhat consoled when you read on the IRS website that “[y]our payment of these taxes contributes to your coverage under the Social Security system.”  However, while researching Social Security, you subsequently learn that you need 40 quarters of Social Security credits to qualify and that you must earn $1,200 in 2014 to qualify for one quarter of credit.  You are disappointed when you realize that you did not reach this level of earnings in 2014 but you vow to earn a little more in 2015 so you can start building credit for Social Security.

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The next night at the dinner table your family is talking tax policy and the self-employment tax comes up. Your pesky older brother rails against his landscaping job because they want to treat him as an independent contractor rather than an employee.  He complains that even though independent contractors seem to have a great advantage because they do not pay Social Security tax if they earn less than $400, he still wants to be an employee taxed on the first dollar.

This makes you wonder why independent contractors get to pass on self-employment taxes up to $400 of earnings and how this will impact your $1,000 earnings. After some research you learn that Congress initially did not make self-employed individuals pay self-employment tax if their earnings from self-employment would not allow them to get credit for a quarter of self-employment earnings; however, in 1978 Congress indexed the earnings necessary to receive one quarter of credit to inflation but it did not index the starting point for self-employment taxes.  So, you must pay self-employment tax on your earnings of $1,000 (about $150) but you get no, zero, nada credit from Social Security for this payment.

Thousands of teenagers similar to Jane and Michael (perhaps tens of thousands), as well as other very low-income earners, face this each year in the Untied States. These individuals, after carefully doing their research, realize that they must pay tax for something billed as insurance and for which they will receive no benefit.  Many of the people faced with this situation are just entering the workforce and many may not have even reached the age of majority, making this a tax on the unrepresented.  The dilemma facing the Janes and Michaels is whether they should pay this tax and be good citizens as they enter the work force because Congress mandated that they pay it.  Should they stand up and rail against the system Congress created or should they quietly let the matter slip because in many instances the IRS has not received a Form 1099 or other indication of the income and enforcement action is unlikely.

To research the behaviors of teenagers faced with this dilemma, I have quizzed my law school students for the past several years. I assume that law students would comprise a very law abiding segment of this group because they face the bar review committee and must demonstrate compliance with the laws and possess high moral character and fitness to practice.  They do not want to put on their bar applications that they have unfiled returns and unpaid taxes.  Because my students have a heightened interest in tax leading them to take a tax clinic course, I assume that on tax matters they demonstrate even a higher standard of tax compliance than ordinary law students.

My first discovery in quizzing this group was that students who end up in my law school class seem, by and large, to never have earned money by babysitting or cutting grass – or at least they decline to admit it in an open classroom. As a group, only a small percentage of them ever worked in self-employed positions.  This lack of self-employment as an entry into the work force may stem from generational changes from when I grew up or may result from the demographics of those who can afford to attend my law school.  I realize that my job as a paperboy from ages 12-17 no longer exists for that age group.

Never having been self-employed, these students have no worries in regard to the self-employment tax and generally demonstrate a complete lack of knowledge about the self-employment tax.

Second, among the minority of students who have held self-employed positions, the percentage of these students reporting self-employed earnings as teenagers hovered right around the percentage I expected – absolute zero. I had one student several years ago who worked for a law firm the previous summer and earned about $6,000–$7,000.  He seemed dazed as he left the class to learn that he had a $1,000 bill for self-employment tax for his summer’s work.  Being the messenger made me slightly uncomfortable in that situation.  Unlike my fictional Jane and Michael, most teenagers in America do not seem to know about their self-employment tax filing obligations.  I do not attribute the failure to pay the tax to a desire on the part of my students to cheat on their taxes but primarily due to ignorance.  I also did not note a clamor to rush to file the missing back tax returns for those coming to the realization of their little known failure to file problem.

All of this background leads to the point of this article allegedly about tax procedure – why do we have a tax imposed for the purpose of providing benefits but which does not? Do we have the expectation that the IRS would/could/should administer this law?  Why do we want to teach people as they enter the work force that they can ignore tax laws?  Does this lead to later non-compliance?  Would tax procedure be better served by laws that the tax administrator could administer and the taxpayer could see some benefit even if it is 50 years in the future?

We will argue in this column for procedures that work, laws that support them and laws that promote compliance. The requirement to pay self-employment taxes even when earnings do not contrubute to Social Scurity credits is a poorly designed law that at best benefits from a lack of understanding and likely promotes non-compliance. Most of the non-compliance in this post’s example likely results from ignorance rather than willfulness but do we want to promote non-compliance in any manner? Don’t we want to introduce our young citizens into a tax system that is rational and just? The current model does precisely the opposite.