Paying Tax on the Same Income Twice, and Getting a Civil Penalty to Boot

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I came across the case of Udeobong v Commissioner, a Tax Court case from last month. The case involves a clash of two principles of our tax system: 1) that the tax system is based on an annual accounting system, so each year stands on its own, and 2) that a taxpayer should not have to pay tax on the same income twice. As I discuss below, the Tax Court hung its hat on the first principle, reaching a result that violates the second principle. In so doing it also penalized the taxpayer, who unless he appeals will pay tax and a 20% penalty on income he previously included.

In this post I will discuss the way the Tax Court resolved the opinion and flag some issues that perhaps the Tax Court should have considered.

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Receiving Income, Returning it After a Dispute and Getting Some of it Back

The case involves a taxpayer, Ita Andrew Udeobong, who started a medical supply business in 2001 (I assume as a sole proprietor) and received millions of dollars in Medicaid reimbursement payments from CIGNA. The taxpayer apparently had some issues with the law with respect to the Medicaid reimbursements. Despite whatever nontax issues Udeobong had with respect to the Medicaid reimbursement the opinion states that in the early 2000s he reported as gross income those payments and paid the tax on the payment he received from Cigna. The opinion states that in a subsequent year as a result of a dispute with Cigna over whether the taxpayer was entitled to the reimbursements the taxpayer repaid those payments to Cigna. When Udeobong repaid those amounts he did not deduct the payments.

Udeobong’s tax problems arose because in 2010 (the year at issue in the Tax Court) after the dispute with Cigna was resolved Cigna returned some of the repaid amounts to Udeobong and issued a new 1099 MISC.

The facts are somewhat muddied because there was some confusion over the precise amount Cigna paid to the taxpayer in 2010 (and the 1099 was incorrect). In 2010 Cigna sent Udeobong 82 checks but stopped payment on all but 4 of those checks. The 1099 Cigna issued included the amounts in the checks for which it stopped payment.

It is clear that Udeobong did not have to include as gross income the amounts reflected in the checks that Cigna stopped payment on, but the IRS continued to press Udeobong on including the amounts reflected in the 4 checks despite his having included as gross income in an earlier year the amounts reflected in those checks.

Udeobong, who appeared to be pro se, argued that he should not pay tax on the amounts Cigna returned to him in 2010 because he properly reported those amounts as gross income in earlier years and in fact paid tax on that income in the earlier year:

[H]e argues that those payments represented the return to him of Medicaid reimbursement payments on which he had paid tax and which he subsequently had returned to Cigna (before 2005). He argues that he should not have to pay tax again on the same income.

Rather than consider whether the amounts reflected in the checks are gross income, the Tax Court opinion focused its inquiry on whether Udeobong was entitled to a deduction under Section 1341. The opinion rightly notes that Section 1341 provided no relief in the year at question:

Here, petitioner received payments from Cigna in earlier years with respect to which he paid Federal income tax. In a later tax year he returned the payments to Cigna. Section 1341 might have allowed him to adjust his tax for the year that he repaid Cigna, if he were entitled to a deduction in that tax year under another Code provision.

Section 1341 mitigates the sometimes-harsh consequences of the annual system of accounting, and allows the unwinding of a prior inclusion of income when later events demonstrate that the earlier income inclusion was unwarranted. If its conditions are met, Section 1341 provides that a taxpayer is entitled to either the equivalent of a refund for income tax paid in the earlier year, or a deduction from income in the year of repayment, whichever is more beneficial to the taxpayer. We have discussed that provision before; see my earlier post on Joseph Nacchio and his efforts to use 1341 to generate a refund on funds forfeited following an insider trading guilty plea and David Vendler’s two part guest post Can a Receiver Take Advantage of the Claim of Right Provisions to Benefit Defrauded Consumers? )

Citing then to Section 61(a), the opinion goes on to conclude that in light of 1341 providing no relief, “the amounts petitioner received from Cigna must be included in his income for 2010 irrespective of whether they represent payments that had been taxed but not retained for prior years.”

Some Thoughts on the Tax Court Approach: Tax Benefit And Accrued Receivable Arguably Provide Support for No Inclusion of Gross Income

It is not surprising that the opinion discusses Section 1341 but I was surprised by its somewhat casual referencing to the amounts constituting gross income under Section 61.

The court is correct that 1341 does not have any relevance to the year in issue. That is because in 2010 Udeobong did not return anything to Cigna; rather it received from Cigna payments that it had previously included and returned to Cigna following a dispute.

I discussed this opinion with my colleague Jim Maule, who nudged me to think about the tax benefit rule. The tax benefit rule provides that recoveries are taxable only to the extent the taxpayer received a tax benefit from the deduction—that is, the deduction must have reduced taxes or increased a credit carry-forward in the prior year.

As Jim points out, “had Udeobong taken the deduction in the earlier year, the tax benefit rule would have required inclusion in gross income to the extent the previous year deduction provided a benefit.”

But one of the challenges in this case was that Udeobong did not deduct any of the amounts he returned to Cigna in earlier years. Does the lack of Udeobong’s deduction mean that tax benefit principles are of no moment in the case? Jim pushes further and points to an analogous situation involving the payment of state income taxes in one year and a refund of those state income taxes in a later year:

Suppose a taxpayer pays state income tax but does not deduct the payment because the taxpayer uses the standard deduction. Part of the state income tax is refunded. It is excluded from gross income because the payment with respect to which it was made was not deducted (there was no deduction). Is it not possible to argue that the Cigna payments in 2010 were refunds of amounts paid in the earlier year, and that because no deduction was claimed for those amounts, that the payments are excluded because of the lack of a tax benefit?

A recent Tax Court opinion, Maines v Commissioner, explains this point further and discusses the payment and refund of state income taxes and how inclusion is tethered to an earlier year’s tax benefit from paying an amount that was deducted:

But what if someone who doesn’t itemize in year 1 gets a refund in year 2? The answer in that case is that he does not have to include his state income-tax refund on his year 2 return, see Tempel v. Commissioner, 136 T.C. 341, 351 n.19 (2011) (stating that state-tax refunds are not income unless the taxpayer claimed a deduction for them–for example, by itemizing for the previous year), aff’d sub nom. Esgar Corp. v. Commissioner, 744 F.3d 649 (10th Cir. 2014): He got no deduction in year 1 for the state income tax that he paid, so he got no federal tax benefit. And without a federal tax benefit, he doesn’t have to bear a federal tax burden on a refund he receives in year 2. See, e.g., Clark v. Commissioner, 40 B.T.A. 333, 335 (1939) (holding that so long as “petitioner neither could nor did take a deduction in a prior year,” any amount he receives the next year “is not then includable in his gross income.”); Rev. Rul. 79-315, 1979-2 C.B. 27.

So perhaps the tax benefit principles might have provided an avenue to find that Udeobong did not have gross income in the first instance.

In addition to the tax benefit argument, Jim suggested an argument that essentially analogizes Udeobong to having in effect an accrued receivable with a corresponding basis:

Udeobong returned the payments but continued to argue that he had a right to payment. Thus, does he not have a basis in his claim because he paid amounts back to CIGNA for which he did not claim a deduction? When CIGNA made payments in the year in issue, cannot the taxpayer offset them by the basis he has in those claims? In other words, are they not accrued receivables?

Parting Thoughts

Both arguments seem to me worth consideration, as they would provide a way for the court to not violate the principle that a taxpayer should only have to include amounts in gross income only once. The upshot of this opinion is now Udeobong will be subject to tax twice for the same income. On top of that unhappy result the Tax Court also sustained a 20 per cent accuracy-related penalty because his “mistaken view of the law does not rise to the level of ‘reasonable cause’ or ‘good faith’. To be sure, the opinion provided some relief for the taxpayer as the Tax Court did not allow the IRS to amend its answer to conform to the evidence that showed that the amount reflected in the retained checks was over $250,000, rather than about $150,0000, which was what IRS originally argued. Nonetheless, this is a harsh result, and while Udeobong might not be the most sympathetic taxpayer, it seems to me that some tax issues were left on the table.

This case blends procedure and substance. Section 1341 and other timing concepts like the tax benefit rule seem to fall on the procedural side because they provide a mechanism to fix a substantive mismatch in income or deductions. Because Mr. Udeobong handled his case pro se, the Court lost the benefit of strong arguments on his side that might have explained the basis for the procedural and substantive rules providing protection in circumstances like this and how tax principles might offer a way around the harsh result produced here. When the adversarial process is unbalanced, the Court and tax law suffers in addition to the underrepresented party.

 

 

 

Leslie Book About Leslie Book

Professor Book is a Professor of Law at the Villanova University Charles Widger School of Law.

Comments

  1. Scott Bonacker CPA says:

    There was a discussion, and several articles, about the question of whether a taxpayer MUST or SHOULD claim all available deductions. Seems like this particular case is related to that – the opinion says in part that ‘Section 1341 might have allowed him to adjust his tax for the year that he repaid Cigna, if he were entitled to a deduction in that tax year under another Code provision.’ Nothing is said about why the taxpayer didn’t claim a tax benefit in the year of repayment, but if it was a conscious choice it was the wrong choice because the opportunity was lost. Not every foregone deduction turns out this way obviously, or is significant enough to have that kind of impact, but there is that risk.

    • Guest Blogger Les Book says:

      Thanks Scott for your comment. Interestingly enough a while back Jim Maule actually wrote a paper discussing whether taxpayers can forego a deduction that they are entitled to take. That article is called No Thanks, Uncle Sam, You Can Keep Your Tax Break http://papers.ssrn.com/sol3/papers.cfm?abstract_id=929119
      I suspect that this opinion now will require some additional thinking on the merits of whether someone should fail to take a deduction in a given year. As an aside, I did not discuss in this post the 1341 issues associated with receiving ill-gotten gains and repaying those back, though there have been a couple of PT posts on that issue.

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