Taxpayer Had Unreported Income Due to Workers' Compensation Offset Rule

(Parker Tax Publishing March 2024)

The Tax Court held that a taxpayer who received both social security disability and workers compensation benefits underreported her taxable social security benefits as a result of the so-called workers' compensation offset provision in Code Sec. 86(d)(3). Under the workers' compensation offset rule, the taxpayer was treated as having received the portion of her social security benefits not paid by the Social Security Administration in order to prevent her from receiving benefits in excess of 80 percent of her average current earnings benchmark in accordance with 42 U.S.C. Sec. 424a(a). Ecret v. Comm'r, T.C. Memo. 2024-23.

Background

Kristen Ecret worked as a registered nurse until 2014. In that year she suffered an injury and became medically disabled. She began receiving New York workers' compensation benefits in 2014. She received approximately $42,000 of such benefits annually through 2019, the tax year at issue.

In 2015 Kristen applied to the Social Security Administration (SSA) for benefits related to her disability. In December 2017 the SSA issued her an award letter indicating that she was entitled to benefits beginning in 2015. In January 2018 she was issued a Form SSA-1099, Social Security Benefit Statement, for 2017, reporting that she had $14,392 of social security benefits for that year. But a federal statute, 42 U.S.C. Sec. 424a(a), limits the total combined amount of workers' compensation and social security benefits that an individual may receive in a given year, and it thus disbursed no benefits to her. The Form SSA-1099 explained that the entirety of her 2017 social security benefits was subject to "workers' compensation offset."

In January 2018 Kristen filed with the SSA a request for reconsideration, asking that it recalculate her workers' compensation offset amount. In January 2019 the SSA issued her a letter granting relief. The SSA acknowledged that, in its initial award letter, it had miscalculated her monthly "average current earnings" (ACE). ACE serves as a benchmark to approximate the monthly earnings an individual would have received if not disabled, and the SSA calculates the workers' compensation offset using a figure equal to 80 percent of ACE. The SSA informed Kristen that, effective January 2018, her ACE was adjusted upward to $5,074 to reflect a rise in the national earnings level. As a result, 80 percent of her ACE was increased to $4,059. The SSA noted that it had paid her $3,060 on December 4, 2018, to account for this adjustment.

Kristen received Form SSA-1099 for 2018. It indicated that she had total social security benefits of $71,918, of which $19,322 was attributable to 2018. The balance, or $52,596, reflected retroactive benefits attributable to 2015 - 2017. The Form SSA-1099 indicated that $20,749 had been paid to her "by check or direct deposit." Another $5,375 was paid as attorney's fees and as voluntary federal income tax withholding. The balance of the $71,918 in benefits, or $45,794, was not paid on account of the "workers' compensation offset."

Kristen received Form SSA-1099 for 2019, the tax year at issue. It indicated that she had total social security benefits of $55,248, of which $19,866 was attributable to 2019. The balance, or $35,382, reflected retroactive benefits attributable to 2016-2018. The Form SSA-1099 indicated that $6,120 was paid to her "by check or direct deposit." Another $1,080 was paid as voluntary federal income tax withholding. The balance of the $55,248 in benefits, or $48,048, was not paid on account of the "workers' compensation offset."

On their joint federal income tax return for 2019, Kristen and her husband reported $5,202 in taxable social security benefits. They appeared to have calculated this sum as 85 percent of the $6,120 cash payment from the SSA. Under Code Sec. 86(a)(2)(B), 85 percent of the social security benefits received during the tax year is the maximum amount includible in gross income.

The IRS selected the Ecrets' 2019 return for examination. It determined that, under Code Sec. 86(d)(3), the base for calculation of their taxable social security benefits should be increased by $49,128, representing the sum of $1,080 (the amount paid by the SSA as voluntary income tax withholding) and $48,048 (the amount of social security benefits not paid on account of workers' compensation offset). The IRS issued the Ecrets a notice of deficiency for 2019, upwardly adjusting their gross income by $41,759 ($49,128 x .85) to reflect additional taxable social security benefits. The Ecrets took their case to the Tax Court.

The IRS conceded that the Ecrets were not liable for income tax in 2019 on the portion of Kristen's social security benefits that constituted a retroactive payment attributable to 2016-2018. But the IRS maintained that, under Code Sec. 86(d)(3), Kristen should be treated as having received in 2019 total social security benefits of $19,866, representing the sum of $6,120 (the cash payment from the SSA), $1,080 (the amount paid by the SSA as voluntary income tax withholding), and $12,666 (the amount of 2019 social security benefits not paid on account of workers' compensation offset). The IRS contended that 85 percent of this sum, or $16,886, was properly includible in the Ecrets' gross income for 2019. The Ecrets contended that they should be taxable only on the social security benefits that were paid to them in cash.

Workers' Compensation Offset

Code Sec. 61(a) provides that gross income means all income from whatever source derived. Generally, under Code Sec. 104(a)(1) gross income does not include workers' compensation. Social security benefits are included income gross income to the extent specified by Code Sec. 86.

Federal law limits the amount of combined workers' compensation and social security benefits that an individual may receive in a given year. Under 42 U.S.C. Sec. 424a(a), an individual generally may not receive combined benefits that exceed 80 percent of his or her ACE benchmark. When payment of social security benefits would cause the individual's combined benefits to exceed 80 percent of ACE, the SSA must stop disbursing benefits. The undisbursed benefits are thus said to be "offset" by the workers' compensation payments.

The term "social security benefit" is defined in Code Sec. 86(d)(1)(A) to include "any amount received by the taxpayer by reason of entitlement to ... a monthly benefit under title II of the Social Security Act." That general definition is modified by Code Sec. 86(d)(3), which provides that if a taxpayer's social security benefits are reduced by reason of the receipt of workers' compensation benefits, the term "social security benefit" includes the portion of the workers' compensation benefit equal to the amount of the reduction. In other words, the amount of an individual's social security benefits for purposes of Code Sec. 86(d) includes workers' compensation payments to the extent those payments offset social security benefits to which the individual is entitled.

Analysis

The Tax Court held that it was compelled under Code Sec. 86(d)(3) to agree with the IRS's position that Kristen had $19,866 in social security benefits attributable to 2019. The court explained that of this amount, the SSA disbursed $6,120 to her as a cash payment after withholding $1,080 of federal income tax, which it paid to the IRS on her behalf. The SSA did not disburse the remaining $12,666 on account of the workers' compensation offset. But the court found that under Code Sec. 86(d) the Ecrets were nonetheless required to treat this sum as social security benefits for federal income tax purposes.

The court explained that, in enacting Code Sec. 86(d)(3), Congress sought to equalize the treatment of taxpayers in the Ecrets' position with taxpayers residing in "reverse offset" jurisdictions, i.e., states where the receipt of social security benefits reduces workers' compensation benefits. The court noted that in 2019 Kristen received roughly $42,000 in workers' compensation benefits from New York and had $55,248 of social security benefits. As the SSA indicated in its January 2019 letter, 80 percent of her monthly ACE was $4,059. The court therefore found that, on an annual basis, her combined workers' compensation and social security benefits were not permitted to exceed $48,708 ($4,059 x 12) under 42 U.S.C. Sec. 424a(a). But the sum of the two streams of benefits substantially exceeded this threshold.

In consequence, the court found that the bulk of the social security benefits to which Kristen was entitled for 2019 were subject to workers' compensation offset. Under Code Sec. 86, up to 85 percent of social security benefits are included in gross income, with the exact percentage depending on various income thresholds. The IRS contended that applicable inclusion ratio in this case was 85 percent, and the Ecrets did not disagree; indeed, on their 2019 return, they reported $6,120 in social security benefits and included 85 percent of those benefits ($5,202) in their gross income. Applying the 85 percent inclusion ratio, the court concluded that the Ecrets for 2019 had taxable social security benefits of $16,886, calculated as 85 percent of the $19,866 in benefits that were attributable to 2019. Because the Ecrets on their 2019 return reported only $5,202 in taxable social security benefits, the court held that they were required to include an additional $11,684 of such benefits ($16,886 - $5,202) in their gross income.

For a discussion of the workers' compensation offset rule, see Parker Tax ¶73,905.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com

We hope you find our professional tax research articles comprehensive and informative. Parker Tax Pro Library gives you unlimited online access all of our past Biweekly Tax Bulletins, 22 volumes of expert analysis, 250 Client Letters, Bob Jennings Practice Aids, time saving election statements and our comprehensive, fully updated primary source library.

Try Our Easy, Powerful Search Engine

A Professional Tax Research Solution that gives you instant access to 22 volumes of expert analysis and 185,000 authoritative source documents. But having access won’t help if you can’t quickly and easily find the materials that answer your questions. That’s where Parker’s search engine – and it’s uncanny knack for finding the right documents – comes into play

Things that take half a dozen steps in other products take two steps in ours. Search results come up instantly and browsing them is a cinch. So is linking from Parker’s analysis to practice aids and cited primary source documents. Parker’s powerful, user-friendly search engine ensures that you quickly find what you need every time you visit Our Tax Research Library.

Dear Tax Professional,

My name is James Levey, and a few years back I founded a company named Kleinrock Publishing. I started Kleinrock out of frustration with the prohibitively high prices and difficult search engines of BNA, CCH, and RIA tax research products ... kind of reminiscent of the situation practitioners face today.

Now that Kleinrock has disappeared into CCH, prices are soaring again and ease-of-use has fallen by the wayside. The needs of smaller firms and sole practitioners are simply not being met.

To address the problem, I’ve partnered with a group of highly talented tax writers to create Parker Tax Publishing ... a company dedicated to the idea that comprehensive, authoritative tax information service can be both easy-to-use and highly affordable.

Our product, the Parker Tax Pro Library, is breathtaking in its scope. Check out the contents listing to the left to get a sense of all the valuable material you'll have access to when you subscribe.

Or better yet, take a minute to sign yourself up for a free trial, so you can experience first-hand just how easy it is to get results with the Pro Library!

Sincerely,

James Levey

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com