Small Business Taxes & Management

Special Report

Timing Can be Critical in Securing Deductions


Small Business Taxes & ManagementTM--Copyright 2023, A/N Group, Inc.




Sometimes tax law is logical, sometimes it isn't. Sometimes it's equitable, sometimes not. It's not unusual that there's a time deadline on securing a deduction, deferring income, etc. Sometimes you can seek an exception to the deadline, but there are situations where neither the IRS nor the courts can grant an exception. And in most cases the year to claim income and deductions is dictated by law--not the taxpayer's opinion.

The facts in the situation below were taken from a case, but we've simplified them to make understanding the law easier.



In 2001 the taxpayer started a medical supply business that used the cash accounting method. As part of his business, before 2005, the taxpayer received Medicaid reimbursement payments from an insurance company. The insurer reported these payments to the taxpayer on Forms 1099, and the taxpayer reported and paid Federal income tax on them. Subsequently, a dispute arose and he returned the payments to the insurer. The taxpayer did not deduct the returned payments on his tax return for that year; nor did he file a claim for refund. Litigation over the payments followed, and the insurer was required to repay the taxpayer certain of the payments that the taxpayer had returned.

In 2010 the taxpayer received 78 checks from the insurer for which payment was stopped or withheld (stopped checks). He also received checks from the insurer that represented payments he kept (retained checks) and cashed. The face amounts of the retained checks totaled some $260,000. The insurer prepared a Form 1099-MISC, for 2010 reporting payments of some $3,000,000. This sum included both the amounts represented by the stopped checks and the amounts represented by the retained checks. For the year 2010 the taxpayer filed his Form 1040 and reported total income of $1,600. He did not include in income any of the payments he received via the retained checks or the payments that the insurer reported on the Form 1099-MISC.

When the IRS examined the taxpayer's 2010 return in 2012 it determined the taxpayer's gross receipts for the year by subtracting the total of the 78 stopped checks from the total shown on the Form 1099 for the year, arriving at some $152,000. (There were discrepancies between the amount of the checks and the copies of the 19 checks (of 78) reviewed by the IRS to the list of stopped checks provided by the insurer. Don't assume the 1099 provider computed the amount on the 1099 correctly. If there's a difference, inform the provider of the 1099.)

The taxpayer petitioned the Tax Court. He admitted that he received the payments made by the retained checks, but argued 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 the insurer (before 2005). He argued that he should not have to pay tax again on the same income.


Court's Holding

The court noted that no statutory provision gives the taxpayer the relief he sought. Section 1341(a) provides a form of relief for a taxpayer on the cash method of accounting, allowing an adjustment to taxes owed in the year of the repayment to reflect taxes already paid. That provision applies if: (1) a taxpayer includes an amount in income for a prior tax year that the taxpayer repays in a later tax year and (2) the taxpayer is entitled to a deduction for the repayment for that later year. Here, the taxpayer received payments from the insurer in earlier years with respect to which he paid Federal income tax. In a later tax year he returned the payments. Section 1341 might have allowed him to adjust his tax for the year that he repaid the insurer, if he were entitled to a deduction in that tax year under another Code provision. As a cash method taxpayer, the taxpayer was entitled to a deduction only for the year in which he repaid the insurer. (Sec. 1.446-1(c)(1)(i)). (For a taxpayer using the cash method of accounting, “expenditures are to be deducted for the taxable year in which actually made”); see also Sec. 1.461-1(a)(1), Income Tax Regs. (stating the general rule that taxpayers making cash disbursements are to take allowable deductions for those disbursements in the year made). That year was not 2010. Therefore, the amounts the taxpayer received must be included in his income for 2010 irrespective of whether they represent payments that had been taxed but not retained for prior years.

Could it get much worse? You bet. At trial the IRS made a motion to amend it's answer and increase the amount of unreported income to $260,000 from $152,000 based on the evidence of the retained checks. The court refused, noting the IRS's motion came at the end of trial, and the court concluded that it was an unfair surprise and prejudicial to taxpayer, who then was unrepresented. But the court did allow the impost ion of the negligence penalty on the unreported income.


Follow Up

The result may seem unduly harsh, but you can't decide when to take a deduction, which was essentially what the taxpayer did here. He should have sought a deduction for the repayment of the amounts repaid the insurer in the year of repayment. He may also have been able to file an amended return for the year of repayment, but by the time the insurer paid him for a portion of the amount he repaid, it was too later for that.

Some additional points and issues.

File a valid return. You may have options in a later year, such as filing an amended return, but you could have problems if you don't file a return or don't file a return on time. For example, you can sometimes make an election to take deduction or defer income, but only on a timely filed return (either by the due date, or if you have an extension, the extended due date).

Claim of right. If you receive an amount which is really not income (e.g., like a deposit) but you have unrestricted use of the money, you must report it as income and can take a deduction in the year paid. You may have other options in some circumstances.

Theft loss. You can only take a deduction in the year the theft is discovered.

Casualty loss. A deduction is only allowed in the year of the loss. But you can't take the loss on your return if you anticipate an insurance reimbursement.

Bad debt and worthless stock. The loss can only be taken in the year the debt or stock becomes worthless. (For individuals, a loss is only allowed for total worthlessness; a partial deduction is allowed for business bad debts.) Determining the year of worthlessness can be tricky. Take it too early and it will be denied; too late and you'll also lose. Check with a tax professional if there's any doubt.

Like-kind exchange. In the sale of real estate you can postpone gain by usng a like-kind exchange.

Installment sale. You may be able to postpone gain on the sale of property if you agree to take back a note and receive the payments over time. You take the gain into income as you receive payments on the note.

Passive activities and amounts at-risk. You may not be able to deduct rental or business losses because of the passive activity, basis, or at-risk rules. But you'll have to work through the computations each year to see if losses are deductible. For example, your basis may increase enough to deduct a loss you've been carrying forward. You can delay taking the loss.

Elections. The tax code contains a numebr of elections. some allow you to opt out of a special benefit, some allow you to take a special benefit, some can delay the timing of an income item or deduction. Elections can be made on a timely filed return. That includes extensions. Some, but much less, elections can be made on an amended return.

Professional help. The bigger the number, the more important it is to use a professional. And don't assume the professional will catch everything. It's more than likely he or she will ask questions about large or unusual items, but the true nature of the item could be disguised. Make a list of any unusual issues during the year and discuss them with your advisor before he prepares the return. Better yet, do so during the year or before the transaction is complete. There could be big savings.


Copyright 2023 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536

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--Last Update 06/30/23