Social Security benefits are included in gross income when the taxpayer’s income exceeds a certain level, the base amount. Generally, the income is included in the year it is received. When a person initially applies for Social Security or disability benefits, approval is often delayed for a year or more. In these cases, the first payment may be a lump-sum which exceeds the base amount and generates a tax liability.
Congress has provided an election which may offer relief to taxpayers who receive a lump-sum payment, § 86(e):
LIMITATION ON AMOUNT INCLUDED WHERE TAXPAYER RECEIVES LUMP-SUM PAYMENT. –
(1) LIMITATION. –If–
(A) Any portion of a lump-sum payment of Social Security benefits received during the taxable year is attributable to prior taxable years, and
(B) The taxpayer makes an election under this subsection for the taxable year,
then the amount included in gross income under this section for the taxable year by reason of the receipt of such portion shall not exceed the sum of the increase in gross income under this chapter for prior taxable years which would result solely from taking into account such portion in the taxable years to which it is attributable.
(2) SPECIAL RULES. –
(A) YEAR TO WHICH BENEFIT ATTRIBUTABLE. – For purposes of this subsection, a Social Security benefit is attributable to a taxable year if the generally applicable payment date for such benefit occurred during such taxable year.
(B) ELECTION. – An election under this subsection shall be made at such time and in such manner as the Secretary shall by regulations prescribe. Such election, once made, may be revoked only with the consent of the Secretary.
The Secretary has not prescribed by regulation the time or manner in which an election under this subsection shall be made.
The election allows a taxpayer to relate back the lump-sum payment to the year(s) in which it would have been received. The taxpayer will have gross income for the payment year only to the amount it would have been included in gross income in the prior years (i.e., for each prior year, there is no taxable income from the allocation unless one-half of the allocation plus the taxpayer’s adjusted gross income for the year exceeds the base amount). Because the taxpayer benefits from a separate calculation for each prior year, this election may reduce the amount of tax due. The prior years are not changed by the election, so the client will not need to file amended returns for those years.
IRS Publication 915 (linked below) contains worksheets helpful in determining the amount of taxable income for each year. The Social Security payments are reported on Form SSA-1099. Review the client’s Wage & Income transcripts to determine the amount allocated to each year. You will also need the adjusted gross income for each year. The amounts can usually be obtained by reviewing the Transcript of Return and the Wage & Income Transcript for those years.
Because this is an election made by the taxpayer, the client must file a return for the tax year in which the lump-sum payment is received.
We have provided a sample memorandum addressing lump-sum payments, below.
Repayment of Social Security benefits
Generally, a person who receives Social Security income must include the benefits in the year received. This is true even if the benefits are repaid. However, the Code provides relief for taxpayers who repay benefits received.
Section 86(d)(2)(A) provides:
In general.--For purposes of this section, the amount of social security benefits received during any taxable year shall be reduced by any repayment made by the taxpayer during the taxable year of a social security benefit previously received by the taxpayer (whether or not such benefit was received during the taxable year).
This has two possible effects, depending on the timing of the repayment. If repayment occurs in the same year the benefits were received, the taxpayer may deduct the amount of the repayment from the benefits received. If repayment occurs in a year following the receipt of the benefits, the taxpayer may deduct the amount of the repayment from the benefits received in the year of repayment. Note, the deduction is not against the benefits that have been repaid, but against benefits received in the same year as the repayment.
This deduction may be problematic, though, if the taxpayer’s repayment is greater than the total income for the year the repayment occurs. The taxpayer will have excess deductions that cannot be used to offset income. In these circumstances, Code section 1341 provides an alternative option for reclaiming tax paid in a prior year for Social Security benefits that have been repaid in a subsequent year.
There are three requirements for § 1341:
1) The benefits must have been included in gross income in a prior year.
2) The taxpayer must have “restored” the benefits by making a repayment.
3) The repayment must be more than $3,000.
See Andrews v. Commissioner, 1992 T.C. Memo 668 at *4.
The taxpayer must demonstrate that the Social Security benefits were included on a return in a prior year. Gasparutti v. Commissioner, 1998 T.C. Memo 382 at *2.
If the taxpayer meets all three requirements for § 1341, the tax liability for the year of repayment should be calculated without a deduction for the amount of repayment. This tax liability is then reduced by the amount of tax paid on the Social Security benefits in the prior year. I.R.C. § 1341(a)(5). If the prior tax paid is greater than the tax liability for the year of repayment, the taxpayer is entitled to a refund for the excess tax paid. I.R.C. § 1341(b)(1). No adjustment is made to the prior year’s tax return.
Publication 915, Social Security and Equivalent Railroad Retirement Benefits. (http://www.irs.gov/pub/irs-pdf/p915.pdf)