Tax Penalty Repayment Is Taxable
Question: I hired a tax preparer for the first time last year, and I’m not sure I ever will again. He made a serious error and I ended up paying the IRS about $2,000 more than he said I owed, plus a penalty. After I threatened to sue him, he finally agreed to pay the penalty. But he insists that I have to report this amount as income on my next tax return. Can that be?--U. G.
Answer: He’s right about the penalty. Somehow the IRS reasons that you realized an economic gain from this reimbursement even though it was the preparer’s error that led to the penalty and you are no better off financially when he reimburses you. The bottom line is that you must add the amount he gave you to your gross income when you next file a tax return.
You could save yourself some money by going back to the preparer and asking him to reimburse you instead for the extra taxes you paid because of his error. Odd as that may seem, the IRS does not count this type of economic gain to the taxpayer. In a recent ruling, the agency decided that a preparer who pays the extra taxes that his mistake caused was merely returning the taxpayer to the same financial position he would have been in had the accountant not made the mistake. Hence, no economic gain and no increase in taxable gross income. The money you could save would be worth paying one more call on this preparer.
Q: My son will be going to college next September, so I am starting to think about financing his education. I’ve read a little about Clifford trusts and custodial accounts and am leaning in that direction. Is there any danger that the tax reform plan will pull the rug out from under these savings plans before I have time to set one up?--L. M.
A: There is no way to predict how the final tax reform plan that emerges from Congress can treat these popular education-savings vehicles. But if the House of Representatives version passed last year stands, the benefit of both savings plans will be sharply curtailed.
Essentially, the drafters of tax reform want to stop parents from getting tax breaks by merely transferring some of their income-earning assets to their children, whose tax brackets are much lower than their parents’. Since this income-shifting concept is at the heart of both the Clifford trust and the so-called custodial account, both could become obsolete as devices for the fast buildup of college funds.
Under a Clifford trust, a parent transfers cash or income-producing property into a trust for at least 10 years and one day. At the end of that period, the money or property is transferred back to the parent. In the meantime, the value and the growth--usually in the form of interest income--is taxed at the child’s low tax rate instead of the parents’ higher one. Thus the attraction for parents in a hurry to build their child’s educational fund. Because there is a whole host of ways to break the stringent Clifford trust rules and lose the tax break, parents who opt for this arrangement would be well advised to have it drawn up by a lawyer.
Those looking for a cheaper and less formal way to accomplish the same thing usually opt for a custodial account instead of a trust. The account must follow rules of the Uniform Gifts to Minors Act, which vary from state to state. Once it is set up and funded, the parents (or whoever is designated as custodian) can distribute income to their child or let the interest accumulate. As the fund grows, the earnings are taxed to the child.
Under the House version of the tax reform plan, parents could still transfer the property to their children, of course. But the tax advantage would be lost. The income generated from the assets would be taxed at the parents’ higher tax rate--not the child’s.
Again, there is no way to predict whether these proposals will survive in their current form or even whether the tax laws will be significantly reformed at all. But if the House-passed income-shifting proposal does remain intact, it’s already too late for you to do anything about it. Only those who acted on or before Dec. 31, 1985, will be able to take advantage of this tax benefit if the House proposal wins final approval.
Debra Whitefield cannot answer mail individually but will respond in this column to financial questions of general interest. Do not telephone. Write to Money Talk, Business section, The Times, Times Mirror Square, Los Angeles 90053.
