Will the IRS Allow Cash-Basis Taxpayers to Deduct Unpaid Severance?

With this column, Julian Block kicks off a three-part series answering questions about COVID-19 and its impact on income taxes.

May 7th 2020
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I frequently use my columns to reply to queries. Unsurprisingly, these past several months, there’s been a surge in the number of queries, just as there’s been a surge in coronavirus infections in most of the fifty states.

Something else that’s unsurprising: Many pandemic-related queries come from individuals who are experiencing economic difficulties, such as not being able to provide necessities like housing, food or transportation. Some emails are especially troubling. What follows is my response to a representative one that I’ve lightly edited and condensed for clarity.

Question: Hi, Julian, I’m Patrick in Portland, Oregon’s Sellwood-Moreland neighborhood. I’m contacting you on behalf of nearly one hundred individuals. We’re all long-time employees of a closely owned publishing outfit that was just compelled to close after fifty years, done in by the abrupt collapse in advertising and revenue as the pandemic inexorably moved across the United States.

Here’s some background on the company: All of its shares are held by three brothers, third-generation owners. They ensconced themselves on the payroll as top-tier executives. Besides their middle-six-figure salaries, they receive generous fringe benefits.

The shareholder-execs want to ensure that they don’t have to answer bothersome questions from the company’s board of directors. Who do they pick, besides themselves, to fill all seats on the board? Their present wives and some of their numerous former mates, most of them recipients of substantial alimony payments.

Predictably, the directors are subsequently struck dumb when they seek to find the words to express their pleasure with how adroitly the three execs select and implement strategies that cause profits to soar. To show their gratitude, the directors unanimously cast annual votes to augment execs’ salaries with sizable annual increases.

Compared with how generously the shareholder-exec-directors reward themselves, how robustly do they compensate me and my co-workers? While they indulge themselves luxuriously in exclusive enclaves, we mostly live in nondescript neighborhoods.  

Let’s move on to what happens when the company receives final rites and the directors record a final vote that bestows substantial severance payments on the trio of about-to-become former execs.

As they scramble to find their way out, the shareholder-exec-directors pause long enough to tell their compliant CFO to say adios to her severance (another middle-six-figure amount), should she dare to authorize any severance payments for rank-and-filers.

Severance for me, someone who punched in for 20 years? It was supposed to be a five-figure $98,000.

The brothers explain their unwillingness to do the right thing in their most recent emails. As is their wont, they offer irrelevant, far-fetched excuses and drone on interminably.

Julian, I’m condensing their version of what purportedly happened. It goes something like this: Their advisers told them that there was only one way for them to spare their spouses and children from having to shell out for fines and to endure extended stays at Club Fed. They must provide substantial assistance to the IRS and the FBI, as well as god knows how many other federal agencies, in their efforts to uncover evasion of corporate and individual income taxes and other criminal acts by executives at other publishers.

In return for their help, all three will receive ratting rewards. The feds will place them in witness protection programs.

Another reward: While hidden away in the programs, they’ll be securely beyond the reach of my co-workers and me, and we’re never going to receive our promised payments.

Some co-workers say they heard that a kinder and gentler IRS will permit us to take deductions for unpaid severance on 2020’s1040s that we’re going to submit in 2021. If true, where on our 1040s should we enter the deductions?

Answer: Patrick, like William Jefferson Clinton, I feel your pain. But there’s no way that you can deduct your $98,000. Nor can the others deduct their unpaid amounts.

The snag: All of you are what’s known as “cash-basis taxpayers.” That’s how the IRS designates individuals (a category that includes almost all filers) who generally don’t have to report payments for severance, wages, bonuses, and other income items until the year that they actually receive them and don’t get to deduct their expenses until the year that they pay them.

The general rule for when to report income is subject to an exception for “constructively received income.” More on that after just two more sentences.

Just as the tax code doesn’t require you to count the $98,000 as reportable income, it doesn’t allow you to deduct an equivalent amount. Only if you were an “accrual basis taxpayer” (few individuals are) and had previously counted the $98,000 as reportable income at the time it became due to you, could you deduct it now, as it hasn’t actually arrived and is a lost cause.

Constructively received income rules. These rules require cash-basis taxpayers to declare as income amounts that, though not actually received, have been credited to their account (interest on savings, to cite a common example) or made subject to their control or set aside for them.

As one would expect, an agency whose mission is to collect taxes opted for an expansive definition of “constructive receipt.” Among other things, it can occur when money is paid to someone else for you.

An example: Your employer has to withhold part of your pay from you and turn it over instead to a creditor who has attached your salary. Although you never see the money, you “constructively” receive it and are taxed on it.

In future columns, I’ll answer more corona questions about income taxes.

Additional articles. A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 350 and counting). 

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