Common But Misunderstood Tax Issues For The Elderly, Their Families, And Other Clients

Presented to the Coconino County Bar Association
Presented by
Thomas J. Murphy
November 30, 2010



 #1. “I Don’t Need To File A Tax Return

A person must file a return if their gross (not adjusted gross) income exceeds:

  • Single, under 65                                                            $9,350
  • Single over 65                                                                $10,750
  • Married filing joint                                                      $18,700
  • Married filing joint, one spouse over 65                 $19,800
  • Married filing joint, both spouse over 65               $20,900
  • Head of household                                                      $12,000
  • Head of Household, over 65                                     $13,400
  • Widow(er) with dependent child                             $15,050
  • Widow(er) over 65 with dependent child              $16,150

Note that this does not include income that is exempt from tax, such as Social Security in most instances
Source: IRC 6012

#2. “My Social Security Is Not Taxable”

The general rule of thumb is that one-half of a person’s Social Security income will be subject to tax if, after adding that one-half amount to any other income that the person has, the combined amount is less than $32,000 for married couples or $25,000 for single persons. Note that this income amount includes tax-exempt interest from savings and municipal bonds.

If the combined amount is more than $32,000 (or $25,000 for single taxpayers), then one-half of the person’s Social Security benefit will be subject to tax. If the combined amount is more than $44,000 (or $34,000 for single taxpayers), then 85% of the Social Security benefit will be subject to tax.

The computation is a little more involved than this. The instructions to form 1040 have a worksheet for determining this or review IRS Publication 915.
Source: IRC 86

#3. Prizes and Awards Are Taxable

Prizes and awards are treated a gross income. Certain scholarships are excluded.
Source: IRC 74

#4. Gambling Winnings Are Taxable. Gambling Losses May Not Be Deductible.

Gambling and lottery winnings are taxable. A Form W-2G will be issued for all gambling winnings over $600, except for $1,200 for winnings from bingo or slot machines, $1,500 for keno games and $2,000 for poker tournaments. There is 25% withholding. Gambling losses can be used to offset gambling winnings but they are taken as an itemized deduction, so if the person does not itemize, the losses cannot be used.
Source: IRC 165

#5. Discharge of Indebtedness Is Taxable Income

The amount of a discharged debt is treated as taxable income and a form 1099C is issued. I have seen this in two instances: where a credit card, certain mortgages or other consumer debt is compromised or where an upset family member or business associate has had to write off a loan and then directs his accountant to issue a form 1099. The only exceptions are a)if the discharge was due to a bankruptcy proceeding b) if the person remains insolvent after the debt discharge or c) was from a short sale or foreclosure of the taxpayer’s personal residence .
Source: IRC 108

#6. Dependency exemption

Every taxpayer gets to claim a personal exemption of $3,650 for themselves, their spouse and their dependents. To most taxpayers, dependents mean minor children but it can also mean anyone who meets the requirements. In particular, children who are supporting their elderly parents need to take a look at this since, in many circumstances, the child may be able to claim the parent as a dependent, entitling the child to another $3,650 exemption.

There are five tests to meet, but the focus is on two of them: the amount of the parent’s income and the amount of support furnished to the parent.

As to income, the parent cannot have more than $3,650 but that amount does not include Social Security, disability or tax-free bond income.

As to support, the child must have furnished, in cash, at least one-half of the parent’s support. Support is defined quite broadly and includes all the usual items except for payment by the child of the parent’s income taxes or life insurance premiums. (Note that if no one child has paid more than half but two children combined have, then one of the children may still be able to claim the exemption. See Treas. Reg. 1-152-3.)

The other three tests are that a) the person claimed as a dependent must be a family member, in-law or step-parent, b) that the dependent has not filed a tax return and c) a United States citizen or resident of the United States, Canada or Mexico.

Note that the parent does not have to live with the child.

You must have a Social Security number to claim the exemption.

If the child qualifies to claim the parent and the parent dies during the year, the full exemption can still be taken.
Source: IRC 151 & 152


#7. Standard deduction v. itemized deduction.

The standard deduction is similar to the personal exemption in that everyone filing a return is entitled to one. The standard deduction is:

Single                                                               $5,700
Head of household                                       $8,350
Married filing joint and widow(er)           $11,400

(Note that as to the standard deduction, there is no longer a marriage penalty since the amount for married couples is now twice that of the single person’s deduction.)

If over age 65 or blind, the standard deduction is increased:

Single or married filing separately          Add $1,400
All others                                                      Add $1,100

But if the amount of your itemized deductions exceeds the standard deduction, then you itemize by filing a Schedule A with your 1040. For most people, this means deducting their mortgage interest, property taxes (which in Arizona includes your car registration), state income taxes and charitable contributions.
IRC 63

#8. Itemized Deductions – Medical Expenses

Most people know that, on your federal income tax return, your medical expenses must exceed 7.5% of your adjusted gross income (ie, the amount at the bottom of the front page of the 1040).

But there are two issues that many taxpayers do not know about. One is that, in Arizona, all medical expenses are deductible. There is no 7.5% hurdle.

The other issue is that the term “medical expenses” is a surprisingly broad term that includes many expenses that might not otherwise be considered medical. The Code defines this as “amounts paid for the diagnosis, cure, mitigation, treatment or prevention of disease, or the purpose of affecting any structure or function of the body, or for transportation primarily for and essential to medical care”. IRC 213(e). A huge amount has been written or issued as to what exactly this terms means and what is covered. You can get pretty creative here.

Note that there is no mention of “as prescribed by a doctor”. There are a few instances where a doctor’s prescription is necessary, most notably with medications. Otherwise, it simply must relate to a treatable condition. Expenses that are beneficial to your general health do not qualify.

Some examples of expenses that the IRS has agreed will qualify are: acupuncture, alcohol or substance abuse counseling, bandages, guide dogs, health insurance premiums (to include Medicare B), legal fees necessary to authorize medical treatment, psychiatric care, stop-smoking programs, special foods and dietary supplements if prescribed, specially equipped telephones or televisions for the hearing-impaired, vision correction, wigs and weight-loss programs if prescribed.

The entire costs of a nursing home are deductible if the “availability of medical care” is the “principle reason for his presence there”. If the person is there for “personal or family reasons”, then only the portion of expenses attributable to medical care is deductible (eg, no deduction for room and board). Treas. Reg 1.213-1(e)(1)(v)(a)&(b).

Improvements or modifications made to the home are deductible. Generally, these expenses are only deductible to the extent they do not increase the value of the home. However, the following expenses are deductible regardless of any increase in the home’s value: entrance and exit ramps, widening doorways, installing handrails and grab bars, modifying the kitchen, lifts other than elevators and ground grading.

Travel to and from the hospital or care provider is deductible. You can use a standard rate of 24 cents per mile or actual, out-of-pocket expenses. In addition, under either method, parking fees and tolls are deductible. Lodging that is “primarily for and essential to” medical care while visiting hospitals or similar facilities is deductible up to $50.00 per person, per night.

Also be aware that you may be able to deduct medical expenses for someone who did not qualify as a dependent for exemption purposes. The test is similar to that previously explained except that a) there is no $3,400 income limit and b) the dependent must live with you.
Source: IRC 213 and IRS Publication 502

#9. Itemized Deductions – Legal Fees

Many legal fees are not deductible. However, any fees incurred “in connection with the determination, collection or refund of any tax” is deductible as a miscellaneous itemized deduction (ie, only to the extent it exceeds 2% of adjusted gross income).

Fees for a guardianship or conservatorship are also deductible, subject to the 2% hurdle.
Source: IRC 212, Treas. Reg. 1.212-1(j)

#10. Itemized Deductions – Charitable Contributions.

There is an ever-growing cottage industry regarding the gifting of non-cash, highly appreciated property to charities. The general rule is that gifts are deductible at their fair market value as of the date of the contribution. But watch out for closely-held businesses that have distributed dividends over the years, for inventory or stock-in-trade or for artwork and manuscripts that the donor would sell for a living.

The income tax deduction is generally limited to 50 percent of adjusted gross income but the excess amount can be carried forward for five years.

The value of services rendered is not deductible but unreimbursed expenses are deductible. Travel expenses, to include meals and lodging, are deductible as long as they were incurred primarily for the charity.
Source: IRC 170 & 306

#11. Tax break For Widows and Widowers

A surviving spouse can file as married filing joint in the year of death. If there are dependent children, then the surviving spouse may continue to use the tax rates as married filing joint for the next two years following the date of death. But the surviving spouse cannot remarry during this time. For the year of death, the surviving spouse files a joint return. If no personal representative has been appointed for the deceased spouse, only the surviving spouse signs, indicating the death of the spouse. If a PR has been appointed, the PR must sign the return as well as the surviving spouse. PR also has the right to disavow a joint return and file a separate return.
Source: IRC 2(a), 6013

#12. The ever-moving tax brackets

These have been changed a number of times during the past ten years or so. The tax brackets in effect since 2003 are: 10%, 15%, 25% (was 28%), 28% (was 31%), 33% (was 36%) and 35% (was 39.6%). But, unless Congress acts by year-end, the pre-2003 brackets will snap back and be re-instituted.

Most people are in the 15% and 25% brackets. A single taxpayer will be in the 15% bracket with taxable (ie, AGI less exemptions and deductions) of up to $33,950 and in the 25% bracket for and AGI between $33,950 and $82,250. For married filing joint taxpayers, the 15% bracket goes up to $67,900 and the 25% bracket tops out at $137,050.
Source: IRC 1

#13 “How Long Should I Hold Onto My Records?”

This is simply another way of asking how long is the statute of limitations (“SL”)? The quick answer is: hold onto as many of your records for as long as you can.

The law in this area is fairly straightforward. First, if you never file, the SL never starts to run. It also never begins to run if a return is filed that is fraudulent or constitutes willful tax evasion (usually, unreported cash). IRC 6501. Note that an assessment by the IRS (ie, where the IRS prepared a return for you) will not start a running of the SL. Treas. Reg. 301.6501(b)-1(c).

If you file a return, the IRS has three years to challenge the return. IRC 6501. The Arizona Dept of Revenue (“ADOR”) has four years. If the IRS audits a taxpayer and a deficiency results, the ADOR has four years from the conclusion of the audit to challenge the return.

If a return has omitted 25% of gross income, the SL is 6 yrs. IRC 6501(e)

Once a deficiency has been assessed, the tax can be collected by lien or levy. The IRS has 10 years to initiate and complete collection activity. IRC 6601.

As a result of all of this, an enforceable deficiency due the IRS can linger for 15 years or longer. You need to keep records for at least that long.

#14. “What Happens If I Don’t File?”

People usually don’t file because they don’t have the money. This is often a mistake. If you file a return but don’t pay the amount owed, the failure to pay penalty is only one-half of one percent per month – roughly 6% per year. But the penalty for failure to file a return is an automatic 100% penalty of the amount later determined to be owed plus 5% per month up to a maximum of 25%.

If the person is self-employed, there will usually be an underpayment of estimated taxes. The penalty is the interest that would have accrued on the amount that should have been paid.

If the return was filed in a sloppy or dishonest manner, there is an accuracy-related penalty of 20%. This penalty will be triggered for a) negligence or disregard of the rules or regulations, b) substantial (ie, in excess of 10% or $5,000) understatement of income tax or 3) substantial (ie, 50%) valuation misstatements.

On top of all this, there is an interest charge imposed at the federal short-term rate plus 3% that is adjusted quarterly.

Finding this income if not reported is easy for the IRS since a 1099 or similar document will be issued and there will not be a corresponding tax return that is reporting the 1099 income. It is a simple matter of cross-referencing data that the IRS has become quite good at.
Source: IRC 6621, 6651, 6654 & 6662

#15. “Will They Come After Me?”

The IRS has two main collection weapons: the lien and the levy. The tax lien is a favorite of the IRS because it is so simple. They record it and then they let it sit like a ticking time-bomb. Theoretically, the lien attaches to every piece of property you own. In reality, it only applies to real estate. It will usually explode when your client attempts to buy or sell a home, to refinance a home or to otherwise obtain finance. Everything comes to a grinding halt until a release is obtained, which normally means payment in full.

It is a ticking time bomb because many times your client does not know it exists. Usually, the client has moved and the lien got sent to an old address or the notice of lien was sent to a former (ie, unpaid) advisor who did not forward to the client.

A tax lien is valid for ten years.

The other collection weapon is the levy. This is the more aggressive tactic where the IRS is grabbing a paycheck or bank account. This is seldom a surprise since the client is usually well aware that the IRS is after them.

Two things to remember about a levy. One is that, once the bank or employer has received the levy notice, you have twenty days to work something out. The account is frozen but the funds are not transferred or the paycheck is not zapped during the 20 day period. However, banks tend to be slow in notifying the client, who may not learn of this until day #17 or #18.

The other point is that a levy on a bank account only applies to the funds in the account on the date of receipt. Any funds deposited after the date of levy are not frozen, so a quick post-levy deposit may prevent checks from bouncing.

#16. “How Will They Find Out?”

There are two types of people that the IRS loves to hear from. One type is disgruntled employees or ex-employees. The other type is ex- or soon-to-be-ex spouses or jilted lovers. From there, the list grows depending on one’s situation – angry children, competitors, friends, acquaintances or business associates under indictment, etc. As one colleague of mine has stated: “There is always someone else who knows.”

#17. Annuities – Our Favorite Whipping Boy

Nearly all estate planning and elder law attorneys hate annuities for the lack of flexibility afforded the annuity owner. Low interest rates and poor investment performance haven’t helped either. But what many people and their advisors (to include attorneys) do not understand are the awful tax consequences of annuities.

First, consider that the capital gains rate is now only 15% on long-term (ie, one-year) capital gains. For all the tax-deferral hype spouted out by annuity salesman, one has to wonder how much is really being saved when we are only facing a 15% tax rate. In other words, all appreciation in an annuity is taxed at ordinary income tax rates rather than the lower capital gains rates. And, when computing any possible capital gain, remember that there is no step-up in basis at the owner’s death.

When a client is being presented with performance numbers that are compared with a mutual fund or other non-annuity product, always make sure that the client is aware that the buildup in the annuity is pre-tax dollars while much of any gain in the mutual fund has already been taxed. Apples are being compared to oranges when analyzing investments using pre- and post-tax dollars.

Annuities also create many other post-mortem problems that few in the annuity industry are aware of. For instance, determining which spouse owns the contract and who is the annuitant can make a huge difference. What happens when the wife dies and the annuity is owned by the husband but is based on the wife’s life (ie, the wife is the annuitant – the measuring life)? This is not an uncommon scenario but few realize that the annuity contract terminates and all funds must be pulled out of the contract.

Or, suppose the annuity is jointly owned by husband and wife with wife as annuitant but the son is the beneficiary. Husband dies. Who pays the tax on the payout? This one is really lovely – the son as beneficiary gets the proceeds but the wife, as half-owner, may have to pay half of the taxes due on the distribution.

Or, suppose a revocable trust owns the contract and is the beneficiary with the husband as the annuitant. What happens when the wife dies? The annuity will pay out. However, if the trust was an irrevocable, non-grantor trust, then nothing would change by virtue of the wife’s death.

This is a very technical area involving scenarios that none of the parties contemplated.
Source: IRC 72

#18. Allocation of income and income taxes

Each May, the IRS releases its annual Statistics of Income Bulletin, available at,,id=183196,00.html. For 2008 (the most recent year available), those with an AGI of over $500,000 constituted slightly less than 1% of all taxpayers, generating 17.8% of gross income and paying 33.3% of all income taxes. Those with an AGI of $100,000 or more constituted 12.7% of all taxpayers. The largest block of taxpayers (13.5%) were in the $50,000 to $75,000 range.

For 1996, those earning $500,000 or more constituted 0.3% of all taxpayers, generating 9.5% of gross income and paying 21.3% of income taxes.


#19. Estate tax – Going….. going….. gone?

One of the more noteworthy but overlooked tax trends is that the number of estates subject to the federal estate tax has plummeted. According to the Statistics of Income Division of the IRS, the figures are as follows:

Year                 # of FET returns         # of FET returns from AZ

2009                        33,515                        607

2008                        38,373                        581

2007                        38,031                        579

2006                      49,050                         713

2005                      45,070                         615

2004                     65,039                         1,262

2003                     73,128                         1,014

2002                     99,603                         1,417

2001                     108,071                       1,706

2000                    108,322                       1,660

1999                     103,979                       1,965

1998                     97,856                         1,628

1997                     90,006                         1,309

1996                     79,321                         1,252

1995                     69,755                         1,180

Only approximately 45% of all federal estate tax returns owe estate taxes. Most often, there will be a surviving spouse that qualifies for the marital deduction that eliminates or lessens the estate tax on the estate of the first spouse to die. So for the year 2009, only 14,713 estate tax returns actually owed estate taxes. Or, for the year 2000 which was the high water mark for estate tax returns, exactly 50,000 estate tax returns owed a tax.

The decrease in the number of Arizona residents owing estate tax occurred despite the second largest percentage of population increase in the country, from 5.1M residents in 2000 to 6.5M residents in 2009.

#20. Gift Tax Is Still Here

For 2010, the gift tax never disappeared, remaining at $1 million.
Source: IRC 2210

#21. Section 2036 – Your Friend, Your Enemy

One of the hottest areas in estate tax concerns the applicability of IRC section 2036. That section essentially says that, if you continue to enjoy the use or control of an asset that you have transferred to another, then that asset will treated as your asset for estate tax purposes. In tax parlance, it is included in your estate.

This can be good or bad, depending on the circumstance. If it is a taxable estate, this will usually be bad. This has become a huge issue with family limited partnerships where the IRS has been trying – somewhat successfully – to invalidate the transfers of FLP units to children or other family members by including the gifted shares in the estate of the donor.

If it is a non-taxable estate, this can be very good since inclusion in the estate means a step-up in basis. This can work really well – you can avoid probate since title is in the child’s name but the child gets the stepped-up basis. So, for instance, the remaindermen of a life estate get this favorable treatment.

#22. Jointly Titled Property Purchased Before 1977

An important case, Gallenstein v. United States, 975 F2d 286 (6th Cir, 1992) has held that property held jointly by a married couple gets a full (rather than one-half) step-up on the death of the first spouse if the property was purchased prior to 1977.

#23. IRD – An Inheritance That Is Taxable

Always explain to a client the effect of “income with respect to a decedent” or “IRD”. A $1M 401(k) is not the same as a $1M life insurance policy since the beneficiary of the 401(k) will pay income taxes on the money received.

IRD is simply money that has not yet been taxed. Typical examples of IRD are retirement plans, deferred compensation plans, accrued interest on savings bonds and CDs, declared dividends, lottery winnings and unpaid salary and commissions.
Source : IRC 691

# 24. Estate Tax Decoupling and Establishing A Domicile.

The 2001 tax bill gradually eliminated the state death tax credit. The federal estate tax had been offset by any state death taxes using a graduated rate table that ranged from 6% to 16% depending on the size of the taxable estate.   However, this credit was phased out in 2004.

Arizona, like many states, simply had a state death tax that was equal to the amount of the credit. But with the phase-out of this credit, twenty-two states currently have an estate tax at the state level. In tax parlance, this is called decoupling.

Surprisingly, Arizona has not yet done anything to change this. There is still no decoupling from the federal estate tax for Arizona. This means that there is no Arizona estate tax. Some form of decoupling has occurred in Connecticut, District of Columbia, Hawaii, Illinois, Indiana, Iowa, Kansas, Kentucky, Maine, Maryland, Massachusetts, Minnesota, New Jersey, New York, North Carolina, Ohio, Oregon, Pennsylvania, Rhode Island, Tennessee, Vermont and Washington.   The amount of the exemption varies greatly. Most states with an estate tax have a $1 million exemption. But Ohio’s estate tax hits at $338,000 and in New Jersey it is $675,000. North Carolina, Oklahoma, Vermont and Washington have a $2 million exemption. See the chart continually updated at

As a result, determining domicile can have wide-ranging impact since the law in the state of domicile will govern, ARS 14-1301. This will affect rules of construction and administration (not the least of them concerning elective shares) as well as determining which state can impose taxes, such as inheritance, income or intangible personal property taxes.   To establish an Arizona domicile as firmly as possible, the client should:

  • register to vote in Arizona,
  • file income tax returns with an Arizona address,
  • register the car in Arizona,
  • have bank and brokerage account statements (and corresponding form 1099’s) sent to an Arizona address
  • join local community and religious organizations and obtain documentation reflecting this.
    Source: IRC 2011

#25 Gifting — Highly appreciated property

The most common mistake, particularly among persons not represented by counsel, is to transfer highly appreciated property rather than having the property past via inheritance or other death-related transfer. If this is done, the donee will have a carry-over basis rather than a stepped-up basis. IRC 1014 & 1015. For many, and probably most, of our clients, the step-up in basis is the single biggest tax break available to them, so be careful not to inadvertently lose it. Yet many clients, including those previously represented by competent counsel, are not aware of this distinction. When discussing annual exclusion gifting or other gifting, warn clients to consult with you if they are planning on some form of gifting other than cash.

#26. Gifting — Transfers within three years of death

This is seldom an issue with most gifting but it can crop up in three settings. First, any transfer of life insurance policies are subject to the three year rule. If made within the three-year period, the face value of the policy will be included in the insured’s gross estate. IRC 2035(a) & 2042. Second, any payment of gift taxes made within three years of death is brought back into decedent’s estate, so avoiding the “tax upon the tax” with estate taxes will not happen. IRC 2035(b). Third, the amount of tax deferral for certain businesses available under IRC 6166 will not apply to any property transferred within the three year period. IRC 6166(k)(5) & 2035(c)(2).

#27. Gifting — Property with encumbrance in excess of basis

A taxpayer will recognize gain to the extent that property is transferred where the encumbrance exceeds the basis. Johnson v. Comm., 495 F2d 1079(6th Cir, 1974); Estate of Levine, 634 F2d 12 (2nd Cir, 1980). The facts of the Johnson case are typical – taxpayer had a basis of $11,000 in stock. At the time of the gift, the stock had an FMV of $500,000 but there was a loan against the stock in the amount of $200,000. Taxpayer was deemed to have a gain of $189,000 by reason of the transfer.

#28 Gifting — Property where basis exceeds FMV

Basis cannot exceed the FMV of the property on the date of the gift. The donee is limited to using the FMV as the basis. IRC 1015(d). Instead, sell the asset for a capital loss, gift the proceeds and use the capital loss to offset capital gains or up to $3,000 of ordinary income. IRC 1211(b)

#29. Gifting — Property that generates tax-exempt income or a large deduction

For a high-income taxpayer, be wary of gifting assets that are generating tax-exempt income, such as municipal bonds, or that generate a large deduction, such as depreciation.

#30. Gifting — Property where AHCCCS/ALTCS could be an issue

The 2006 passage of the Deficit Reduction Act (“DRA”) has increased the lookback period from three years to five years. Currently, any gift made within five years of the application date will come within the lookback period and will be subject to a period of ineligibility. Also note that the DRA also requires that the ineligibility period will not commence until an application is submitted in which the applicant would be otherwise eligible but for the transfer. Under prior law, the period began to run when the gift was made. This change has the effect of greatly lengthening the period of ineligibility.

#31. Charitable gifting.

There is an unlimited estate and gift tax charitable deduction. This will not only get the asset and any subsequent appreciation out of client’s taxable estate but, if done before death, will also allow for an income tax deduction that the estate is not entitled to. If the gift is testamentary, make sure the correct name of the charity is used. This can most easily be done by getting a copy of the IRC 501(c)(3) letter or from IRS Publication 78.
Source: IRC 170(a), 2055 & 2522

#32. Payment of Estate Tax in 15 Year Installments.

A big tax breaks for family businesses and farms. If the value of the business or farm constitutes at least 35% of the gross estate, then the estate can elect to pay the estate and/or generation-skipping tax in ten annual installments beginning five years after the estate tax return is filed and with a low 2% interest rate.
Source: IRC 6166

#33. Generation-Skipping Tax

One of the most complicated areas of tax law. Two basic items to keep in mind. One is that the tax only applies when a generation is skipped, such as when a grandparent makes a transfer to a grandchild. The grandchild’s parent has been skipped so a generation has been skipped. However, the parent must be alive when the transfer takes place. If the parent is deceased, then there is no skip.

The second item is that if you have a GST problem, it is a big problem. For 2008, there a 45% tax on all skips that, in total, exceed $2.0M. This tax is the responsibility of the transferee (ie, the grandchild) so it is in addition to any estate tax that is owed.
Source: IRC 2601 et seq.