In IRS Information Letter 2015-0026 a taxpayer discovered that sometimes when the IRS changes its mind in what appears to be a taxpayer favorable fashion, taking advantage of that relief may introduce its own complications, in this case triggering the excess contributions tax of IRC §4973.
In this case the taxpayer had received Medicare waiver payments as a caregiver. In Notice 2014-7 the IRS had determined that such payments were excludable from income and allowed taxpayers to amend their returns to take advantage of this change in position.
In this case the taxpayer filed an amended 2011 income tax return to take advantage of this ruling. When she removed that income from her return her adjusted gross income became negative. Although she had filed an amended return, she contacted her Congressman’s office to ask about how that impacted her taxes. Presumably she wondered if she could do something with that negative income.
Well, for better or worse, she forwarded the amended return to the Congressman’s office who forwarded that to the IRS. And the IRS discovered why her adjusted gross income had gone negative. The letter notes:
We note that her original and amended returns show an IRA deduction of the maximum amount for the year that reduces her adjusted gross income.
A taxpayer's IRA deduction from gross income may be limited by the amount of the taxpayer's taxable compensation. Thus, it appears that because * * * reduced her taxable compensation by payments described in the notice, she should also have reduced her IRA deduction from gross income. If she had reduced her IRA deduction, her amended return would have shown a positive amount for adjusted gross income.
That by itself wouldn’t be a bad thing. But it turns out that there’s the little problem of whether she still had any earned income to fund the IRA. And, it turns out, those Medicaid payments represented her only earned income for the year, creating a problem. As the letter noted:
Further, it appears that she has made excess contributions to her IRA for 2011, for which she may have an ongoing excise tax liability. See Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs), formerly part of Publication 590, Individual Retirement Arrangements (IRAs).
Because of issues like this, the IRS had offered taxpayers an option in Notice 2014-7 as the IRS explains:
Notice 2014-7 allows a taxpayer to amend a return for a tax year before 2014 to exclude payments described in the notice, but a taxpayer may choose not to amend an earlier tax year's return to exclude those payments. If a taxpayer chooses to amend an earlier tax year's return to claim a refund, the amended return must be filed within certain time limits (generally, 3 years from the time the original return was filed or 2 years from the date the tax was paid, whichever period ends later).
So the IRS outlined her choices:
In deciding whether to amend her 2012 and 2013 federal income tax returns to exclude from income payments described in the notice, * * * should consider whether she must reduce an IRA deduction from gross income and whether excluding those payments from taxable compensation would result in excess contributions to her IRA for the year. Thus, for example, she may choose not to amend her 2012 and 2013 tax returns to exclude payments described in the notice from income, because of the effect the exclusion would have on her allowable IRA contributions and her IRA deduction, as well as her tax liability.