Income from investing tax-exempt income is still taxable

Douglas and Renitta Lundy are a married couple who failed to distinguish between disability payments that are excludable from income and the income that such payments may produce when they are invested.

In 2005, the Lundys had a dispute with the IRS regarding their 2005 Form 1040 return. The IRS was treating $42,181 of retirement income, which had been reported on a Form 1099-R, as taxable income.

The Lundys were treating that amount of money as nontaxable. Their position was that the money represented disability retirement benefits, which were fully exempted from taxes.

The Lundys ended up winning the case and did not have to pay income taxes on the $42,181 received as the result of a disability.

Fast-forward a few years to the timely filing of the Lundys’ 2011 Form 1040 return. They filed a joint return as in previous years. Mr. Lundy had wages of $11,983. Mrs. Lundy had net self-employment income of $19,326. A Schedule C was attached regarding the self-employment income.

The 2011 return showed a total amount of $3,536 in income taxes due. This amount consisted of $1,093 in regular income tax, $2,374 in self-employment tax and an estimated tax penalty amount of $69.

The Lundys did not make any estimated income tax payments nor did they have any money withheld from Mr. Lundy’s wages. No payment was enclosed when the tax return was submitted, so the Lundys made no tax payments at all for tax year 2011.

For a number of months, the taxpayers and the IRS went back and forth on the issue of whether any of this income was taxable in 2011. The two parties exchanged letters and various correspondences.

Finally in April 2013, the IRS sent out a form called a “Final Notice of Intent to Levy and Notice of Your Right to a Hearing.” This is the final step the IRS takes before it levies bank accounts. The notice was sent out regarding the unpaid 2011 income taxes. The Lundys followed up on this notice with a Form 12153, “Request for a Collection Due Process or Equivalent Hearing.”

In addition, they attached a letter to the form. Their letter stated that whatever income they had derived by investing their original tax-exempt disability benefits would also be nontaxable to them. They were adamant about their opinion.

The facts in this case were not in dispute. The Lundys felt that they did not owe any income tax on the wages or the self-employment income.

Their defense was that nontaxable disability income was the seed money that started the Schedule C business and therefore any income earned from the Schedule C business should be nontaxable as well. They didn’t address why they felt that Mr. Lundy’s wages should be nontaxable.

Internal Revenue Code Section 61(a) provides that gross income means all income from whatever source derived. This includes compensation for services and income derived from business. Exclusions from income are construed narrowly, and taxpayers must bring themselves within the clear scope of the exclusion.

Because they did not have an applicable exclusion, Mr. Lundy’s wage income and Mrs. Lundy’s net business income are included in gross income (Douglas W. Lundy and Renitta H. Lundy vCommissioner, U.S. Tax Court, TC Memo, 2014-209, TCM, Oct. 8, 2014).

The Lundys’ disability income from tax year 2005 was nontaxable. Any income earned from that money, which was invested in business assets, is not. The Lundys learned this the hard way. They ended up owing the IRS the $3,536, plus additional interest and penalties.