Recent Developments in Individual Taxation

By David R. Baldwin, CPA; Lawrence H. Carlton, CPA; Valrie Chambers, Ph.D., CPA; Donna Haim, CPA; Jonathan Horn, CPA; Susanne M. Morrow, CPA; Kenneth L. Rubin, CPA; Kaye F. Sheridan, DBA, CPA; David E. Taylor, CPA; and Donald J. Zidik Jr., CPA

EXECUTIVE
SUMMARY

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  • A taxpayer whose claim for a first-time homebuyer credit was disallowed by the IRS prevailed when the court found that a recreational vehicle she had previously lived in was not a personal residence for purposes of the credit because it was personal property under state law.
  • Circuit courts came to conflicting conclusions about whether the Sec. 36B premium tax credit is available for insurance purchased through exchanges run by the federal government. The Supreme Court agreed to hear one of the cases to decide the issue.
  • In cases decided this year, taxpayers were largely unsuccessful in escaping the additional 10% tax on their early withdrawals from retirement plans.
  • In two cases, taxpayers succeeded in convincing a court that their business activities were entered into with a profit motive, and, therefore, the losses from these activities were fully deductible.

This article covers recent developments affecting ­taxation of individuals, including regulations, cases, and IRS guidance. The items are arranged in Code section order.

Sec. 1: Tax Imposed

No major changes have been made to the tax brackets per se. Tax brackets are indexed for inflation, but self-employment tax, alternative minimum tax (Sec. 55), and net investment income tax (Sec. 1411) are not inflation-adjusted. The inflation-adjustment changes are coded into commercial software packages.

Those whose marital status has changed as a result of the Supreme Court's decision 1 striking down one section of the Defense of Marriage Act 2 may be subject to a different tax table (i.e., married filing jointly or separately), but that was true last year as well. Many same-sex couples who were already married when the Supreme Court issued its decision may still need to file amended tax returns or protective claims for amended tax returns before the statute of limitation expires. All of these amended returns could greatly increase the workload this tax season.

Sec. 31: Taxes Withheld on Wages

Taxes withheld on wages are treated as having been evenly withheld throughout the year, as opposed to withheld in the quarter in which they were actually deducted from a taxpayer's paycheck. Therefore, an underwithheld taxpayer can lessen or eliminate the penalty for underpayment/underestimation by withholding substantially more at the end of the year.

For households with self-employed taxpayers who make quarterly tax payments, underpayments of estimated quarterly taxes may be offset with overpayments of withholding, regardless of whether most of the withholding occurred at the end of the year. As an added tip, while some taxpayers are required to make quarterly estimated payments, many of those taxpayers may find it easier to break up those payments into smaller monthly estimated tax payments rather than have to come up with large amounts of cash every quarter. 3

Sec. 32: Earned Income

In a Tax Court case, a noncustodial father was not entitled to claim a minor child for purposes of the earned income tax credit (EITC), even though a pre-July 2, 2008, final divorce judgment awarded him the dependency exemption. 4 The EITC is awarded to the parent the child has spent more than one-half of the tax year with, if that abode is located in the United States. Thus, noncustodial parents generally have difficulty claiming their dependent as a qualifying child for EITC purposes. 5

Sec. 36: First-Time Homebuyer Credit

In Oxford, 6 the taxpayer sold her residence in October 2004 when she lost her job and moved in with her daughter in Kansas. After finding employment in California, in 2007, she bought a recreational vehicle (RV) that she lived in when she was not traveling. The RV was not stationary and was parked in an RV village that required owners to move their vehicles every six months. In March 2009, she had a house built, which she moved into in November 2009. She claimed a first-time homebuyer credit on her 2009 tax return, which the IRS disallowed, claiming that the RV was a home and therefore she had owned a principal residence during the three-year period required to qualify for the credit.

The Tax Court noted that the term "principal residence" has the same meaning for the first-time homebuyer credit as it does for Sec. 121. Regs. Sec. 1.121-1(b)(2) provides that the taxpayer's principal residence is the property the taxpayer uses during most of the year. However, a principal residence does not include personal property that is not a fixture under local law. Applying California law, the Tax Court determined that the taxpayer's RV was personal property, not a principal residence. Therefore, the taxpayer qualified for the credit.

Sec. 36B: Refundable Credit for Coverage Under a Qualified Health Plan

In Oklahoma v. Burwell, 7 a federal district court judge agreed that tax credits for coverage under a qualified health plan are available only in states where the states have established insurance exchanges. Under the Patient Protection and Affordable Care Act (PPACA), 8 Sec. 36B provides a premium tax credit to low- and moderate-income individuals and families who obtain health coverage required under PPACA through insurance exchanges. The question in this case was whether the provision authorizing the Sec. 36B tax credit applies to individuals who are covered through an exchange the federal government established.

The district court considered two recent appeals court cases, Halbig v. Burwel l 9 (D.C. Cir.) and King v. Burwel l 10 (4th Cir.), that reached different conclusions on this issue. In Halbig, the court concluded that the premium tax credit is available only to taxpayers who buy insurance on state-established exchanges. In King, the court concluded that the premium tax credit is available to taxpayers who buy insurance on either state-established or federally facilitated exchanges. The district court in Oklahoma sided with Halbig and agreed tax credits apply for taxpayers only in states where states have established exchanges. 11 Also, on Nov. 7, 2014, the Supreme Court agreed to hear King. 12

Sec. 61: Gross Income Defined

The Tax Court found that salary a Junior Reserve Officer Training Corps instructor received was not excludable from gross income as a nontaxable military allowance since the taxpayer was not on active duty at the time he received the compensation and it was paid to him by a school district. 13 Therefore, the compensation was not considered a nontaxable military allowance for subsistence and housing because, to be a nontaxable military allowance, the taxpayer must be on active duty, or if not on active duty, be participating in full-time training, training duty with pay, or other full-time duty, and the payments must be paid to the taxpayer by the federal government.

The Tax Court concluded that a stipend a taxpayer received under a fellowship grant was taxable because he did not prove that he used the funds to pay his education expenses. 14 The Tax Court further found that other funds the taxpayer received for performing research were subject to self-employment tax because he received them for performing research and he was engaged in the trade or business of medical research.

Sec. 71: Alimony and Separate Maintenance Payments

The Tax Court disallowed an alimony deduction for spousal maintenance payments that were scheduled to end when the youngest child graduated from high school. 15 The court found that the payments were child support payments since they were linked to a "child-related contingency." The parties' intent that these payments were deductible alimony, written in their separation agreement, could not overrule Sec. 71(c)(2), which treats payments that are reduced upon a child-related contingency, including leaving school, as child support payments.

In another case, the Tax Court found that a lump-sum payment a divorced taxpayer made to his ex-wife constituted a nondeductible property settlement, not deductible alimony. 16 The taxpayer's argument that the payment was part of a spousal support obligation was contradicted by the separation agreement's requiring the taxpayer to make a lump-sum payment as a property settlement.

Sec. 72: Annuities; Certain Proceeds of Endowment and Life Insurance Contracts

In Robertson, 17 the Tax Court upheld the imposition of the Sec. 72(t) 10% additional tax on an early distribution from a retirement plan. Although the taxpayer claimed that he filed a tax return for the year and had paid the other tax due on his wage income at that time, he was unable to prove he filed the return and was unable to show that he did not receive the distribution or that he was exempt from the penalty.

In Matthews, 18 the taxpayer, who had lost his job, requested a distribution from his 401(k) plan. At the time, he had an outstanding loan from the plan. The distribution he requested was reduced to repay the outstanding loan, and the balance was transferred to the taxpayer. The Tax Court concluded that the loan offset and the plan distribution were both subject to the additional 10% tax on early distributions and that, unfortunately, there was no exception for hardship.

In another case, the taxpayer withdrew money from his IRA to purchase real property, arguing that the purchase was made on the IRA's behalf. 19 The Tax Court upheld the IRS's determination that this was a taxable distribution that was also subject to the 10% additional tax on early withdrawal. The Tax Court reasoned that the financial institution maintaining the IRA did not permit investments in real property and thus the taxpayer did not act as the IRA's agent and the IRA did not purchase the property.

In Letter Ruling 201424014, the IRS found periodic payments received under a new annuity option are amounts received as annuities under Sec. 72(b)(1) only to the extent they don't exceed an amount computed by dividing the investment in the contract, as adjusted for any refund feature, by the number of payments anticipated during the time they are to be made.

In Letter Ruling 201434030, the IRS found that a division of an IRA account in a divorce was not a taxable transfer. In addition, since the transfer was not a distribution and the interest transferred was treated as the former spouse's account, it did not modify the substantially equal periodic payments or trigger tax under Sec. 72(t)(4).

The IRS has issued final regulations clarifying the tax treatment of qualified retirement plans' payments for accident or health insurance. 20 Amounts held in a qualified plan that are used to pay accident or health insurance premiums are considered taxable distributions unless they fall within certain statutory exceptions. The final regulations add an exception for arrangements under which amounts are used to pay premiums for disability insurance that replace retirement plan contributions should a participant become disabled.

Sec. 83: Property Transferred in Connection With Performance of Services

In Letter Ruling 201438006, the Service upheld a Sec. 83(b) election a taxpayer made by mailing a copy of the election to the IRS, though he failed to submit a copy with his tax return.

Sec. 104: Compensation for Injuries or Sickness

A district court found that it was improper for an employer to withhold taxes from damages awarded to a former employee for personal injuries and lost pay. 21 Although the awarded damages might partially be considered compensation under the Railroad Retirement Tax Act, all of it qualified for exclusion from income under Sec. 104(a)(2), which excludes damages received for physical injuries from income even if the award includes compensation for back pay.

Sec. 108: Income From Discharge of Indebtedness

In Koriakos, 22 the taxpayers bought a residence in Florida using a line of credit secured by their Arizona home. After acquiring the Florida home, the taxpayers abandoned the Arizona home, which was sold at auction following a foreclosure. The taxpayers received two Forms 1099-A, Acquisition or Abandonment of Secured Property, one reporting the forgiven principal balance on the first mortgage and one reporting the balance on the line of credit used to purchase the Florida home. They reported the income from the two forms on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, claiming they were excluded from gross income because they were attributable to the discharge of qualified real property indebtedness.

The Tax Court concluded that because the taxpayers used the line of credit that was secured by the Arizona home to acquire the Florida home, the line of credit did not constitute qualified principal residence indebtedness, and they could not exclude the discharge from their income. Alternatively, the taxpayers argued that they should be able to exclude the discharged indebtedness income under Sec. 121 because it was gain from the sale or exchange of a principal residence. But Sec. 121 did not apply since the amount realized on a sale of property that secures a recourse liability does not include amounts that are income from the discharge of indebtedness.

Sec. 121: Exclusion of Gain From Sale of Principal Residence

In Debough, 23 the taxpayer excluded gain on the installment sale of his personal residence under Sec. 121. The property was later reacquired after the buyers defaulted. The Tax Court determined that, under Sec. 1038 (Certain Reacquisitions of Real Property), the taxpayer must recognize long-term capital gain on the reacquisition equal to the amount of installment payments received less the amount of gain previously recognized to "[ensure] that tax treatment of the transactions matches the underlying economic reality." None of the gain that was excluded under Sec. 121 could be excluded under this calculation. The Tax Court pointed out that Sec. 1038 provided a limited exception from gain recognition where the residence was resold within one year of reacquisition, which did not apply to the taxpayer.

In Anyanwu, 24 the Tax Court found that capital gains from the sale of two properties were includible in the taxpayer's income despite her claiming that the gains should be attributable to her divorced husband or should be excluded under Sec. 121. Both properties were owned jointly but ultimately were awarded to the taxpayer in the divorce. Although the taxpayer lived in one house, she did not provide any evidence that she met the requirements to exclude gain on the sale of the house, and she never lived in the other house. In addition, the taxpayer with her former husband had bought, repaired, and sold the house she did not live in.

Sec. 152: Dependency Exemptions

The same noncustodial father involved in the Hendricks case, discussed above under Sec. 32, was not entitled to a dependency exemption for a minor child even though a pre-July 2, 2008, final divorce judgment awarded it to him. The judgment failed to meet the requirements because the ex-wife had not signed it. Nor was the father entitled to the Sec. 24 child tax credit because the child was not his qualifying child. 25

Sec. 162: Trade or Business Expenses

The government was again successful at disallowing deductions for inadequate substantiation. In Crawford, 26 the taxpayer sold nutritional supplements and had substantial expenses for car travel, meals, and entertainment. He maintained a calendar that contained mileage entries. Additionally, he submitted various receipts, invoices, a spreadsheet, and travel reservations. The court found that the notations on the calendar were insufficient to substantiate the business purpose of the trips and the spreadsheet was not sufficient evidence that the items were connected to the taxpayer's business. The final result was that all of the expenses were disallowed. Despite the fact that the Code does not require that a concurrent log be kept, the case shows once again the need for a concurrent log to be maintained clearly indicating business activity and actual mileage. In addition, to be able to claim meal and entertainment expenses, the taxpayer must establish a business purpose.

Sec. 166: Bad Debts

One Tax Court case involved a real estate agent who loaned money to a third party to buy real property. 27 When the borrower did not repay the loan, the agent claimed a business bad debt deduction that the IRS disallowed because the taxpayer was not in the trade or business of making loans. The Tax Court agreed with the IRS because the taxpayer had made only six loans in his 30 years of real property activities; therefore his lending activities were not frequent enough to rise to the level of a separate trade or business.

Sec. 170 Charitable, etc., Contributions and Gifts

In Smith, 28 the Tax Court denied a taxpayer's $27,767 noncash charitable deduction that consisted of several items of furniture valued at $11,730, numerous items of clothing valued at $14,487, and electronic equipment with a value of $1,550.

Although the taxpayer testified that he made numerous donations throughout the year, he produced only two blank tax receipts signed by attendants from the charitable organization, on which he said he had consolidated all of his donations and a spreadsheet that provided details of the donations.

The Tax Court found that the taxpayer failed to satisfy the "contemporaneous written acknowledgment" requirement for charitable contributions of more than $250 because the receipts from the charitable organization's drop-off attendants were signed before he donated any property (thus calling into question whether the receipts were actually an acknowledgment of the donations) and there was no evidence that the spreadsheet describing the donated items was created contemporaneously with the donations.

Sec. 183: Activities Not Engaged in for Profit

Showing that a taxpayer can prevail when he or she does things the right way, in Roberts, 29 the Tax Court found that for two of the years at issue, a taxpayer's money-losing horse-breeding activity was run with a profit motive, so the taxpayer could deduct the losses from the activity. Because the taxpayer's horse-breeding operation had continuing substantial losses, the IRS had argued that it was not operated with a profit motive for any of the years at issue. The Tax Court, however, determined that the taxpayer, after making significant changes to his operations, carried on the horse-breeding activity with a profit motive because he carried on the activity in a businesslike way, developed expertise, spent significant time on the activity, had a reasonable expectation that his assets would appreciate in value, was active in professional organizations, hired an assistant trainer, and had a record of previous successful businesses. The court also noted that he maintained good accounting records and used the records to make business decisions.

In another Tax Court case, doing things correctly again paid off for the taxpayer. 30 The taxpayer had a long and successful, but rarely profitable, career as an artist. She actively marketed her work through galleries and her website and used mailings to bring attention to her exhibits. She regularly attended events to network with collectors, journalists, and art professionals. She maintained good records and used a bookkeeper. In addition to being a working artist, she was a tenured art professor.

The IRS argued that her teaching and art career were a single activity, and, therefore, she could deduct her art expenses only as unreimbursed employee business expenses on Schedule A, Itemized Deductions, not as business expenses on Schedule C, Profit or Loss From Business (Sole Proprietorship). The court found that based on the facts, the two activities were separate and that her expenses from her artist activity had no relevance to her teaching. Applying the nine factors of Regs. Sec. 1.183-2(b), the court held that she worked as an artist with the intent of making a profit and her activity as an artist was a trade or business, in large part because she conducted it in a businesslike manner.

Sec. 262: Personal, Living, and Family Expenses

In Rogers, 31 a longtime tax attorney was disallowed deductions claimed on his Schedule C. The Tax Court applied the substantiation rules to assess whether deductions claimed for travel, meals, and entertainment expenses were genuine expenses of the taxpayer's business activities. The court found the expenses were for both personal and business purposes and, because the portion of the expenses that was for business purposes was not properly substantiated, it disallowed the deductions.

Sec. 263: Capital Expenditures

In Briley, 32 married S corporation owners were denied a net operating loss (NOL) carryforward for losses their corporation incurred in home construction. The corporation purchased residential properties late in 2002, started work on the properties in 2003, and completed the work and sold the properties in 2004. During the development process, the corporation deducted costs for labor, material, interest, and other construction costs. The 2003 Form 1120S, U.S. Income Tax Return for an S Corporation, reported a number of expenses, including the expenses related to the work on the properties, and no gross sales, resulting in an NOL.

The owners reported the NOL on their personal income tax return for 2003 and carried it forward to their 2004 and 2005 tax returns to offset their income. The court disallowed the carryover NOL, holding that the corporation should have capitalized the costs related to the construction under Sec. 263A and deducted them in 2004 when the properties were sold.

Sec. 280A: Disallowance of Certain Expenses in Connection With Business Use of Home, Rental of Vacation Homes, Etc.

In Rogers, 33 discussed under Sec. 262 above, the IRS also disallowed home office deductions the taxpayer claimed. Under Sec. 280A(a), no deductions are allowed for personal living expenses, unless a specific room or area of the home is used exclusively and on a regular basis for business purposes in connection with the taxpayer's trade or business. The taxpayer claimed he used three rooms in the home for business, but provided no information on the total rooms in his home. In testimony, he argued that 50% of the home was used for business purposes. Since the taxpayer did not provide credible evidence that any specific portion of the home was used solely for business purposes, he did not meet the exclusive-use test, and the court upheld the IRS's disallowance of the deductions.

In Hunter, 34 the court disallowed deductions for rental property because the taxpayer could not establish that he did not use his residence personally or that he rented it for fair market value. The taxpayer worked as a merchant marine, which required him to be at sea for long periods. When he was away, his friend occupied the residence, and he collected whatever the friend could afford to pay. He collected only one rental payment from his friend over the years she lived there.

Under Sec. 280A(d)(1), a taxpayer's residence is treated as having been used personally if it is used for personal purposes for more than 14 days or 10% of the number of days during a year a residence is rented to others at fair rental value. The court found that even if he did not actually use the residence himself, he was deemed to have used the residence for personal purposes for more than 14 days because he rented it to his friend for less than fair market value. Accordingly, the court did not allow the rental expenses the taxpayer deducted on Schedule E, Supplemental Income and Loss. (The court instead allowed the property taxes and mortgage interest as itemized deductions on Schedule A.)

In another case, the taxpayers, who were both in the insurance business, were not entitled to depreciation and interest deductions on their RV that they used for both personal purposes and to sell insurance. 35 The taxpayers sold several different types of insurance, including life, disability, health, and homeowner's. They later began selling specialized RV insurance at weekend RV rallies. The taxpayers would use the rallies to market their insurance business and sometimes would set up a display booth outside their RV or outside the clubhouse. The taxpayers claimed business use of the RV and took depreciation and other deductions.

The Tax Court held that Sec. 280A prohibited deductions for business use of the RV because the RV was a residence used for personal purposes for more than 14 days in the year. Furthermore, the taxpayers did not use any portion of their RV exclusively as a place of business to meet with clients in the normal course of business.

Sec. 280F: Limitation on Depreciation for Luxury Automobiles; Limitation Where Certain Property Used for Personal Purposes

In Baker, 36 a self-employed truck driver's deductions for fuel, insurance, maintenance, and other expenses were reduced for not having any documentation. The taxpayer used his Mack Truck to haul tank trailers from pickup to designated destinations. He did not maintain records of his expenses or actual mileage and instead estimated his truck-driving operation expenses, including fuel expenses of $38,516 based on 65,000 miles driven.

At examination, the taxpayer did not present sufficient evidence to support the number of miles driven or any of the expenses he claimed to have incurred. Under the Cohan rule, taxpayers who are unable to produce records of actual expenditures may rely on reasonable estimates. 37 However, Sec. 274(d) supersedes the Cohan rule in determining the deductibility of travel, meals, and certain listed property. Under the general rule in Sec. 274(d)(4), substantiation is required for any listed property defined in Sec. 280F(d)(4) used for transportation. The Tax Court found that the taxpayer's truck fell within the exception in Sec. 280F(d)(4)(C) to the general rule because the truck was property used in the business of transporting persons or property for compensation or hire. Therefore, the truck expenses were not subject to strict substantiation requirements for listed property, and the court allowed some of the deductions. The court found that the taxpayer's travel expenses did not fall within the Sec. 280F(d)(4)(C) exception and disallowed the deductions because the taxpayer did not substantiate them.

Sec. 469: Passive Activity Losses

The IRS Chief Counsel issued advice on the effect of Sec. 121 gain exclusion for a sale of a primary residence on the deductibility of suspended passive activity losses for the same residence that was rented and then disposed of in a sale or exchange. 38

Losses from a rental residence become suspended passive activity losses for a "previous passive activity" when the real estate is converted to a principal residence. The suspended losses are deductible when the residence is sold to an unrelated party. 39 The IRS concluded that the gain exclusion under Sec. 121 provides "gross income shall not include gain from the sale or exchange"—and therefore it is not an item of passive activity gross income under Temp. Regs. Sec. 1.469-2T(c). The suspended passive activity losses are not reduced by the exclusion and become fully deductible against the taxpayer's other income.

The IRS clarified in Chief Counsel Advice (CCA) 201427016 that the election to group activities under Regs. Sec. 1.469-9(g) applies only after the taxpayer qualifies as a real estate professional and thus has no effect on whether the taxpayer meets the requirements in Sec. 469(c)(7)(B) and Regs. Sec. 1.469-9(b)(6) to be a real estate professional. The IRS issued the CCA to address court cases that had reached differing conclusions.

The IRS noted two cases, Jafarpour and Hassanipour, 40 may be read to conclude that the election affects the determination of real estate professional status. The IRS Chief Counsel, however, advised that first the taxpayer must meet the requirements under Sec. 469(c)(7)(B) before it is determined whether the passive loss rules apply to the taxpayer. In the example provided, the taxpayer has two rental real estate properties and a real property development business. Under Sec. 469(c)(7)(C), time spent on the real estate development business can be combined with that spent on the rental properties in determining whether the tests for real estate professional are met (at least 750 hours and more than 50% of total time in all activities). Once those tests are met, the passive loss rules under Sec. 469(c)(2) and Temp. Regs. Sec. 1.469-5T are analyzed to determine if the taxpayer materially participates in each activity. If the election under Regs. Sec. 1.469-9(g) to group all activities has been made, the taxpayer is considered to have only one rental real estate activity, not two, for purposes of the material participation tests of Temp. Regs. Sec. 1.469-5T.

The IRS determined in CCA 201415002 that a foreclosure on real property subject to recourse debt qualifies as a fully taxable disposition for passive activity purposes even though the taxpayer's cancellation-of-debt (COD) income that resulted from the foreclosure was excluded from income under Sec. 108. Thus, the amount of the suspended losses that are freed up by the foreclosure that can be used by the taxpayer are not reduced by the amount of the excluded COD income.

The Tax Court determined that a taxpayer met the requirements for material participation in the activities of two related S corporations under the test in Temp. Regs. Sec. 1.469-5T(a)(7), which provides that a taxpayer materially participates in an activity if "based on all facts and circumstances, . . . the individual participates in the activity on a regular, continuous, and substantial basis during the year." 41 Factors that convinced the Tax Court that the taxpayer met the "all facts and circumstances" material participation test included his nonmanagement activities of developing products, contacting customers, securing financing critical for the continued operation on the companies, and visiting the companies' industrial facilities to meet the staff.

Because the taxpayer met the all-facts-and-circumstances test, the court did not address whether the taxpayer met the test for material participation under Temp. Regs. Sec. 1.469-5T(a)(1), under which a taxpayer materially participates in an activity if the taxpayer spends in excess of 500 hours working on an activity during a year. However, the court noted that for passive activity purposes, the two separate S corporations, one a plastic recycling business and the other a plastic manufacturing business that used the recycled plastic, could be combined as a single economic unit because the corporations were interdependent and shared common ownership and control.

Sec. 1031: Exchange of Property Held for Productive Use or Investment

The Chief Counsel has approved deferred like-kind exchange (LKE) program transactions in which previously matched replacement properties under Sec. 1031 are determined later to be ineligible, if other replacement properties were timely identified and acquired. 42 The unmatched replacement properties were properly identified because the taxpayer received them under the LKE program before the end of the identification period, and therefore the time requirements for identification and receipt of previously unmatched replacement properties were satisfied.

In Blangiardo, 43 the taxpayer's sale of property and later purchase of vacant land failed to qualify as a like-kind exchange under Sec. 1031. The taxpayer failed to meet safe-harbor requirements under Regs. Sec. 1.1031(k)-1(g) when he used his son as an intermediary. The taxpayer mistakenly believed that his son was a qualified intermediary because he was an attorney, the funds from the sale were held in an attorney trust account, and the real estate documents referred to the Sec. 1031 exchange. The court noted that the regulations specifically state that a lineal descendant is a disqualified person.

The IRS has ruled privately that a taxpayer that owned commercial office buildings entered into a reverse like-kind exchange that was also a qualified exchange accommodation agreement (QEAA) with two related affiliates. 44 The letter ruling stated that the taxpayer met the safe-harbor provisions of Rev. Proc. 2000-37 (parking arrangements). The IRS ruled that the taxpayer met the requirements of the QEAA separately and distinctly from the QEAAs entered into by the two related affiliates.

Sec. 1033: Involuntary Conversions

The IRS issued Notice 2014-60, which grants a one-year extension to taxpayers for the replacement period under Sec. 1033 if a sale or exchange of livestock is treated as an involuntary conversion on account of drought. The appendix to the notice contains the list of counties that qualify for the extension during the 12-month period ending Aug. 31, 2014. The extension continues until the end of the taxpayer's first tax year ending after a drought-free year.

In Peters, 45 a U.S. District Court held that a couple could not defer the tax on gain from the sale of their residence under Sec. 1033. The court ruled that the sale was not an involuntary conversion as the taxpayers voluntarily sold the property, and did not, as they claimed, sell it under threat of condemnation. In addition, the taxpayers did not use the proceeds to purchase a replacement property.

Sec. 1042: Sales of Stock to Employee Stock Ownership Plans or Certain Cooperatives

The IRS has privately ruled that married taxpayers met the requirements under Sec. 1042(a) to not recognize long-term capital gain on the sale of "qualified securities" to an employee stock ownership plan (ESOP). 46 The taxpayers initially failed to properly file the election statement under Sec. 1042 but later filed an amended return within the extended filing period and with the proper election statement. In the subsequent year, notarized statements regarding the purchase of qualified replacement property were not attached to the return. Upon discovering the error, the taxpayers filed an amended return with the notarized statements when they made the private letter ruling request.

Sec. 1092: Straddles

Final regulations were issued under Sec. 1092 that provide guidance about the circumstances in which an issuer's obligation under a debt instrument may be a position in actively traded personal property and be part of a straddle. 47 Sec. 1092(d)(1) defines "personal property" to mean personal property of a type that is actively traded. Debts and obligations are typically not property of the debtor or obligor. However, if the debt instrument provides for payments that are or will be reasonably linked to the value of personal property, then the obligor has a position in personal property that is referenced by the debt instrument. Therefore, the final regulations expressly provide that an obligation under a debt instrument may be in a position of personal property that is part of a straddle. The effective date of the final regulations applies to straddles established on or after Jan. 17, 2001.

Sec. 1221: Capital Asset Defined

In Allen, 48 a U.S. district court held that an individual taxpayer's income from the sale of undeveloped real estate was "other income" subject to regular income tax rates instead of capital gain. The taxpayer undertook substantial efforts to develop and sell the property during the time he owned it. Although the taxpayer claimed that his intent about the property changed over time to investment property, he failed to prove when, how, or why his intent changed. The court found that the taxpayer failed to rebut the government's contention that he purchased and held the property to develop and sell it in the ordinary course of his trade or business.

Secs. 1401–1403: Self-Employment Tax

In a legal memorandum, 49 the IRS determined that partners of a limited liability company (LLC) providing investment management services are not limited partners under Sec. 1402(a)(13) and are subject to self-employment tax on their distributive share from the LLC.

The LLC, which was formed to be the investment manager to a group of investment funds, was also one of the two general partners of each investment fund. (The other general partner did not conduct any management activity or control the funds' activities and was not part of the discussion.) The LLC had full control over the investment funds' activities and received a management fee quarterly determined by the value of the assets in the investment funds. The LLC owned a small interest in each of the investment funds and office equipment, cash, and an airplane.

The LLC's only income was the management fees the investment funds paid to it. No other amounts were distributed from the investment funds. The partners of the LLC were all individual taxpayers, each of whom worked full time and provided a variety of professional services. For the years at issue, each partner received a Form W-2, Wage and Tax Statement, for wages paid to him or her. During the years in question, the LLC treated all its partners as not subject to self-employment tax on their distributive share. However, guaranteed payments, which consisted of health insurance premiums and parking benefits the LLC paid on the partners' behalf, were reported as income subject to self-employment tax.

Sec. 1401 imposes a tax on an individual's self-employment income, including the individual's "net earnings from self-employment." Sec. 1402(a) defines "net earnings from self-employment" as the gross income derived by an individual from any trade or business, less allowable deductions, plus a partner's distributive share of income or loss of a trade or business of a partnership in which the individual is a partner. Sec. 1402(a)(13) provides that, except for guaranteed payments for services rendered, a limited partner's share of partnership income is generally not subject to self-employment tax. However, Sec. 1402(a)(13) does not define a "limited partner."

In the memorandum, the Chief Counsel concluded that the partners' share of the LLC's income from management fees was not the type of income Congress intended to exclude from self-employment income. The income was not from a return on invested capital, but for performing services. Therefore, the LLC partners are not limited partners for purposes of Sec. 1402(a)(13), and their income is subject to self-employment tax.

It is not clear what implications this memorandum, which cannot be used or cited as precedent, may have on the current regulations under Sec. 1402(a)(13), proposed in 1997 but never finalized, or the self-employment tax treatment of owners of passthrough entities in general. The IRS's position in the memorandum is largely based on the Renkemeye r 50 Tax Court case.

In Morehouse, 51 the Eighth Circuit reversed a Tax Court decision holding payments a married couple received from the U.S. Department of Agriculture Conservation Reserve Program (CRP) were taxable as self-employment income. The Eighth Circuit held that the CRP payments constituted real estate rents under Sec. 1402(a)(1).

In 1994, Rollin Morehouse inherited over 1,200 acres of mostly tillable cropland in various South Dakota counties. The greater part of the land was already enrolled in the CRP at this time, and in 1997, Morehouse enrolled most of the rest of the land in the program.

Enrolling land in the CRP meant Morehouse agreed to abstain from producing agricultural commodities or undertaking "any action . . . which tends to defeat the purposes of this CRP contract, as determined by the [Commodity Credit Corp.]." 52 He also agreed to implement conservation plans and file annual reports. In return, the Commodity Credit Corp. paid part of the costs to implement the conservation plans and an annual rental payment.

Morehouse reported these payments on Schedule E as rents received and did not report these payments as income from self-employment. The IRS issued a notice of deficiency, indicating the payments should have been reported on Schedule F, Profit or Loss From Farming, and should have been subject to self-employment tax. The Tax Court agreed with the IRS, concluding that the CRP payments were from Morehouse's own use of his land and not rents received. According to the Tax Court, Morehouse "was engaged in the business of participating in the CRP . . . with the primary intent of making a profit" and that there was sufficient nexus between this business and the CRP payments, thus categorizing the payments as net earnings from self-employment.

In reversing the Tax Court, the Eighth Circuit explained that Rev. Rul. 60-32 concluded that soil bank payments were excluded from self-employment income if they were made to persons who did not materially participate in a farming operation and that Rev. Rul. 65-149 indicated that soil bank payments to nonfarmers were rental income. In addition, the Eighth Circuit found that even though the CRP contracts required some farming activity on the land, the activity did not rise to the level of an active farmer. The only reason the individuals engaged in the activity or arranged for the activities was that the contract for the CRP program required them.

Sec. 5000A: Requirement to Maintain Minimum Essential Coverage

Notice 2014-10 provides relief for individual taxpayers who might be liable for the shared-responsibility payment under Sec. 5000A for not maintaining minimum essential coverage in 2014. The notice and proposed rules clarify that the shared-responsibility payment was not imposed for the months in 2014 when individuals had limited benefit health coverage under Medicaid and chapter 55 of Title 10, U.S. Code, that was not minimum essential coverage.

Sec. 6013: Joint Returns of Income Tax by Husband and Wife

In Salzer, 53 the Tax Court held that additions to tax for penalties, including underpayment of estimated tax payment penalties, were proper because the taxpayer failed to file income tax returns electing the married-filing-jointly status.

The taxpayer was a married individual with children and substantial wage income. He and his wife did not file an income tax return for 2010 because they disagreed with the U.S. government's actions and policies. They took similar positions in 2008 and 2009. The IRS prepared a substitute return for the taxpayer using the married-­filing-­separately status, allowing the standard deduction and one personal exemption. After filing the substitute return, the IRS determined a tax deficiency and assessed penalties and interest.

The Tax Court agreed with the IRS and rejected the taxpayer's claim that his tax should be computed using the married-filing-jointly status, which would not have resulted in a deficiency because his withholding was sufficient to cover his tax liability. Joint return rates apply only if an individual files a return jointly with his or her spouse under Sec. 6013. A husband and wife may file a joint return even if one of the spouses does not have gross income or deductions (Sec. 6013(a) and Regs. Sec. 1.6013-1(a)).

The court stated it cannot make a determination based on what could have been done, but rather what was actually done. Since the taxpayer did not file a return, he necessarily did not file a joint return. Thus, the court sustained the IRS's use of the married-­filing-­separately status in preparing the taxpayer's substitute return. In addition, the court upheld the penalties the IRS imposed for failure to timely file and to pay tax and estimated tax.

Sec. 6038D: Information With Respect to Foreign Financial Assets

In Rev. Proc. 2014-55, the IRS issued guidance modifying the reporting requirements for U.S. citizens and residents with interests in Canadian retirement plans, including Canadian registered retirement savings plans (RRSPs), registered retirement income funds (RRIFs), and registered pension plans (RPPs). Rev. Proc. 2014-55 simplifies the procedure for U.S. taxpayers making elections under Article XVIII(7) of the U.S.-Canada Income Tax Convention. It does not apply to other Canadian plans that do not provide pension or employee benefits.

The revenue procedure addresses two categories of individuals who have not made elections under Article XVIII(7): (1) individuals who have not reported accrued income from a Canadian retirement plan but have reported any and all distributions received from that plan; and (2) individuals who have reported undistributed, accrued income from a Canadian retirement plan.

Eligible individuals in the first category will automatically be treated as if they had made an election to defer taxation until distributions are received in the first year in which the individuals would have been entitled to elect the benefits under the treaty. Individuals who previously made the election and filed Form 8891, U.S. Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans, are no longer required to file this form. In addition, the requirement to file this form is eliminated for tax years ending after Dec. 31, 2012.

Individuals in the second category are not "eligible individuals" and will continue to be currently taxable on undistributed, accrued income in their plans. Those individuals interested in making an election to defer taxation must obtain the IRS's consent.

Individuals with interests in a Canadian retirement plan do not need to report these interests, or contributions to or distributions from the plan, on Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, or Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner (Under Section 6048(b)) (regardless of whether they are "eligible individuals"). However, individuals may be required to report these plans on FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR), or Form 8938, Statement of Specified Foreign Financial Assets.

Sec. 6654: Estimated Tax Rules

In Fisher, 54 the Tax Court held that payments the taxpayer received were compensation for services provided to her employer and not loans from him. For the years in question, her employer made payments for services the taxpayer provided. The employer's wife, who was his bookkeeper during those years, did not issue the taxpayer a Form 1099-MISC, Miscellaneous Income, for the amounts paid.

Because the taxpayer did not file tax returns for the years in question, the IRS prepared substitutes for returns.

The taxpayer contended the payments received from her employer were loans to support a book she was writing and to purchase equipment from her deceased husband. However, the promissory note documenting the payments as loans contained a signature that her employer testified was forged. In addition, the employer and his wife testified the payments were compensation for billing and other business services. They also testified that they did not purchase equipment from the taxpayer's husband.

The Tax Court concluded that the payments were compensation for services. In addition to finding the taxpayer liable for failure to timely file tax returns and pay taxes, the Tax Court also found her liable for underpayment of estimated tax under Sec. 6654.

In Topsnik, 55 the taxpayer was held to be a U.S. resident and subject to U.S. tax on the gain he recognized from his installment sale of stock in a U.S. company. Additions to tax for failure to file returns, pay tax, and pay estimated tax were sustained.

The taxpayer was a German citizen residing in the United States during 2004 when he sold his stock in a U.S. corporation under an installment sale agreement. Payments were received between 2004 and 2009. The taxpayer filed U.S. income tax returns for 2004 and 2005, erroneously reporting duplicate portions of the gain. He did not file U.S. income tax returns for 2006 through 2009. The IRS challenged the installment sale reporting on his 2004 and 2005 returns and prepared substitute returns for 2006–2009.

The taxpayer argued he was due a refund of all payments he made for 2004 and 2005 in addition to all amounts the IRS collected under a jeopardy assessment and levy on his installment payments from the stock sale. He claimed he was a German resident and U.S. nonresident alien and that, under the U.S.-Germany income tax treaty, he was not subject to U.S. tax because he had "informally" abandoned his status as a "lawful permanent resident" in 2003.

The judge rejected the taxpayer's arguments and found that he was a U.S. resident for tax purposes because he had not formally abandoned his legal permanent resident status. As such, the court held that he was taxable in the United States on his worldwide income, and he was not exempt from tax on his income under the U.S.-Germany tax treaty because he was not subject to German taxation. The court also held that the taxpayer was liable for tax and penalties.

Footnotes

1 Windsor, 133 S. Ct. 2675 (2013).

2 Defense of Marriage Act, P.L. 104-199, §3.

3 See Chambers and Curatola, "Estimated Tax Payments and Small Business Owners," 11-14 Strategic Finance 69 (November 2012).

4 Hendricks, T.C. Memo. 2014-192.

5 See Sec. 32(c)(3).

6 Oxford,T.C. Summ. 2014-80.

7 Oklahoma v. Burwell, No. CIV-11-30-RAW (E.D. Okla. 9/30/14).

8 Patient Protection and Affordable Care Act, P.L. 111-148.

9 Halbig v. Burwell, 758 F.3d 390 (D.C. Cir. 2014).

10 King v. Burwell, 759 F.3d 358 (4th Cir. 2014).

11 For more on these cases, see McKenna and McKenna, "Do PPACA Credits and Mandates Apply in States With Federal Exchanges?" The Tax Adviser (February 2015).

12 King v. Burwell, No. 14-114 (U.S. 11/7/14) (petition for cert. granted).

13 Ambrosius,T.C. Memo. 2014-126.

14 Wang,T.C. Summ. 2014-39.

15 Johnson,T.C. Memo. 2014-67.

16 Peery, T.C. Memo. 2014-151.

17 Robertson, T.C. Memo. 2014-143.

18 Matthews,T.C. Summ. 2014-84.

19 Dabney,T.C. Memo. 2014-108.

20 T.D. 9665; Regs. Sec. 1.72-15.

21 Cowden v. BNSF R. Co., No. 4:08CV01534 ERW (E.D. Mo. 7/7/14).

22 Koriakos,T.C. Summ. 2014-70.

23 Debough, 142 T.C. No. 17 (2014).

24 Anyanwu, T.C. Memo. 2014-123.

25 Hendricks, T.C. Memo. 2014-192. See Sec. 151 for what constitutes a personal exemption, Sec. 152 for a dependency exemption.

26 Crawford, T.C. Memo. 2014-156.

27 Langer, T.C. Memo. 2014-210.

28 Smith,T.C. Memo. 2014-203.

29 Roberts, T.C. Memo. 2014-74.

30 Crile, T.C. Memo. 2014-202.

31 Rogers, T.C. Memo. 2014-141.

32 Briley, T.C. Memo. 2014-114.

33 Rogers, T.C. Memo. 2014-141.

34 Hunter, T.C. Memo. 2014-164.

35 Jackson, T.C. Memo. 2014-160.

36 Baker, T.C. Memo. 2014-122.

37 Baker, T.C. Memo. 2014-122, citing Cohan, 39 F.2d 540 (2d Cir. 1930).

38 CCA 201428008.

39 Sec. 469(g)(1)(A).

40 Jafarpour, T.C. Memo. 2012-165, and Hassanipour, T.C. Memo. 2013-88.

41 Wade, T.C. Memo. 2014-169, citing Temp. Regs. Sec. 1.469-5T(a)(7).

42 TAM 201437012.

43 Blangiardo, T.C. Memo. 2014-110.

44 IRS Letter Ruling 201416006.

45 Peters, No. 4:12-CV-01395 (E.D. Mo. 11/24/14).

46 IRS Letter Ruling 201435014.

47 T.D. 9691.

48 Allen, No. 13-cv02501-WHO (N.D. Cal. 5/28/14).

49 CCA 201436049.

50 Renkemeyer, Campbell, and Weaver, LLP, 136 T.C. 137 (2011).

51 Morehouse,769 F.3d 616 (8th Cir. 2014), rev'g and rem'g 140 T.C. 350 (2013).

52 The Commodity Credit Corp. executes the CRP contracts for the CRP properties.

53 Salzer,T.C. Memo. 2014-188.

54 Fisher, T.C. Memo. 2014-219.

55 Topsnik, 143 T.C. No. 12 (2014).


Contributors

David Baldwin is a partner with Baldwin & Baldwin PLLC in Phoenix. Lawrence Carlton is director of taxes with Carlton & Duran CPAs PC in Bedford, Mass. Valrie Chambers is an associate professor of taxation and accounting at Stetson University in Celebration, Fla. Donna Haim is a tax manager with Harper & Pearson Co. PC in Houston. Jonathan Horn is a sole practitioner specializing in taxation in New York City. Susanne Morrow is a tax partner with Ernst & Young LLP in San Francisco. Kenneth Rubin is a partner with RubinBrown LLP in St. Louis. Kaye Sheridan is a professor and director of the Troy University School of Accountancy in Troy, Ala. David Taylor is a partner at Anton Collins Mitchell in Denver. Donald J. Zidik Jr. is a director with Marcum LLP in Needham, Mass., and an adjunct professor of taxation at Suffolk University in Boston. Mr. Rubin is the chair, Mr. Horn is the immediate past chair, and the other authors are members of the AICPA Individual and Self-Employed Tax Technical Resource Panel. For more information about this column, contact Mr. Rubin at ken.rubin@rubinbrown.com.

 

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