Directions in Individual Taxation

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

 Directions in Individual Taxation
ILLUSTRATIONS BY RETROROCKET/ISTOCK
 

EXECUTIVE
SUMMARY

 
  • Several taxpayers were denied alimony deductions in Tax Court cases where payments were recharacterized as child support or a nontaxable transfer of property incident to divorce or were made under a divorce or separation instrument that did not terminate them at the death of the payee spouse.
  • In two cases, the Tax Court dealt with the issue of whether the taxpayers had adequately substantiated that they qualified for real estate professional status without having contemporaneous records of time spent on their activity, finding in one case that the taxpayer did qualify and in the other that the taxpayer did not.
  • The Seventh Circuit, overturning a decision of a district court, held in a case involving a challenge to the constitutionality of the Sec. 107(2) parsonage exclusion that the taxpayers did not have standing.
  • The Tax Court in two cases addressed whether the refundable portion of certain New York state economic development credits was includible in the taxpayers' income.
  • The IRS issued proposed regulations on qualified ABLE programs, which are designed to help disabled persons and their families save for and pay certain disability-related expenses.

This article covers recent developments in the area of individual taxation, including the treatment of support payments and IRA and qualified plan distributions, the Sec. 469 material participation rules, and the taxability of state economic development credits. The items are arranged in Code section order.

Sec. 48: Energy Credit

A reflective roof can qualify for the solar energy credit to the extent that the ­reflective roof's cost exceeds a standard roof's cost, according to IRS private rulings.1

Sec. 61: Gross Income Defined

The Tax Court in Shah2 upheld the IRS's determinations after examination that the taxpayers were not entitled to various expenses deducted on their personal and corporate returns since they failed to substantiate the amounts and/or their business purpose and to establish a profit motive. In addition, the Tax Court found that the bank deposits method used to reconstruct the corporation's income was an acceptable method to determine income that the corporation had failed to report.

In another case, the Tax Court held that a physician received cancellation-of-debt (COD) income from forgiveness of a loan he received as part of a recruiting agreement with a rural hospital.3

Sec. 66: Treatment of Community Income

The Tax Court in Mottahedeh4held that the IRS used a permissible method of reconstructing the married taxpayers' unreported income and properly treated this income as community property attributable one-half each to the husband and the wife. The taxpayers operated a business that taught tax-evasion techniques, which they applied to their own financial situation by having customers pay cash, avoiding banks, and not keeping financial records or filing tax returns. The Tax Court found that the IRS's reconstruction of the taxpayers' taxable income through its investigation of their business and reliance on average spending statistics from the U.S. Bureau of Labor Statistics was valid and that the business was a joint effort between both spouses. Thus, the income from the business was held to be community property.

The Ninth Circuit held that the Tax Court in Hiramanek5 properly determined that a former spouse was not jointly and severally liable for a tax deficiency since she signed a joint tax return under duress, based on the former spouse's testimony at trial. The Ninth Circuit agreed with the Tax Court that she was entitled to equitable relief under Sec. 66(c) because equitable relief resulting from the operation of a community property law may be available, even if the requirements for traditional relief are not satisfied, when it would be inequitable to hold the requesting spouse liable for the unpaid tax or deficiency.

Sec. 67: 2% Floor on Miscellaneous Itemized Deductions

In Peterson,6 the Tax Court held that a police officer improperly deducted unreimbursed business expenses on Schedule A, Itemized Deductions, of his tax return. Under Sec. 67(a), miscellaneous itemized deductions are allowed only to the extent they exceed 2% of adjusted gross income. Moreover, to be deductible as unreimbursed employee business expenses, the expenses must be incurred through the performance of services as an employee, and the taxpayer must not have the right to reimbursement for such expenses from his or her employer. The court found that the taxpayer failed to prove he met these requirements.

Sec. 71: Alimony and Separate Maintenance Payments

The Tax Court disallowed an alimony deduction for spousal maintenance payments that were based on a contingency related to a child's living with the taxpayer's ex-wife.7 The divorce instrument contained a provision that allowed for maintenance to be paid to the taxpayer's ex-wife in the form of mortgage payments on the marital residence until either the mortgage was paid off or the oldest child no longer resided with the ex-spouse in the marital residence. Since this event was a contingency relating to the child of the payer spouse, under Sec. 71(c)(2), the amount of maintenance payments had to be treated as fixed by the divorce instrument as child support and not deductible as alimony.

In Hampers,8 the Tax Court determined that a taxpayer was not entitled to an alimony deduction for payment of his ex-wife's current attorney's fees as required by their divorce decree, which also obligated him to pay her future attorney's fees. The divorce decree was silent regarding termination of the payments upon the death of the payee spouse, and state law was not clear on the issue, so the court held that the requirements of Sec. 71(b)(1)(D) were not met. Therefore, the payments were not alimony.

In another case, the Tax Court determined that a taxpayer was not entitled to an alimony deduction for 2006 although he made significant support payments to his wife during the year.9 Although their divorce was finalized during 2006, there was no separation agreement with an alimony provision before the divorce was finalized, and the 2006 final divorce decree was not amended to include an alimony provision until 2007. Thus, because none of the 2006 support payments were made under a qualifying agreement, the court held that the payments did not constitute alimony under Sec. 71(b)(1)(A).

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

In McKnight,10 the Tax Court approved the IRS's imposition of the 10% additional tax imposed under Sec. 72(t) against a taxpayer who received a distribution from a retirement plan before age 59½. The court found that the taxpayer failed to prove that any exception applied to this distribution, and he was unable to produce documentation to support his claim that he rolled over a portion of the distribution into another qualified plan within 60 days of receiving it.

The Tax Court in El11 determined that a portion of the taxpayer's loan from his qualified plan constituted a deemed distribution. The court found that it was taxable under Sec. 72(p)(2)(A)(ii) because the outstanding loan balance in the taxpayer's account was more than the greater of one-half of his nonforfeitable accrued benefit or $10,000. The Tax Court also concluded that the deemed distribution was subject to the additional 10% tax imposed under Sec. 72(t).

The taxpayer in Morles12 took a withdrawal from his qualified plan before age 59½ and used the distribution to pay rent to prevent eviction. He claimed the distribution was excluded from income because he took it due to economic hardship. The Tax Court held the IRS had properly determined that it was a taxable distribution subject to a 10% early-withdrawal tax under Sec. 72(t) because there is no exclusion under that subsection for economic hardship.

The taxpayer also took a distribution from an IRA that he failed to include in his income. While he claimed the amount of this distribution was funded by a nondeductible IRA contribution, he had never reported the contribution as such on Form 8606, Nondeductible IRAs. Even though the taxpayer did not comply with the reporting requirements, the court held that he was allowed to consider the nondeductible contribution as his investment in the contract. However, the court held that only part of the IRA distribution amount was nontaxable as an investment in the contract, noting that Sec. 72(e)(3) requires an IRA distribution to be allocated between taxable income and investment in the contract pursuant to a formula.

In Letter Ruling 201510060, a taxpayer was receiving a series of substantially equal periodic payments from her IRA. The acquisition of the entity holding her IRA account by another entity resulted in the distribution of two additional payments to her in the year of acquisition from the IRA, in violation of her direction. The taxpayer claimed in her ruling request that she did not intend to modify the series of substantially equal periodic payments and had no reason to believe the financial institution would make the two additional distributions. She also provided a document from the entity that confirmed that the two additional payments were made due to the acquisition. The IRS ruled that the additional distributions were made in error and should not be considered a modification of a series of substantially equal periodic payments under Sec. 72(t)(4) and thus were not subject to the 10% additional tax on early distributions.

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

The taxpayer in Brinkley13 took the position that income he received as a result of a merger of his employer with another corporation and that was reported to him as ordinary compensation income was derived wholly from the sale of his stock in the employer and qualified for long-term capital gain treatment. The IRS acknowledged that the Sec. 83(b) election filed by the taxpayer permitted subsequent appreciation in the stock to be taxed as capital gain and that any gain recognized from the exchange of stock for consideration in the acquisition was capital. The IRS argued, however, that the taxpayer's merger-based income in excess of the determined value of his stock was taxable as ordinary income. The Tax Court held that under the merger agreement that the taxpayer signed, the income at issue was deferred compensation that was taxable as ordinary income.

Sec. 86: Social Security and Tier 1 Railroad Retirement Benefits

The taxpayers in McCarthy14 improperly excluded from gross income the husband's Social Security benefits and misreported a portion of the wife's distribution from a defined benefit retirement plan as Social Security benefits. The Tax Court upheld the IRS's determination that a portion of the husband's Social Security benefits was taxable under Sec. 86. Since the taxpayers failed to show any applicable exclusion for the wife's retirement distribution, the full amount was includible in their taxable income.

In Powell,15 the Tax Court found that the taxpayers were not entitled to various deductions they took as the sole owners of an S corporation. As a result, the court held that the portion of the taxpayers' Social Security income that they were required to include in gross income under Sec. 86 for the years at issue had to be determined in post-trial calculations.

Sec. 104: Compensation for Injuries or Sickness

Married taxpayers in a tax refund case claimed that the proceeds of an agreement the husband entered into to settle a claim were not taxable under Sec. 104(a)(2) because the payment was on account of physical injury or sickness.16 However, the Court of Federal Claims held that the award was to settle a whistleblower retaliation claim and was not excludable from taxable income because it was not for physical injury or sickness. The taxpayers were unable to show that the payment represented tort damages for physical injuries, and it was therefore not excludable under Sec. 104(a)(2).

The taxpayer in Perez17 attempted to exclude from gross income as compensation for physical injuries or sickness under Sec. 104 income she received for participating in an egg donation program to produce eggs for an infertile couple. The Tax Court determined that the amounts received were not excludable under Sec. 104 because the woman's pain and suffering resulted from the consensual performance of a service contract. The court distinguished the payments from damages and held that while she endured painful, invasive, and dangerous procedures, they were not unwanted or involuntary but rather the result of her performance of services and compliance with her contractual obligations.

The Tax Court held in Campbell18 that the taxpayer could not exclude from income payments he received while on temporary disability retirement status from the Coast Guard. Sec. 104(a)(4) generally excludes from income amounts received as a pension, annuity, or similar allowance for personal injuries or sickness resulting from active service in the armed forces, but Sec. 104(b)(4) limits this exclusion to amounts received by an individual who would have been entitled to receive disability compensation from the Department of Veterans Affairs (VA). The taxpayer failed to establish that he would have received disability pay from the VA, so the court found that the payments he received did not qualify for the exclusion under Sec. 104.

Sec. 107: Rental Value of Parsonages

The Seventh Circuit vacated and remanded the decision of a district court in a case involving a challenge to the constitutionality of the Sec. 107(2) exclusion for a rental allowance paid to a minister of the gospel (commonly called a parsonage exclusion). It held that the plaintiffs (co-presidents of the Freedom From Religion Foundation) did not have standing to challenge the statute.19 The Seventh Circuit found that to have standing, the plaintiffs must have suffered an injury and noted that the plaintiffs did not suffer a "judicially cognizable injury merely because others receive a tax benefit that is conditioned on allegedly unconstitutional criteria, even if that person is otherwise 'similarly situated' to those who do receive the benefit. Only a person that has been denied such a benefit can be deemed to have suffered a cognizable injury." According to the court, since the plaintiffs never claimed or requested the parsonage exclusion, it had never been denied to them, and they had thus not suffered any injury that would give them standing to challenge it.

Sec. 108: Income From Discharge of Indebtedness

In Johnston,20 as part of an employment agreement, the taxpayer's new employer loaned funds to the taxpayer for his separate business with the understanding that the taxpayer would continue to manage the separate business while performing duties of his new executive position. The loan would become due if the taxpayer resigned his executive position with the employer/creditor. However, when the taxpayer resigned in 2001, the employer/creditor made no efforts to collect the loan. In 2005, the taxpayer went back to work for the employer/creditor after his separate business failed. In 2011, the employer/creditor notified the taxpayer that the loan was still due, and the taxpayer began making payments on the loan via payroll deductions. Upon audit of the taxpayer's 2007 return, the IRS determined that his debt was discharged in 2007 because the creditor failed to take collection action after the loan became due and before the state period of limitation for collection expired. The IRS argued that such inaction manifested the intention of the creditor to forgive the loan. However, the Tax Court concluded that the taxpayer had no COD income because the loan was still outstanding and was being paid.

In Bacon,21 the Tax Court held that the taxpayer did not receive COD income from the Federal Emergency Management Agency (FEMA) after the statute of limitation for a collection action had expired. FEMA issued a Form 1099-C, Cancellation of Debt, to the taxpayer for 2007 for an erroneous claim paid in 1994 that FEMA had tried unsuccessfully to recoup. The Tax Court found that the taxpayer defaulted on her debt to FEMA in or around January 1995, and FEMA curtailed its efforts to collect the debt and referred the matter to the U.S. Justice Department in 1997. The court further found that the period of limitation for filing an action expired in January 2001, and the underlying debt was extinguished when the United States became time-barred from collection through judicial enforcement. Therefore, the Tax Court reasoned, there was no debt to cancel when FEMA issued the Form 1099-C.

Sec. 111: Recovery of Tax Benefit Items

In Maines,22 the Tax Court concluded that taxpayers who owned a limited liability company (LLC) and an S corporation were required to include in federal taxable income portions of the amounts they received from state refunds of the New York Qualified Empire Zone Enterprise (QEZE) real property tax credit, Empire Zones (EZ) investment credit, and the EZ wage credit, even though the taxpayers paid no state income taxes. The taxpayers argued that these payments were not income because New York referred to these refundable credits as overpayments. They also argued that since they had not taken a deduction for state taxes in an earlier year, the exclusionary part of the tax benefit rule applied, causing the refunded taxes to be nontaxable.

The Tax Court found that its precedent established that a particular label given to a legal relationship or transaction under state law is not necessarily controlling for federal tax purposes, and the refunded portions of the EZ wage credit and EZ investment credits were taxable direct subsidies and not overpayments. The court found that the refunded portion of the QEZE real property tax credit was an overpayment but still held it was includible in the taxpayers' income under the tax benefit rule. According to the court, although the taxpayers did not deduct the real property taxes associated with the credit on their personal tax return, they received a benefit because the property tax was paid and deducted by their LLC, which decreased the income that was passed through to the taxpayers from the LLC and reduced their tax liability.

In Elbaz,23 the Tax Court concluded that taxpayers who were shareholders in an S corporation and members in two LLCs were required to include the amount they received from a refund of a New York QEZE real property credit in their taxable income, even though they did not deduct the real property taxes associated with the credit on their personal tax return. As it had in Maines, the Tax Court determined that the taxpayers received a benefit because the property tax was paid and deducted by their S corporation and LLCs, which decreased the income that was passed through to the taxpayers from those entities and reduced their tax liability.

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

In Villegas,24 the Tax Court held that married owners of a residence used for a group home did not qualify for the exclusion of gain on the sale of a residence because they did not use the home as a principal residence for two of the prior five years preceding the sale. The taxpayers claimed the wife stayed overnight in the spare bedroom of the residence. However, testimony from group home employees and the taxpayer's sister showed the taxpayers lived at a different residence and that the spare bedroom was used as an office.

Sec. 162: Trade and Business Expenses

In Crawford,25 the IRS disallowed deductions for inadequate substantiation. The taxpayer sold nutritional supplements and had extensive car travel and meal and entertainment expenses. The taxpayer maintained a calendar that contained mileage entries. Additionally, he submitted various receipts, invoices, a spreadsheet, and travel reservations. The government argued that the notations on the calendar were insufficient to substantiate the business purpose of the trips and that the spreadsheet was insufficient to assure that the items were connected to the taxpayer's business. The Tax Court agreed with the IRS.

Sec. 166: Bad Debts

In Langert,26 the taxpayer, a real estate agent, loaned money to an individual to buy real property. When the borrower did not repay the loan, the taxpayer claimed a business bad debt deduction that was disallowed by the IRS. The Tax Court found, as the IRS argued, that he was not entitled to the deduction because, based on the infrequency with which he had made loans during his 30 years in business, he was not in the business of making loans. The court stated in a footnote that even if the taxpayer had established that the debt was a bona fide bad debt that was not a nonbusiness debt, he would not have been entitled to a deduction because he had failed to prove that the debt became wholly or partially worthless in the year in question.

Sec. 170: Charitable, etc., Contributions and Gifts

During 2015, the IRS won at least three cases27 involving noncash charitable contributions where the written acknowledgments received by the donors did not meet the requirements of Sec. 170(f). While each of the cases involved large contribution amounts, their reasoning could jeopardize the noncash charitable contribution deductions of many individual tax clients.

In the case of a noncash charitable contribution valued at $250 or more, Sec. 170(f)(8)(A) requires a contemporaneous acknowledgment from the donee organization that includes a description (but not value) of the property contributed; a statement of whether the donee organization provided any goods or services in exchange for the gift; and if the donee provided goods or services, a description and good-faith estimate of their value.

The taxpayer in each case attempted to satisfy the contemporaneous acknowledgment requirement with generic receipts provided by the charitable organizations that were either blank or did not contain a description of the property donated. The Tax Court held that these receipts did not contain enough information to satisfy the requirements of Sec. 170(f)(8)(A) and the associated regulations. In Kunkel, the taxpayer also asserted that the total amount claimed as noncash contributions to charities represented multiple donations in different batches, each of less than $250 worth of goods, so no acknowledgments were necessary. The court, noting that this would have required the taxpayer to make donations on 97 occasions, found that the taxpayer's assertion was not credible and disallowed the deduction.

Sec. 179: Election to Expense Certain Depreciable Business Assets

In Evans,28 the Tax Court allowed a Sec. 179 deduction for a motor home used to transport the taxpayer's son and motorcycles in a motocross business. The taxpayer's son slept in the motor home while traveling; however, it was also used to transport and store motorcycles at races. The IRS argued the motor home was used primarily for lodging and thus the taxpayer could not take the Sec. 179 deduction; however, the Tax Court found that it was used primarily in the racing activity and not as lodging, based on facts that included modifications allowing the vehicle's rear wall to be folded down into a ramp, accommodating the loading and unloading of motorcycles. Accordingly, the court held the taxpayer could take the Sec. 179 deduction.

Sec. 183: Activities Not Engaged In for Profit

In Roberts,29 a taxpayer ran a horse-breeding operation that showed continuing substantial losses. The IRS argued that it was not a business operated with a profit motive. The court determined that the taxpayer did conduct a bona fide business for the two latter years of the four years at issue and held partly in favor of the taxpayer. The court determined that in all years at issue, the taxpayer developed expertise and spent significant time on the activity. For the latter two years, he also carried on the activity in a businesslike way and had a reasonable expectation that his assets would appreciate in time. The Tax Court also noted that the taxpayer was active in professional organizations, hired an assistant horse trainer, and had a record of previous successful businesses. The court, calling his accounting records "rudimentary," nonetheless found that they allowed him to make informed business decisions.

In Crile,30 the taxpayer, a tenured art professor, also 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 also regularly attended events that allowed her to network with collectors, journalists, and art professionals. In addition, she maintained sufficient records and used the services of a bookkeeper.

The government argued that her teaching and art career were a single activity, so her artist expenses were not deductible. The Tax Court concluded that the two activities were separate and that her expenses had no relevance to her teaching. Applying the nine factors in Regs. Sec. 1.183-2(b) to her art career, the court found that it was a bona fide business that was conducted in a businesslike, for-profit manner and, consequently, the taxpayer could deduct her expenses from her art career.

Sec. 215: Alimony, etc., Payments

In Iglicki,31 the taxpayer was denied a deduction for past-due alimony paid under a "final money judgment." In 1999, the taxpayer, David Iglicki, signed a separation agreement with his wife requiring him to pay $735 per month in child support but no alimony. However, he also agreed that if he ever defaulted on the child support payments, he would become liable for $1,000 per month spousal support to last 36 months or until his or his wife's demise.

Iglicki did default in 2002. Effective Nov. 1 that year, he became liable for the monthly spousal support (in addition to the continuing child support payments). In 2003, his now ex-wife filed suit, and a final judgment was issued in August 2008 for $16,500 in past-due child support, $36,000 in past-due spousal support, and interest on both amounts. Iglicki's wages were garnished, and he began paying off the liabilities. In 2010, he claimed an alimony deduction for $39,350.

In 2012, the IRS issued a notice of deficiency disallowing the entire alimony deduction, on the basis that the payments failed the fourth conjunctive test in Sec. 71(b)(1), that there must be no liability to make payments after the death of the payee spouse. Under Colorado law (where Iglicki resided), a judgment to pay past-due alimony is considered a "final money judgment" and is subject to the general 20-year statute of limitation on payment. The liability does not end upon the death of the payee spouse. The Tax Court ruled in favor of the IRS and upheld an accuracy-related penalty.

In Wish,32 an unusual trigger clause was objected to by the IRS but upheld as valid by the Tax Court. The taxpayer and his wife had a son with learning disabilities whom the wife home-schooled. After they divorced, the couple decided that the wife should continue to home-school their son. In recognition of the fact that this would preclude her working and earning a living, the taxpayer agreed to pay her $1,200 a month child support and $3,800 a month spousal support. However, the agreement included a provision that would reduce the spousal support to $1,900 if she discontinued home-schooling their child.

After a number of months, the ex-wife requested an increase in the spousal support, which was refused. She then discontinued the home-schooling and returned to work. The taxpayer accordingly reduced the spousal support in subsequent months from $3,800 to $1,900. Upon examination, the IRS disallowed the additional amounts paid prior to this reduction, claiming that the extra payment was made subject to a contingency connected to the child and thus was child support under Sec. 71(c)(2)(A). However, the Tax Court disagreed and found "a clear and direct relationship between the amount of spousal support payments and his former wife's choice to work." Therefore, the contingency under which the support payments were reduced was connected to the ex-wife, not the child, so the payments were alimony.

Ringbloom33shows the danger of not considering the tax consequences of special provisions in divorce or separation agreements. The taxpayer separated from his wife in October 2008 and subsequently lost his job, making it difficult for him to pay the agreed spousal support. Therefore, in April 2009, the couple agreed to an amended decree of legal separation to ensure that the wife received the payments. The taxpayer agreed to make 48 monthly payments of $2,289, with the first 17 months of payments "prefunded" by transferring his interest in an IRA worth $38,913 to his spouse. The taxpayer's first direct payment was to be made on Sept. 1, 2010. There is no mention of whether the taxpayer claimed an alimony deduction in 2009. However, in 2010, he claimed $27,468 (12 × $2,289) as an alimony deduction. On examination, the IRS allowed only $6,920, the amount actually paid by the taxpayer via check in 2010.

The Tax Court found two reasons for supporting the IRS's determination. First, the court noted that the transfer of an interest in an IRA generally is a nontaxable transfer of property incident to divorce under a divorce or separation instrument and not a cash payment as required for alimony characterization under Sec. 71(b). However, even if the transfer of the IRA interest qualified as "payment in cash" under Sec. 71(b), payments of lump-sum alimony are deductible in the year made—in this case, 2009. Second, the agreement did not mention what would happen if the spouse died before the conclusion of the 17-month period ending Sept. 1, 2010. Presumably, the court noted, her estate or beneficiaries would receive the balance of the funds in the IRA, and that would be contrary to the requirement in Sec. 71(b)(1)(D).

Sec. 262: Personal, Living, and Family Expenses

In Peterson,34 an attorney pilot's business deductions for airplane-related expenses reported on Schedule C, Profit or Loss From Business, were argued. The taxpayer included among his "repair" expenses a donation to a church; court fees; parking costs; receipts with notations for expenses for meals, hotels, and transportation; and the cost of flight training to become instrument-rated. The court found that these expenses were not only mostly personal but also that the taxpayer had failed to substantiate them properly.

Sec. 263: Capital Expenditures

The taxpayer in Peterson, discussed under Sec. 262, was also disallowed repair and maintenance expenses he claimed as home office deductions attributable to his law practice. The taxpayer argued that replacing the sewer line and fence at his residence constituted deductible repairs made to restore the property to operating condition because his family could not live in the house without a sewer that worked. The court held that replacing the sewer line and fence counted as improvements or betterments made to increase the value of the property, requiring capitalization under Sec. 263(a)(1).

Sec. 274: Disallowance of Certain Entertainment, etc., Expenses

In Lussy,35 the Tax Court denied a self-employed real estate appraiser's business deductions for depreciation, interest, repairs, and certain other expenses due to a lack of substantiation. The taxpayer did not maintain records of his expenses and could not prove they were ordinary and necessary expenditures paid or incurred for carrying on a trade or business. The court also denied the taxpayer's travel expenses because of the absence of adequate records required under Sec. 274(d) to support each expense's amount, time and place, and business purpose.

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

In Van Malssen,36 the taxpayers deducted expenses related to the rental of their condominium. As a general rule, no deduction is allowed for personal use of a residence by a taxpayer (Sec. 280A(a)). If a taxpayer rents a residence and also uses it for personal purposes in a year, a limited deduction for rental expenses for the residence is allowed. The amount of rental expenses that the taxpayer can deduct is limited to an amount that bears the same relationship to the expenses as the number of days during the year that the residence is rented at a fair rental bears to the total number of days during the year that the residence is used. Days spent performing repairs and maintenance on a substantially full-time basis generally do not count as days of use (Sec. 280A(d)(2), flush language). For purposes of computing the limitation ratio, the IRS argued that days the taxpayer spent traveling to the residence to perform repairs and maintenance counted as days of use, while the taxpayers claimed they did not.

The court reasoned that if days spent performing repairs and maintenance were not days of use, then days spent traveling to the property for the principal purpose of performing maintenance and repairs also should not count as personal-use days. Accordingly, to determine the days of use, the court was required to analyze whether travel days of the taxpayer to and from the condominium on mixed-purpose trips counted as personal-use days or repairs-and-maintenance days. The court stated that travel days would escape classification as days of use only if the principal purpose of the trip as a whole was to perform repairs and maintenance. Ultimately, the court determined that travel days for mixed-purpose trips were not days of use when the days the taxpayer spent working on the trip outnumbered the days spent vacationing during it.

In another Tax Court case, Savello,37 all rental real estate loss deductions were disallowed. Personal use is deemed under Sec. 280A(d)(2)(C) when a residence is rented to any member of the family of the taxpayer for less than fair value. In Savello, the taxpayer rented bedrooms to her daughters at one of the taxpayer's properties at fair rental value. However, the taxpayer often failed to collect rent from her daughters and occasionally occupied the dwelling herself. Because she failed to produce any evidence substantiating how much rent was collected or how many days she personally resided in the dwelling, the court concluded that the taxpayer had failed to meet the burden of showing that her personal use of the property did not exceed 14 days or 10% of rental days. The property taxes and mortgage interest on the property that were disallowed on Schedule E, Supplemental Income and Loss, were instead allowed as itemized deductions on Schedule A.

In McClellan,38 the taxpayers were not entitled to home office deductions for their consulting business for call centers. The taxpayers maintained a permanent residence in Gulfport, Miss. The business entered into a temporary consulting agreement with another call center business based in New York City. The taxpayers rented an apartment in New York City to provide the consulting services to the client business and other call center companies. The taxpayers incurred duplicative living expenses while working away from their residence in Gulfport.

The Tax Court agreed that the taxpayers could deduct rent and utilities expenses for the New York City apartment as lodging expenses incurred while traveling away from home for their business because Gulfport was their tax home. The taxpayers, however, were not allowed home office deductions claimed for the apartment because the court allowed a deduction for lodging away from home with respect to it, and the taxpayers did not provide evidence they incurred additional home office expenses for it. The court also disallowed their home office deduction with respect to their Gulfport home for one year because they did not substantiate that a portion of their home was used exclusively and on a regular basis for business or inventory purposes as required under Sec. 280A(c)(1).

During one year at issue, the husband wrote for his publication company from both the New York City apartment and the Gulfport residence and claimed a home office deduction for the writing activity. The publication company reported no income, so the court disallowed the home office deduction under Sec. 280A(c)(5), which limits the deduction to the gross income derived from that activity.

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

In Howard,39 a commercial truck driver claimed deductions for certain unreimbursed employee business expenses including per diem expenses while on the road, hotel expenses, and truck stop electrification (TSE) expenses. TSE allows drivers to power their vehicles while resting or otherwise stopped without having to idle their engines during the U.S. Department of Transportation's mandated 10 hours of rest for every 14 hours of driving per day. The IRS disallowed the TSE deduction as an unreimbursed travel expense (that was nondeductible because he had no tax home to be away from), maintaining that it was equivalent to hotel expenses. However, the taxpayer argued that the TSE expenses were more analogous to a diesel fuel expense since the driver must power the vehicle during those 10 hours for business reasons. The court agreed with the IRS that the taxpayer had no tax home because he had no principal place of business or permanent residence but found, as the taxpayer argued, that the TSE expenses were unreimbursed business expenses, not travel expenses, and thus the expenses were deductible. The court also found that because Sec. 280F(d)(4)(C) specifically excludes "property substantially all of the use of which is in a trade or business of providing to unrelated persons services consisting of the transportation of persons or property for compensation or hire," that the TSE deduction was not subject to the heightened substantiation requirements of Sec. 274(d)(4) because the expense was related to his truck.

Sec. 469: Passive Activity Losses and Credits Limited

In Williams,40 the taxpayer reported for 2009 and 2010 passive income from an S corporation that leased real estate to a C corporation, both of which the taxpayer owned 100%. The C corporation provided health care services to the local community, and it paid wages to the shareholder/taxpayer for his services. The taxpayer offset the passive rental income of the S corporation against other passive losses incurred during the years at issue.

Under Sec. 469(a), net passive losses of individuals and certain other taxpayers can be used to offset only passive income, with disallowed losses suspended and carried forward until passive income occurs or the activity is completely disposed. To prevent manipulation of income and expenses, the self-rental rules of Regs. Sec. 1.469-2(f)(6) require nonpassive treatment for net rental income from the rental of property to a business in which the taxpayer materially participates. In Williams, the issue was whether the net income from a rental activity of an S corporation could offset other passive losses of the taxpayer, thus reducing his current-year tax liability.

The taxpayer argued that Sec. 469 does not, on its face, apply to S corporations, and, consequently, Regs. Sec. 1.469-4(a), defining a taxpayer's activities for passive activity purposes to include those conducted through an S corporation, was invalid. The taxpayer further argued, citing Dirico,41 that the S corporation was not involved in the business of the C corporation and did not materially participate in its activities, so the self-rental rules did not apply.

The Tax Court upheld the IRS's determination that the taxpayer's reported passive income from the S corporation should be reclassified as nonpassive under the self-rental rule of Regs. Sec. 1.469-2(f)(6). The court, citing many of its own cases, found that it was well-settled that the passive activity rules of Sec. 469 applied to passthrough entities. With regard to the taxpayer's second argument, the court, citing Shaw,42 further found that the self-rental rule applied where a taxpayer controlled both sides of rental transactions as lessor and as an officer of the lessee businesses. The court stated that the taxpayer had misinterpreted Dirico and that Regs. Sec. 1.469-2(f)(6) does not require the distinct passthrough entity to participate.

In Lamas,43 the Tax Court held that a taxpayer materially participated in two business entities. The taxpayer owned 20% interests in a real estate development S corporation and a condominium project LLC that generated large losses in 2008. He treated his portion of those losses as nonpassive and carried them back to 2006, generating a tentative refund for that year exceeding $5.2 million. On examination, the IRS held that the 2008 losses were passive rather than nonpassive and issued a notice of deficiency for 2006 for approximately $4.9 million.

At trial, the taxpayer did not supply contemporaneous records of his participation in the business entities but did provide telephone records and the testimony of 10 witnesses on the nature and extent of his activities. The IRS claimed the taxpayer did not materially participate in the S corporation or LLC, citing the lack of written substantiation and the contrary testimony of one of the witnesses. Also, the IRS argued that a significant portion of the taxpayer's activities were investor hours and thus excluded from being considered participation under Temp. Regs. Sec. 1.469-5T(f)(2).

The court sided with the taxpayer, noting that Temp. Regs. Sec. 1.469-5T(f) does not require contemporaneous records and determining that the witnesses' testimony was credible and supported the taxpayer's position. The witnesses included business associates, the taxpayer's entity's CPA, an ex-mayor of Miami—Dade County, investors, members of the taxpayer's entity's board of directors, and the taxpayer's spouse, the totality of which supported the taxpayer's contention of his material participation and real estate professional status.

Additionally, the court, citing Temp. Regs. Sec. 1.469-5T(f)(2), explained that an individual's investor hours are treated as participation in an activity if the "individual is directly involved in the day-to-day management or operations of the activity." Finding that the taxpayer was involved in the day-to-day management of the activity, the court included all of his investor hours in determining whether he met the participation tests under Sec. 469.

Two other Tax Court cases remind taxpayers and their advisers how credible testimony can establish tax-favorable treatment as a real estate professional under Sec. 469(c)(7)(B). If a taxpayer meets this requirement, his or her rental activities will not be considered per se passive. To be a real estate professional, the taxpayer must perform:

  • More than one-half of all the personal services he or she performs in trades or businesses during the tax year in real property trades or businesses in which he or she materially participates; and
  • More than 750 hours of services during the tax year in real property trades or businesses in which he or she materially participates.

CPAs should recommend that clients keep well-supported logs and calendars for their real estate and business activities and impress upon them the importance of such records' credibility. Temp. Regs. Sec. 1.469-5T(f)(4) states that "an individual's participation in an activity may be established by any reasonable means" that are not limited to contemporaneous logs or similar documents. However, it has been established in the Tax Court that "ballpark guesstimates" after the fact do not provide sufficient evidence to substantiate participation.44

In Lewis,45 the Tax Court held that the taxpayer qualified as a real estate professional despite his lack of a contemporaneous log or calendar. The taxpayer was disabled (60%, as a military veteran) and unemployed except for managing a triplex apartment next door to his home. The taxpayer testified that he performed all routine maintenance and repairs on the triplex and the normal duties of property management and tenant communications, and that these totaled more than 750 hours annually.

The IRS denied the taxpayer's status as a real estate professional, claiming that he had overstated the hours spent on the activity, particularly since it involved only a single building, and that no documents supported his claim.

The court determined that since the taxpayer had no other business activities, he met the first requirement to be a real estate professional. The court also concluded that he met the second requirement, finding that although a person who is not disabled may be able to complete the activities he described in substantially less than 750 hours, his testimony concerning the time required for him to maintain and manage the property was credible.

However, a different result occurred for the taxpayers in Lopez,46 who produced logs of activities that were reconstructed from their daily planners. The IRS rejected these, and the court agreed, stating the logs and documents were not credible and that their hours were therefore not includible in the taxpayers' participation hours. The records contained discrepancies and included hours and costs for work done on nonrental properties.

Sec. 529A: Qualified ABLE Programs

ABLE accounts are similar to Sec. 529 plans but are for the benefit of disabled persons whose disability occurs before age 26, to maintain their long-term health and quality of life. Nondeductible contributions up to the annual gift exclusion under Sec. 2503(b) ($14,000 for 2015) are allowed. An eligible beneficiary must be the owner of the ABLE account. Payouts are tax-free if spent for housing, transportation, education, job training, and other "qualified disability expenses."

In June 2015, the IRS issued proposed regulations (REG-102837-15) on Sec. 529A. Among other matters, the proposed regulations clarify that if the eligible beneficiary is unable to establish the account, the individual's agent under a power of attorney or, if none, a parent or guardian may establish the account for the individual. Such persons with signature authority over the account may not have any beneficial interest in the account and must administer it solely for the beneficiary's benefit.

Sec. 1001: Determination of Amount of and Recognition of Gain or Loss

In Costello,47 the Tax Court held that basis in a sale of farmland development rights should be determined in accordance with Rev. Rul. 77-414 rather than "equitably apportioned among the several parts" of the land according to W.C. & A.N. Miller Development Co.48 In Rev. Rul. 77-414, which the court noted dealt with a similar sale, the IRS ruled that because it was not possible to allocate the basis in the property in question between the development right to be conveyed and the interests to be retained, the amount received in consideration for the transfer of the development right should be applied to reduce the taxpayer's basis in the land.

In Dudek,49 the Third Circuit affirmed a Tax Court decision in which an oil and gas lease bonus payment the taxpayers received was characterized as ordinary income rather than long-term capital gain, as the taxpayers had reported it. The Third Circuit pointed to Burnet v. Harmel,50 in which the Supreme Court held that bonus payments made as part of an oil and gas lease are ordinary income, as well as its own precedent in Laudenslager.51 In the latter case, the court stated, "Where the owner of the land retains an economic interest in the deposits, the transaction is regarded as a lease and the proceeds are taxable as ordinary income, subject, under certain conditions, to a deduction for depletion." The taxpayers also claimed they were entitled to a depletion deduction but did not provide any evidence to support that claim, and so the court held that they were not entitled to the deduction.

Sec. 1045: Rollover of Gain From Qualified Small Business Stock to Another Qualified Small Business Stock

The Ninth Circuit affirmed a Tax Court ruling in which an individual was not allowed to defer the recognition of capital gain under Sec. 1045.52 The taxpayer was unable to show (other than by his own testimony) that he met the requirements for Sec. 1045 deferral of qualified small business stock, which include acquiring the original issue of stock in the corporation and that at least 80% of the assets of the corporation are used in the active conduct of a qualified trade or business.

Sec. 1221: Capital Asset Defined

In Long,53 the Eleventh Circuit reversed part of a Tax Court decision in which an individual taxpayer's assignment of his position in a lawsuit was treated as ordinary income. The IRS had argued that the proceeds from the assignment agreement, in which the taxpayer assigned his position as plaintiff in a lawsuit to enforce a land purchase contract, were ordinary income because they were a lump-sum substitution for ordinary income that he would have earned from developing the property. The Tax Court, while holding that the income from the assignment was ordinary, did not adopt the IRS's theory. It instead treated the sale as a sale of the land underlying the purchase contract and held that the income from the sale was ordinary income because the taxpayer had intended eventually to sell the land in the ordinary course of his business.

The Eleventh Circuit found that the Tax Court had erroneously considered the property at issue to be the land underlying the purchase right. Rather, it determined that the property sold was the right to purchase the land, which was a capital asset under Sec. 1221. Because the taxpayer did not hold the contractual right as an asset primarily for sale to customers in the ordinary course of business, the income from its sale was not ordinary income.

Despite the Tax Court's rejection of it, the IRS again pressed its substitution-for-ordinary-income doctrine argument on appeal. However, the Eleventh Circuit concluded that the doctrine did not apply because the right sold was the right to earn income in the future, not a future right to income that had already been earned.

Sec. 1235: Sale or Exchange of Patents

In Cooper,54 the Tax Court did not allow husband and wife taxpayers to treat royalty income as capital gain under Sec. 1235, which allows a transfer (other than by gift or inheritance) of all substantial rights to a patent by any holder to be treated as a sale or exchange of a capital asset held for more than one year, regardless of whether payments are contingent on the productivity, use, or disposition of the property in the transfer. The taxpayer husband was an engineer and inventor who held patents to his inventions. The taxpayers established a corporation to which the husband transferred rights to the patents. The Tax Court held that the taxpayers failed to meet their burden of proof to establish that all substantial rights were transferred, since the taxpayer husband had indirect control over the corporation.

Sec. 5000A: Requirement to Maintain Minimum Essential Coverage

In Hotze v. Burwell,55 the Fifth Circuit vacated a district court's decision on a challenge to the individual and employer mandate provisions of the Patient Protection and Affordable Care Act,56 finding that the plaintiffs lacked standing or were barred from suing. Steven Hotze, a doctor, and his employer, Braidwood Management Inc., argued that the law is unconstitutional because it started in the Senate via amendment rather than the House of Representatives, violating the origination clause of the U.S. Constitution that requires "bills for raising revenue" to originate in the House. The individual mandate under Sec. 5000A requires individuals to either maintain health insurance or pay a penalty. The employer mandate under Sec. 4980H requires employers under some circumstances to either provide affordable health insurance coverage to their employees or pay a tax. The district court rejected the plaintiffs' argument and ruled that both provisions were constitutional in light of the origination clause. On appeal, the Fifth Circuit determined that the plaintiffs lacked standing to challenge the individual mandate and that the Anti-Injunction Act barred the challenge to the employer mandate. As a result, the Fifth Circuit vacated the district court's judgment and remanded the case to that court with instructions to dismiss the complaint for lack of jurisdiction.   

Footnotes

1IRS Letter Rulings 201450013 and 201523014.

2Shah,T.C. Memo. 2015-31.

3Wyatt, T.C. Summ. 2015-31.

4Mottahedeh,T.C. Memo. 2014-258.

5Hiramanek, No. 12-70325 (9th Cir. 12/18/14), aff'g T.C. Memo. 2011-280.

6Peterson,T.C. Memo. 2015-23.

7Resnik,T.C. Summ. 2015-11.

8Hampers,T.C. Memo. 2015-27.

9Milbourn,T.C. Memo. 2015-13.

10McKnight,T.C. Memo. 2015-47.

11El, 144 T.C. No. 9 (2015).

12Morles, T.C. Summ. 2015-13.

13Brinkley,T.C. Memo. 2014-227.

14McCarthy, T.C. Memo. 2015-50.

15Powell,T.C. Memo. 2014-235.

16Duffy, 120 Fed. Cl. 55 (2015).

17Perez, 144 T.C. No. 4 (2015).

18Campbell,T.C. Summ. 2014-109.

19Freedom From Religion Foundation, Inc., 773 F.3d 815 (7th Cir. 2014), vacating and remanding No. 12-C-0818 (W.D. Wis. 7/29/14).

20Johnston,T.C. Memo. 2015-91.

21Bacon,T.C. Summ. 2015-15.

22Maines,144 T.C. No. 8 (2015).

23Elbaz,T.C. Memo. 2015-49.

24Villegas,T.C. Memo. 2015-33.

25Crawford, T.C. Memo. 2014-156.

26Langert, T.C. Memo. 2014-210.

27Kunkel, T.C. Memo. 2015-71; Jalloh, T.C. Summ. 2015-18; and Smith,T.C. Memo. 2014-203.

28Evans,T.C. Memo. 2014-237.

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

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

31Iglicki,T.C. Memo. 2015-80.

32Wish, T.C. Summ. 2015-25.

33Ringbloom, T.C. Summ. 2015-12.

34Peterson, T.C. Memo. 2015-1.

35Lussy, T.C. Memo. 2015-35.

36Van Malssen, T.C. Memo. 2014-236.

37Savello, T.C. Memo. 2015-24.

38McClellan, T.C. Memo. 2014-257.

39Howard, T.C. Memo. 2015-38.

40Williams, T.C. Memo. 2015-76.

41Dirico, 139 T.C. 396 (2012).

42Shaw, T.C. Memo. 2002-35.

43Lamas, T.C. Memo. 2015-59.

44See, e.g., Moss, 135 T.C. 365 (2010).

45Lewis, T.C. Summ. 2014-112.

46Lopez, T.C. Summ. 2015-22.

47Costello, T.C. Memo. 2015-87.

48W.C. & A.N. Miller Dev. Co., 81 T.C. 619 (1983).

49Dudek, No. 14-1597 (3d Cir. 12/24/14).

50Burnet v. Harmel, 287 U.S. 103 (1932).

51Laudenslager, 305 F.2d 686 (3d Cir. 1962).

52Holmes, 593 Fed. Appx. 693 (9th Cir. 2015).

53Long, No. 14-10288 (11th Cir. 11/20/14).

54Cooper,143 T.C. No. 10 (2014).

55Hotze v. Burwell, No. 14-20039 (5th Cir. 4/24/15), vacating and remanding 991 F. Supp. 2d 864 (S.D. Tex. 2014).

56Patient Protection and Affordable Care Act of 2010, P.L. 111-148.

 

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 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. 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 E. ­Taylor is a partner at Anton Collins Mitchell LLP 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 article, contact Mr. Rubin at ken.rubin@rubinbrown.com.

 

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