Individual Taxation Report

By Ellen Cook, MS, CPA; Anna C. Fowler, CPA, MBA, Ph.D.; Jonathan Horn, CPA; Annette Nellen, CPA, Esq.; Darren L. Neuschwander, CPA, MST; Nora Stapleton, CPA, MST; and Joseph W. Walloch, CPA, MBA, MBT

Executive Summary

  • The American Recovery and Reinvestment Act of 2009 contained a number of changes to individual income tax provisions. The act changed the rules for many credits (such as the child tax credit) and introduced the new making work pay credit in Sec. 36A. It also increased the AMT exemption amounts, increased the NOL carryback period for eligible small businesses, and added a standard deduction for taxes on qualified motor vehicles.

  • In response to current events, the IRS issued a revenue procedure and a revenue ruling dealing with the treatment of losses from Ponzi schemes; however, the guidance leaves many questions unanswered.

  • The Tax Court rebuffed the IRS in two innocent spouse cases, holding in one that the regulatory two-year limitation for seeking equitable innocent spouse relief was invalid and in the other that the standard of review in a case where the taxpayer is challenging a denial of innocent spouse relief is the de novo standard instead of the abuse of discretion standard.

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

Sec. 24: Child Tax Credit

While the amount of the child tax credit remains at $1,000 per dependent child under age 17, under the American Recovery and Reinvestment Act of 2009 (ARRA),1 the refundable portion is increased for tax years 2009 and 2010. Specifically, the child tax credit is refundable to the extent of 15% of the taxpayer’s earned income in excess of $3,000 (lowered from $8,500). Beginning for tax year 2009, a qualifying child for the purposes of the child tax credit must also be the taxpayer’s dependent.

Sec. 25A: Hope and Lifetime Learning Credit

Effective for tax years beginning after December 31, 2008, the Sec. 25A Hope credit, renamed the American opportunity tax credit by ARRA, is increased to a maximum of $2,500 per year (100% of the first $2,000 of qualifying expenses and 25% of the next $2,000), with 40% of the credit refundable.

The credit phases out for taxpayers with adjusted gross incomes (AGIs) between $80,000 and $90,000 ($160,000 and $180,000 for married taxpayers filing jointly). ARRA extended the credit to all four years of college and expanded the definition of qualifying expenses to include course materials. Congress has directed Treasury to study (1) how to coordinate the education credits with the federal Pell Grant program and (2) the feasibility of requiring students to perform community service for purposes of the education credits.

Secs. 25C and 25D: Residential Energy Credits

ARRA included changes to a range of energy tax incentives for individuals and businesses, including credits for installing energy-efficient equipment or building components (Sec. 25C) and residential energy- efficient property (Sec. 25D), plug-in electric drive vehicles (Sec. 30D), and renewable energy production (Sec. 45).

Sec. 32: Earned Income Credit

For tax years 2009 and 2010, the earned income tax credit percentage for families with three or more qualifying children is increased from 40% to 45%.2

Sec. 36: First-Time Homebuyer Credit

Effective for home purchases after December 31, 2008, and before December 1, 2009, ARRA increased the amount of the first-time homebuyer credit from $7,500 to $8,000 ($4,000 for married taxpayers filing separately). A first-time homebuyer is an individual who had no ownership interest in a principal residence in the United States during the three-year period prior to the purchase of the home to which the credit applies. The taxpayer may elect to take the credit on the 2008 return by treating the purchase as though it were made on December 31, 2008.

Further, taxpayers who remain in the home for 36 months are not required to repay the credit. In any case, no amount is required to be recaptured after the death of the taxpayer. The credit phases out for AGI between $75,000 and $95,000 ($150,000 and $170,000 AGI for joint filers).

Notice 2009-123 explains how to divide the new homebuyer’s credit when two or more unmarried individuals purchase the principal residence. The notice provides several examples on how to claim the credit.

Sec. 36A: Making Work Pay Credit

New Sec. 36A allows a credit against income tax in the amount of the lesser of 6.2% of an individual’s earned income or $400 ($800 for married filing jointly). Net earnings from self-employment that are included in taxable income qualify. In addition, earned income for these purposes includes combat pay excluded from gross income under Sec. 112.

Effective for tax years 2009 and 2010, the credit is intended to effectively offset an individual’s share of FICA on the first $6,452 of earnings. The credit is phased out at a 2% rate for individuals whose modified adjusted gross income exceeds $75,000 ($150,000 for married taxpayers filing jointly). The credit is not available to nonresident aliens, individuals who may be claimed as a dependent by another taxpayer, or any estate or trust. It may be claimed through a reduction in wage withholding or in a lump sum on the tax return filed for the year the wages were earned.

The credit will be reduced by the onetime economic recovery payments of $250 provided by the Veterans Administration, Railroad Retirement Board, and Social Security Administration under ARRA Sections 2201 or 2202. New Schedule M, Making Work Pay Credit and Government Retiree Credits, is used to be sure the proper credit amount is claimed.

Sec. 55: Alternative Minimum Tax

ARRA increased the AMT exemptions for 2009 to $70,950 for a joint return, $46,700 for single taxpayers and heads of household, and $35,475 for married taxpayers filing separately. Commonly referred to as the “AMT patch,” this measure comes with an estimated cost of $70 billion to provide AMT relief to an estimated 26 million taxpayers. ARRA also extends the rule allowing nonrefundable personal tax credits to offset AMT to tax years beginning in 2009.

Sec. 56: Adjustments in Computing AMT

A change enacted as part of ARRA allows for up to a five-year carryback of AMT net operating losses (NOLs) of eligible small businesses for tax years beginning or ending in 2008.4 However, the 90% limit on use of AMT NOL did not change (a proposal to change to 100% did not become law).

Sec. 57: Items of Tax Preference

Interest income from private activity bonds issued in 2009 and 2010 will not be a tax preference item.5 This also includes bonds issued in 2009 and 2010 to refund a bond issued from 2004 to 2008.

Sec. 61: Gross Income Defined

School board reimbursements: The IRS stated that parents of a disabled child who received reimbursement from the school board per the Individuals with Disabilities Education Improvement Act of 2004 (IDEA) did not have to include the payments in income.6 The information letter states, “It is also a long-standing position of the Internal Revenue Service that in a nonemployment context, reimbursements for expenses incurred by a taxpayer on behalf of another are not includible in the taxpayer’s gross income.” These types of payments have been held to be, in essence, those of the school board because it is obligated to provide the services. Thus, when the board reimburses the parent for incurring the payments, such payments are not income.7

Katrina incentive payments: In another information letter, the taxpayer received an incentive payment under the Deficit Reduction Act of 2005,8 where the secretary of Health and Human Services provided $50 million to Louisiana for health care due to Hurricane Katrina.9 The state used the funds to entice health care professionals to the area. Payments were for sign-on bonuses, malpractice insurance, relocation costs, and technology. The Service noted that there was no exclusion for such payments and that Sec. 6159 and the filing of Form 9465, Installment Agreement Request, provide the only relief by possibly allowing the taxpayer additional time to pay his or her tax liability.

Jury duty travel allowance: The IRS affirmed that an individual does not need to include in gross income any mileage and subsistence allowance received for jury duty.10 The rationale is per Jernigan,11 which held that such payments were not similar to nondeductible commuting expenses but instead were to enable the court to carry out its functions. However, the payment for jury service (attendance fee) is taxable.

Statutory contingency payment: A payment by an employer to the employee’s attorney was held to be gross income to the employee.12 The Ninth Circuit reasoned, “Green’s employer’s payment to her attorney (whether court-ordered or not) reduced her own payment obligation accordingly and was thus constructively received by Green.” This treatment led to an AMT consequence for Green. While the court noted that it was sympathetic, it was unable to change the “unfairness” of the result.

Personal injury awards: Due to a stoppayment order on a check to purchase a used car that turned out to be defective, wife (W) was arrested for an insufficient funds check.13 The charges were later dropped. While W was held against her will, she suffered no physical injury. She did see a psychologist a few times, with the charges covered by her medical insurance. W brought suit against the car dealer and the bank. Through mediation, she was awarded $49,000 from the bank.

W was told by her attorney, the mediator, and the bank’s attorney that the settlement was not taxable. Husband (H) and W self-prepared their tax return and did not report the $49,000 settlement award. The bank did issue W a Form 1099-MISC, Miscellaneous Income, noting the settlement amount. H and W later received a deficiency notice from the IRS.

At issue was whether the settlement proceeds were excludible under Sec. 104(a)(2). A two-part test must be met for an award to be excluded under Sec. 104(a) (2): “(1) The underlying cause of action giving rise to the settlement award must be based upon tort or tort type rights, and (2) the damages must be received on account of personal physical injuries or physical sickness.”14

H and W contended that the claim against the bank was for breaching its fiduciary duty of care by incorrectly marking a $1,100 check as for insufficient funds. They also contended that the bank paid for W’s physical restraint and detention, which is a tort.

The court noted that a breach of a fiduciary duty can involve both tort and contract claims. It stated that W brought the action against the bank due not to financial loss but to damages tied to her arrest, which produced tort-type injuries such as “emotional distress, mental anguish, mortification, humiliation, and damage to reputation.” Thus, the court found that W received the bank settlement proceeds “for claims based on tort or tort type rights.” However, the court did not find that W suffered physical injury as required for exclusion of the award under Sec. 104(a)(2).

H and W also argued that the settlement was not gross income under Sec. 61 and that Sec. 104 was unconstitutional. The court found these claims invalid. Citing Murphy 15 and other cases, the court noted that “the taxation of awards received for personal, nonphysical injury [is] within the power of Congress and that such a tax [is] not subject to the apportionment requirement and [is] uniform.”

Finally, the court held that H and W were not liable for the Sec. 6662 substantial understatement of tax penalty. It noted that three different individuals had told them that the settlement was not taxable, with two of these individuals being disinterested parties with no relationship to H and W. While none of these parties was a tax expert, they each had experience with personal injury actions and settlements. It was reasonable for H and W to rely on their statements in good faith. The court also found that “reasonable persons could disagree as to whether additional advice was required” in preparing their tax return. Finally, “receipt of Form 1099 should not preclude a finding of reasonable cause.”

Sec. 63: Taxable Income Defined

Taxpayers may deduct “qualified motor vehicle taxes,” defined as state or local sales or excise taxes imposed on the purchase of a new qualified motor vehicle. The vehicle must be a passenger car, light truck, or motorcycle weighing 8,500 pounds or less or a motor home. The taxpayer must acquire the vehicle after February 17, 2009, and before 2010. The deduction is limited to the first $49,500 of the purchase price.

Taxpayers who itemize and elect to deduct sales tax rather than income tax may not claim the additional standard deduction for the vehicle sales tax. The deduction phases out for individuals with modified AGI between $125,000 and $135,000 ($250,000 and $260,000 if married filing jointly). The additional standard deduction is also allowed for AMT purposes; guidance is needed as to whether the deduction is available to itemizers in calculating AMT.

Sec. 68: Overall Limitation on Itemized Deductions

In a news release on April 7, 2009, the IRS reversed a previous position.16 It has decided that a taxpayer can deduct convenience fees associated with the electronic payment of federal tax, including payment of estimated tax, as a miscellaneous itemized deduction. Accordingly, taxpayers that are able to file Schedule A, Itemized Deductions, and deduct miscellaneous deductions in excess of 2% of their AGI will get a tax deduction for these fees.

Credit or debit card convenience fees charged for paying taxes electronically vary but average about 2.5% of the tax payment. The fees are deductible in the year they occur.

Most individuals still pay their federal tax obligations by check, but last year more than 4 million taxpayers paid their taxes electronically, according to the news release.

Sec. 85: Unemployment Compensation

For 2009, $2,400 of unemployment compensation is excluded from tax.17

Sec. 162: Trade or Business Expenses

Travel expenses: In a decision by the Seventh Circuit, an airline mechanic was denied deductions for travel expenses because he had no business reason to live in two places at once.18 The taxpayer had been employed with Northwest Airlines in Minneapolis and lived nearby in Wisconsin. Northwest laid him off in 2003. He was able to obtain a few short stints of employment with Northwest by bumping mechanics over whom he had seniority, but then he was bumped. Later, he obtained a position for several months with Northwest in Anchorage.

The taxpayer also had a real estate business in Minneapolis that produced $2,000 of income for 2003. He deducted travel expenses associated with his employment away from Minneapolis. The Seventh Circuit affirmed the Tax Court in denying travel away from home deductions. The court applied the business exigencies rule and determined that the taxpayer had no business reason to live in two places at once. The court rejected the “temporary vs. indefinite” and “personal choice vs. reasonable response” tests for deductibility. The court did not view the real estate activities as being a business that would lead to the Minneapolis area being his tax home.

Payments to corrections center: In a private letter ruling, the taxpayer, a former prisoner, was assigned to live in a community corrections center (CCC).19 To live at the CCC he had to agree to abide by all its rules, one of which was to pay 25% of his weekly gross income to the CCC. The taxpayer requested a ruling that the payments would be deductible under Sec. 162 as trade or business expenses or under Sec. 212 as expenses of producing income. The IRS ruled that a deduction was not available under either section. It reasoned that the payments were not related to the performance of his job but rather were “inherently personal.” For the same reason—that they were personal in nature—they were not deductible under Sec. 212 either.

Education expenses: In a Tax Court case, the taxpayer had been employed in the profession of human resources for at least 12 years.20 While employed at Weyerhaeuser Co. as a human relations generalist, she enrolled in a doctorate of education program; she was not required to do so as a condition of employment. Furthermore, the taxpayer acknowledged to the court that her intention upon completing her doctorate degree was to become a consultant. She further admitted to receiving job offers for two teaching positions once she received the degree. While agreeing that the educational program would improve the taxpayer’s skills in her existing trade or business, the Tax Court held that it also allowed her to become qualified in a new trade or business and thus was no longer deductible as an ordinary and necessary business expense.

IRS litigation tactics: In another Tax Court case, an aspiring comedian/actor worked primarily as a pharmaceutical rep and nurse during the year in question.21 On its face, this was a simple hobby loss case; however, the IRS abandoned that line of reasoning after trial because the taxpayer was able to present sufficient evidence from later years that he intended to profit from performing as a comedian/actor. On brief, the Service abandoned the Sec. 183 argument and contended that the activity was not a going concern in the year in question (2003) within the meaning of Sec. 162. The taxpayer did not file a brief. Because almost all the evidence presented by the taxpayer related to later years or was of doubtful accuracy, the court ruled that the taxpayer had not satisfied the requirements laid down in McManus 22 and denied the deduction for all his 2003 expenses.

Practice tip: The lesson to be learned is “watch your back.” Do not assume that just because the client has sufficient evidence to refute the original argument, the IRS will not change course in the middle of an appeal.

Taxpayer testimony: Another seemingly run-of-the-mill Tax Court case had a twist.23 This was a simple substantiation of business expense case. Both sides made some concessions before trial. In the court’s view, the taxpayer testified openly, honestly, and consistently. He admitted to numerous errors and mistakes that were not in his best interest. Therefore, the court was willing to accept his testimony to resolve most of the unresolved deductions in his favor, with the key exception of claimed rental expenses. It held that there was no proof of a bona fide rental. The court also upheld the imposition of penalties under Sec. 6662(a) due to “negligence or disregard of rules or regulations.” For this finding, the taxpayer’s open and honest testimony worked against him. Many of the errors he admitted (deducting the cost of care for his dogs, deducting wedding and birthday gifts, failing to report income) were cited as evidence that he did not act with reasonable care and in good faith.

Finally, the court cited the fact that the taxpayer did not call the return’s preparer as a witness as reason to believe that the testimony could have been even more damaging to the taxpayer.

Sec. 165: Losses

Ponzi schemes: On March 17, 2009, the IRS issued Rev. Rul. 2009-9 and Rev. Proc. 2009-2024 in response to the rash of Ponzi scheme losses incurred recently, most notably in the Madoff case. While the Service deserves credit for responding so quickly to the situation (in months rather than years) and for being surprisingly favorable to taxpayers in its ruling, there remain many unresolved questions and many taxpayers holding losses from these schemes that cannot take advantage of the safe-harbor procedure provided by the Service.

First, the IRS has determined that losses from Ponzi schemes qualify as theft (rather than capital) losses from a transaction entered into for profit under Sec. 165(c)(2). Thus, they are not subject to limitation as a personal loss under Sec. 165(h). They are further exempted from the itemized deduction limitation by Sec. 68(c)(3).

Second, the Service has stated that the amount of the loss is generally equal to amounts invested, plus taxable income previously reported and reinvested in the scheme, less distributions received and reimbursements or recoveries (including expected amounts).

Third, the year of discovery for the loss is the investor’s tax year during which an indictment or complaint under federal or state criminal law is issued.

Finally, this theft loss may create an NOL. For an individual taxpayer, the IRS has declared that it may treat any NOL created as coming from a sole proprietorship business.

In the Madoff losses, 2008 is the year of discovery; thus, taxpayers who qualify as an eligible small business have the choice in the event of an NOL of electing to carry the loss back for either three, four, or five years. Eligible small businesses are businesses with gross receipts of $15 million or less.25

Rev. Proc. 2009-20 provides an optional safe-harbor procedure under which qualified investors may deduct either 75% or 95% of their qualified investment (basically amounts invested plus previously taxed income less withdrawals) less actual recoveries to date and less potential insurance/ SIPC recoveries. To deduct the 95% figure, the taxpayer must declare that he or she has not pursued and has no intention of pursuing any third-party recovery— essentially the taxpayer is giving up the right to file a lawsuit against anyone connected to the scheme. Depending on the amount of the actual future recovery, the taxpayer may have income or an additional deduction in later years.

The revenue procedure states that using the safe-harbor procedure “avoids potentially difficult problems of proof in determining how much income reported in prior years was fictitious or a return of capital, and alleviates compliance and administrative burdens on both taxpayers and the Service.”

Qualified investors: One of the main issues with the IRS guidance is the definition of a “qualified investor.” Only those individuals who invested directly with the fraudulent arrangement are included. Investors in so-called feeder funds cannot use the IRS guidance or safe-harbor procedure. However, the feeder funds themselves may meet the definition of a qualified investor. This raises the question of how and when these feeder funds should report their loss on the scheme to their investors, as well as what the character of the passthrough loss will be (capital, theft, or operating).

Tax-deferred accounts: Another area that is still unclear concerns funds invested through IRAs, pensions, and annuities. For tax-deferred accounts, it is clear that there is no loss deduction available for “phantom income” because the income was never taxed. However, consider an IRA that is now worth $0 by virtue of being fully invested in a Ponzi scheme. Can investors claim that they are withdrawing the full value of the account and claim a loss for their basis in it (reduced by any previous withdrawals)? If so, what is the nature of the loss: capital or theft? If they are under age 59½, would they be subject to a 10% early withdrawal penalty on the 25% or 15% recovery reserve amount? And what about Roth or nondeductible IRA accounts? Investors have paid tax on their contributions—are they not entitled to some recovery?

Trusts and partnerships: Trusts and partnerships that are qualified investors are another unclear area. How should they report the loss to the beneficiaries or partners? What would the character of the loss be? One assumes that a partnership would report the entire loss in 2008 and allow each partner to determine if they have an NOL and carryback. However, it is possible that the partnership might take the carryback at the top level and issue amended Schedule K-1s.

Finally, consider the case of a qualified investor who decides not to pursue legal action and uses the 95% safe-harbor option. Two years from now, he is notified that a court has declared him to be a member of a class in a class action lawsuit. Must the investor disclaim his membership to avoid charges from the Service, or may he report any class settlement as income when received?

Unfortunately, there has been no indication that the IRS is considering providing guidance on these or other questions that continue to arise from Ponzi scheme losses.

Gambling losses: In a Tax Court case, in addition to several other sources of income, married taxpayers received about $20,000 from Social Security.26 The wife won $4,000 at slots and lost more than $4,000. The taxpayers did not include the winnings in gross income or deduct the losses. They attached to their return a note disclosing their winnings. On audit, the Service included the winnings and allowed a deduction for $4,000 of losses. It also increased the amount of Social Security included in gross income by $2,494 and reduced the miscellaneous itemized deductions by $130.

The taxpayers contended that the treatment of gambling winnings and losses discriminates against the elderly and should not be enforced. They referred to casinos as being like Disneyland to the elderly. The court acknowledged that the taxpayers’ arguments raised policy issues. Nevertheless, it agreed with the IRS’s conclusions, including imposition of a $132 accuracy-related penalty.

In another Tax Court case, the taxpayer failed to file returns for three tax years despite receiving a Form W-2G, Certain Gambling Winnings, for $13,240 in 1999, $139,714 in 2001, and $459,397 in 2002.27 Just before trial, she prepared but did not file returns claiming losses exceeding winnings in 1999 and for $126,924 and $413,279 in 2001 and 2002, respectively. The taxpayer claimed to have kept contemporaneous logs that supported her claimed losses but could not produce them. Most of her winnings were for under $4,000.

The court stated, “We regard it as a virtual certainty that petitioner, playing a game of chance frequently over the course of several years, placed many losing bets in addition to her winning ones.” Citing Doffin 28 and Cohan,29 the court stated it had a duty to approximate the losses. Its determination was to allow losses equal to 60% of the amounts reported on the Forms W2-G for each year.

This continues a trend of the court allowing an increasingly greater percentage when forced to approximate a taxpayer’s gambling losses. In 2002, the court was allowing around one-third of winnings. In two cases in 2007, the figure rose to around 50%.

In a memorandum, the IRS explained that the expenses of a professional gambler are not subject to the loss limitation rule of Sec. 165(d) but to Sec. 162. Sec. 165(d) applies only to wagering losses.30

In other informal guidance, the IRS explains how a casual gambler determines the amount of winnings and losses.31 Recognizing the burden of defining “transaction” too narrowly, such as each play on a slot machine, the Service states:

The better view is that a casual gambler, such as the taxpayer who plays the slot machines, recognizes a wagering gain or loss at the time she redeems her tokens. We think that the fluctuating wins and losses left in play are not accessions to wealth until the taxpayer redeems her tokens and can definitively calculate the amount above or below basis (the wager) realized.

This advice memorandum illustrates the identification of gains and losses and netting using an example where an individual visits the slot machine on 10 separate occasions during the year. On each visit, the individual purchases $100 of slot machine tokens. Five times the taxpayer lost the entire $100. On the other occasions, the individual redeemed the tokens that remained after terminating play and received $20, $70, $150, $200, and $200. The result is that on five occasions, the taxpayer lost $500. On the occasion where the individual redeemed $20, the loss was $80. Similarly, when the individual redeemed $70, the loss was $30. The redemptions in excess of the amount gambled resulted in winnings less $100 for each visit.

Prospect of recovery: Another Tax Court case involved a taxpayer who invested with Anderson Ark (Ark) in 1999 after listening to a tape and attending a conference in Costa Rica.32 Ark operated an international fraud scheme that involved marketing phony investment programs. Various principals of Ark were arrested and indicted beginning in 2001. Convictions were obtained in 2004 and 2005, and several of the principals were ordered to forfeit property to the United States.

The taxpayer claimed a theft loss deduction for 2001 and 2002 to be carried back to 1999. The court denied a theft loss deduction for 2001 on the grounds that the taxpayer had not met the burden of establishing that “no reasonable prospect of recovery” existed at the end of 2001. It emphasized that it was reasonable in 2001 to believe that the district court might require the Ark principals, if convicted, to pay restitution to their victims, including the taxpayer, and to forfeit to the United States property that could be used for restitution.

Sec. 170: Charitable Contributions and Gifts

Religious school tuition: In a Ninth Circuit decision, the taxpayers returned to court (after a 2002 case) for a different tax year (1995) in an attempt to receive a charitable contribution deduction for some of the tuition paid to orthodox Jewish day schools.33 In 1995, they paid about $27,000 total for tuition and other charges for five children. They deducted $15,000 as charitable contributions on the grounds that 55% of the tuition payments was for purely religious education. The Ninth Circuit upheld the Tax Court’s denial of any charitable contribution deduction for the 1995 tuition. It commented, “The principle the Sklars advance does not stop with them and their 1995 taxes; its logic would extend to all members of religious organizations who benefit from educational services that are in whole or part religious in nature.”

In 1993, the Sklars learned of a confidential closing agreement between the IRS and the Church of Scientology under which the IRS allowed Scientologists deductions for costs of certain religious educational services. They amended their 1991 and 1992 returns and filed their 1993 returns to reflect a deduction for a portion of their children’s tuition to the Jewish day schools. The Service allowed the deductions, possibly because it thought the Sklars were Scientologists. On their 1994 return, the Sklars deducted some tuition payments, but the IRS denied these on the grounds the payments were for personal tuition expenses. The Sklars litigated in the Tax Court and Ninth Circuit. In this earlier round of litigation, they lost at both levels.34

Despite the closing agreement with the Church of Scientology, the Supreme Court had concluded in Hernandez 35 in 1989 that payments for educational services such as Scientologist “auditing” and “training” are forms of religious education and are ineligible for charitable contribution deductions.

In its 2008 Sklar decision the Ninth Circuit commented, “Thus, the Hernandez decision clearly forecloses the Sklars’ argument that there is an exception in the Code for payments for which one receives purely religious benefits.”

Litigation papers: In a Tenth Circuit case, the taxpayer was the lead defense attorney for Timothy McVeigh, the Oklahoma City bomber.36 The government furnished the taxpayer with discovery material (copies of FBI witness statements, FBI lab notes, photos, and computer discs) that it had organized and categorized for the benefit of the taxpayer and his client. It put the materials in banker’s boxes and explained in letters what each box contained.

Prior to donating these materials to a university, the taxpayer engaged an appraiser who valued the materials at about $295,000. The taxpayer donated the materials to the university and deducted the appraised value. The IRS reduced the contribution deduction to zero on two grounds—that the taxpayer did not own the materials and that the materials were not long-term capital gain assets. The Tax Court agreed with the IRS.

The Tenth Circuit upheld the denial of a deduction but with a slightly different rationale. The Tax Court had categorized the materials as letters, memos, etc., created by the taxpayer’s efforts and thereby precluded from capital asset status. The Tenth Circuit classified the materials as letters, memos, etc., of the taxpayer for whom they were prepared or produced. It acknowledged that they were not originally prepared for him but were later made ready for his use by the government’s work in organizing, categorizing, etc., the materials. Thus, they were not capital assets, and the taxpayer’s deduction was limited to his basis, which was zero. Because of this conclusion, the court indicated it did not need to address whether the taxpayer owned the materials.

Actuarial tables: The IRS has extended the actuarial tables for Sec. 7520 to include interest rates in the range of 0.20%–2.0%.37

Transaction of interest: The IRS has identified a transaction of interest that has the potential for avoiding tax on the gain from sale of appreciated assets using a charitable remainder trust (CRT).38 In its simplest form, a grantor creates a CRT and contributes appreciated assets to the trust. The trust sells the assets and purchases new assets. Because the CRT is tax exempt under Sec. 664, the sale is tax exempt, and the CRT’s basis in the new assets is their purchase price. Then both the CRT and the grantor dispose of their interests to an unrelated third party (transaction as described in Sec. 1001(e)(3)) for approximately the CRT’s current fair market value (FMV). The grantor takes a charitable deduction for the portion of the appreciated assets’ FMV attributable to the remainder interest on the date of contribution.

Because the entire interest in the CRT is sold, Sec. 1001(e)(1), which disregards basis in the sale of a term interest, does not apply. Furthermore, the gain on the sale is calculated using the uniform basis rules in Regs. Secs. 1.1014.-5 and 1.1015- 1(b). As a result, the grantor receives its share of the appreciated FMV of the contributed assets without any tax liability on the gain from their sale. Transactions similar to this description entered into after November 2, 2006, must be disclosed.

Preservation easement: A district court case involved an IRS denial of a charitable deduction for $216,000, the value of a preservation easement for the facade of the taxpayers’ home, due to the taxpayers’ failure to meet the Code’s substantiation requirements.39 The taxpayers claimed that they “substantially complied” and should be allowed the deduction. The failure to substantiate came in three areas. First, the taxpayers failed to produce a contemporaneous written acknowledgment of the easement donation. They provided a letter acknowledging two cash contributions and listing amounts, check numbers, and the word “easement” recorded under the type of donation. There was no statement on whether “goods or services were provided” in the letter.

Surprisingly, after initially disallowing the cash donation, the IRS withdrew its objection at trial and allowed the taxpayers to take the deduction despite the faulty acknowledgment letter. However, as to the easement, the court held that the failure to produce a contemporaneous written acknowledgment alone was sufficient to deny the deduction. The court chose to examine the other two failures to see if the taxpayers could have prevailed under their “substantial compliance” argument for those failures.

The taxpayers’ second failure was not providing the qualifications of the appraiser. The taxpayers claimed that listing the appraiser’s license number was sufficient. The court held that the regulations are very specific as to the information required. It stated that if a license number were sufficient, the regulations would not specify the additional detailed information required.40

The third failure was that the appraisal did not include a full description of the property; specifically, it was missing an attachment that described in detail the facade easement. However, that attachment was included with the executed document filed with the Cook County recorder a week later. The court stated that if this had been the only failure to comply with the substantiation requirements, it would have been reluctant to disallow the deduction. It felt that this failure would be allowable under the doctrine of “substantial compliance.”

The final ruling upheld the denial of a charitable deduction of $216,000 for the preservation easement and the imposition of a substantial underpayment penalty.

Sec. 172: Net Operating Losses

ARRA amended Sec. 172(b)(1)(H) to allow eligible small businesses to carry back a 2008 NOL up to five years instead of the otherwise available two-year limit.

In April, the IRS issued a clarifying revenue procedure because numerous taxpayers had inadvertently submitted invalid elections to claim a three-, four-, or five-year carryback for 2008 NOLs.41 It modifies and supersedes Rev. Proc. 2009-19.42 To be eligible for the longer carryback period, the loss must arise from an eligible small business—a proprietorship, partnership, or corporation with average gross receipts of $15 million or less for the three-year period ending in 2008.43 The NOL must have arisen in a tax year ending or beginning in 2008.

There are two options for electing the longer carryback period.

Option 1: The taxpayer can make the election on the original return by attaching a statement to a timely filed return and specifying the longer carryback period elected. If the tax year for the loss ended before February 17, 2009, the taxpayer must make the election no later than the later of the due date (including extensions) or April 17, 2009.

Option 2: The taxpayer can make the election by filing an appropriate form and applying the carryback period selected. The appropriate forms are 1139, Corporation Application for Tentative Refund, 1120X, Amended U.S. Corporation Income Tax Return, 1045, Application for Tentative Refund, 1040X, Amended U.S. Individual Income Tax Return, and amended 1041, U.S. Income Tax Return for Estates and Trusts. The taxpayer does not need to file a statement or label with the form. Taxpayers selecting this option by filing an amended return must file the return for the earliest tax year to which the taxpayer is carrying back the loss. The form must be filed no later than the later of six months after the due date (including extensions) for the tax return of the loss year or April 17, 2009. (Note that this date is earlier than the typical due date for filing Forms 1045 and 1139, which is within 12 months after the tax year of the NOL.)

A taxpayer who had earlier elected to waive the carryback was required to file the revocation and new election no later than April 17, 2009.

Sec. 183: Hobby Losses

In a Tax Court case, the taxpayers were a pipeline inspector and a teacher.44 In addition, they participated in cattle activities involving no more than 30 cows situated on about 52 acres in Bryan, TX. They did not sell any cows or calves in the years in question and did not maintain books and records of their cattle activity. The husband was away from home much of the time, with the result that the wife and children had to feed the cattle. The opinion does not indicate what amount of expenses the taxpayers deducted as cattle activity expenses. The court concluded that the couple did not conduct the cattle activity in a manner that demonstrated an honest objective to make a profit. The court did not allow any deductions other than those allowed by the IRS in its audit.

Sec. 213: Medical and Dental Expenses

Debit card restrictions: The deadline for imposing new restrictions on the use of debit cards for medical expense reimbursements was extended to June 30, 2009.45 The new requirements for their use are described in Notice 2006-69.46 Several exceptions to the requirements are described in Rev. Rul. 2003-43.47 The original deadline of December 31, 2008, was established in Notice 2007-2.48

Sperm and egg donations: In a Tax Court case, the taxpayer (apparently unmarried at the time) arranged on two occasions for an anonymous donor to donate her eggs and a second anonymous donor to act as a surrogate mother for these eggs, which were to be fertilized with the taxpayer’s sperm.49 He deducted $34,050 in 2004 and $28,230 in 2005 as medical expenses related to these procedures. The IRS denied the deductions and the Tax Court concurred. The taxpayer had previously had twin sons with his former wife through natural means. The court held that the expenses did not meet either portion of the definition in Sec. 213(d)(1)(A). The taxpayer had no medical defect, such as infertility, nor did the expenses affect a structure or function of his body. The court specifically did not address whether the expenses would have been deductible if there was an underlying medical condition.

Sec. 215: Alimony

A Tax Court case involved a former husband who deducted $12,625 of alimony on his tax return, a deduction that the Service disallowed in full.50 The divorce decree required him to pay child support of $1,000 of month, child support arrearage of $250 a month, alimony of $1,000 a month until the payments totaled $72,000, and 75% of the children’s medical insurance and health expenses not compensated by insurance. The taxpayer paid $17,962.82 in 2004, an amount less than the aggregate amount of the child support obligation, arrearage, unpaid child support for the prior year, and medical expenses for the children. The court ruled that all the payments had to be allocated to child support and agreed with the IRS’s denial of an alimony deduction.

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

Development rights:  

The IRS has privately ruled that residential density development rights (considered under state law to constitute interests in real estate) to be transferred by the taxpayer as relinquished property were for Sec. 1031 purposes of like kind to a fee interest in real estate, a leasehold interest in real estate with 30 years or more remaining at the time of the exchange, and land use rights for hotel units.51

Vehicles: The IRS has privately ruled that crossovers, sport utility vehicles, minivans, cargo vans, and similar vehicles (i.e., vehicles that share characteristics of both a car and a light-duty truck) are of like kind for purposes of Sec. 1031 to both cars and light-duty trucks.52

Certain intangibles: On January 13, 2006, the Office of Associate Chief Counsel (Income Tax and Accounting) issued technical advice concluding that the registered trademarks and trade names of a business entity could not be of like kind to the trademarks and trade names of another business entity because they were “closely related to (if not a part of) the goodwill or going concern value of a business.”53

On March 13, 2009, the IRS completely reversed this position and in a chief counsel advice declared that intangibles such as trademarks, trade names, mastheads, etc., that can be valued separately and apart from goodwill qualify as likekind property for Sec. 1031 purposes.54 The Service changed its position after reanalyzing the Supreme Court’s decision in Newark Morning Ledger Co.55

Related-party exchanges: The Tax Court held that the taxpayer’s related property transaction did not qualify for Sec. 1031 nonrecognition because the taxpayer failed to prove that its exchange with a related party was not for federal tax avoidance purposes.56 The taxpayer chose to purchase property from a related LLC only after an unsuccessful search for replacement property and provided no evidence to support its claimed business purposes. Therefore, the transaction lacked the intent to avoid the related-party exchange provisions of Sec. 1031(f).

Sec. 1035: Certain Exchanges of Insurance Policies

The IRS has issued a revenue procedure,57 adopting with changes the provisions of Notice 2003-51,58 that describes the tax treatment of the direct exchange by an insurance company of a portion of an existing annuity contract with an unrelated insurance company for a new annuity contract (a partial exchange). Under the revenue procedure, an exchange will be treated as a Sec. 1035 tax-free exchange if there is no withdrawal or surrender of either contract during the 12 months beginning on the date the partial exchange was completed or the taxpayer demonstrates that one of Sec. 72(q)’s conditions or a similar life event occurred between the partial exchange and the surrender or distribution.

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

The IRS denied a taxpayer’s request for a late Sec. 1045 election under Regs. Secs. 301.9100-2 and -3 on the sale of qualified small business stock (QSBS) because the taxpayer demonstrated the intent to evade taxes by not reporting the sale of the QSBS on his originally filed returns.59 An IRS agent later discovered the sale of the QSBS during an audit, at which time the agent informed the taxpayer of the necessity of electing the application of Sec. 1045.

Sec. 1058: Transfers of Securities Under Certain Agreements

Under Sec. 1058, an owner of securities recognizes no gain or loss when the owner transfers securities for contractual obligation of the borrower to return identical securities. Sec. 1058(b)(3) specifically provides that the agreement cannot reduce the lender’s risk of loss or opportunity for gains as to the transferred securities. In a recent Tax Court case, the taxpayers purchased approximately $1.64 billion of securities from Refco Securities, LLC, in October 2001 and simultaneously transferred the securities back to Refco according to Refco’s promise to transfer identical securities to them on January 15, 2003.60 The Tax Court held that the agreement failed to qualify under Sec. 1058 because it prevented the taxpayers on all but three days of the approximately 450-day transaction period from causing Refco to transfer the securities to them, thus reducing the taxpayer’s “opportunity for gain . . . in the transferred securities” under Sec. 1058(b)(3).

Sec. 6015: Innocent Spouse

The Tax Court has held that Regs. Sec. 1.6015-5(b)(1), which applies a two-year limitation period for seeking equitable innocent spouse relief, is an invalid interpretation of Sec. 6015(f), finding that the IRS erred in denying an individual’s request for relief because she failed to request relief within two years of the first collection action.61

The court held that the two-year limitation period for seeking innocent spouse relief under Sec. 6015(b) or (c) does not apply to requests for equitable innocent spouse relief made under Sec. 6015(f). Following Lantz, the Tax Court now will consider whether a requesting spouse is entitled to relief under Sec. 6015(f), regardless of the time elapsed between the collection activity and the filing of the claim for relief.

The Service disagrees with the Tax Court holding in Lantz. As a result, the chief counsel’s office has advised IRS attorneys to continue to argue at trial that relief under Sec. 6015(f) is unavailable in all Sec. 6015(f) cases in which the petitioner files for relief outside the two-year limitation period.62 The notice advises IRS attorneys to raise the two-year rule issue in a pretrial memo, at trial, and on brief, but not in a summary judgment motion.

Finally, the chief counsel’s office instructs IRS attorneys to ask that the Cincinnati Centralized Innocent Spouse Operations unit consider the merits of a Sec. 6015(f) claim in any docketed case in which the Service’s denial of Sec. 6015(f) relief was based solely on the two-year rule without considering the claim’s merits.

In another case, a divided Tax Court has held that the proper standard of review in a case challenging the IRS’s denial of innocent spouse relief under Sec. 6015(f) is a de novo standard of review and, after weighing the factors for granting relief, held that the individual was entitled to equitable innocent spouse relief.63

In this holding, the court addressed the standard of review that should apply in the case and determined that based on Congress’s amendments to Sec. 6015, a de novo standard of review, rather than an abuse of discretion standard, should apply. Judge Haines, writing for the court, wrote that the lack of limitation regarding review in Sec. 6015(e) when a similar section contained a limitation indicated that the court was not held to an abuse of discretion standard when reviewing equitable innocent spouse relief cases.

The IRS also objects to this holding and has instructed its attorneys to raise the issue of the scope of Tax Court review and the standard to be applied in all innocent spouse litigation and to note the Service’s disagreement with the Porter decision. IRS attorneys are directed to attempt to get taxpayers to stipulate to the evidence in the administrative record and to object at trial if the taxpayer wishes to introduce evidence from outside that record.64


The IRS has compiled a useful summary of its guidance on wage compensation for S corporation officers. It describes who is an employee, what is and how to determine reasonable compensation, and the treatment of medical insurance premiums in language that the average taxpayer can understand.65

The IRS also has several webpages devoted to guidance under ARRA.66


Ellen Cook is the assistant vice president for academic affairs and a professor at the B.I. Moody III College of Business Administration at the University of Louisiana in Lafayette, LA. Anna Fowler is professor emeritus at the University of Texas at Austin. Jonathan Horn is a sole practitioner specializing in taxation in New York, NY. Annette Nellen is a professor at San Jose State University in San Jose, CA. Darren Neuschwander is a shareholder in Neuschwander, Faircloth & Hardy, P.C., in Robertsdale, AL. Nora Stapleton is a partner with Blackman Kallick LP in Chicago, IL. Joseph W. Walloch is a professor of advanced taxation at the University of California, Riverside, CA. The authors are all members of the AICPA’s Individual Income Tax Technical Resource Panel. For more information about this article, please contact Ms. Cook at


1 American Recovery and Reinvestment Act of 2009, P.L. 111-5.

2 Sec. 32(b)(3)(A), as amended by ARRA Section 1002(a).

3 Notice 2009-12, 2009-6 I.R.B. 446.

4 Sec. 172(b)(1)(H).

5 Sec. 57(a)(5)(C)(vi), as amended by ARRA Section 1503.

6 Information Letter 2009-0014 (1/2/09).

7 See Rev. Rul. 57-60, 1957-1 C.B. 25, clarified by Rev. Rul. 60-280, 1960-2 C.B. 12.

8 Deficit Reduction Act of 2005, P.L. 109-171.

9 Information Letter 2009-0007 (11/20/2008).

10 Information Letter 2008-37.

11 Jernigan, T.C. Memo. 1968-18.

12 Green, No. 07-73111 (9th Cir. 2/24/09).

13 Stadnyk, T.C. Memo. 2008-289.

14 Id.

15 Murphy, 493 F.3d 170 (D.C. Cir. 2007).

16 IR-2009-37 (4/7/09).

17 Sec. 85(c), as amended by ARRA Section 1007.

18 Wilbert, No. 08-2169 (7th Cir. 1/21/09), aff’g T.C. Memo. 2007-152.

19 IRS Letter Ruling 200842006 (10/17/08).

20 Kent, T.C. Summ. 2009-40.

21 Loup, T.C. Memo. 2009-23.

22 McManus, T.C. Memo. 1987-457.

23 Chaney, T.C. Memo. 2009-55.

24 Rev. Rul. 2009-9, 2009-14 I.R.B. 735; Rev. Proc. 2009-20, 2009-14 I.R.B. 749.

25 Sec. 172(b)(1)(H)(iv).

26 Sjoberg, T.C. Summ. 2008-162.

27 Briseno, T.C. Memo. 2009-67.

28 Doffin, T.C. Memo. 1991-114.

29 Cohan, 39 F.2d 540 (2d Cir. 1930).

30 AM 2008-013 (12/19/08).

31 AM 2008-011 (12/12/08).

32 Vincentini, T.C. Memo. 2008-271.

33 Sklar, 549 F.3d 1252 (9th Cir. 2008), aff’g 125 T.C. 281 (2005).

34 Sklar, T.C. Memo. 2000-118, aff’d 282 F.3d 610 (9th Cir. 2002).

35 Hernandez, 490 U.S. 680 (1989).

36 Jones, No. 08-9001 (10th Cir. 3/27/09), aff’g 129 T.C. 146 (2007).

37 Notice 2009-18, 2009-10 I.R.B. 648.

38 Notice 2008-99, 2008-47 I.R.B. 1194.

39 Bruzewicz, No. 07-cv-04074 (N.D. Ill. 3/25/09).

40 See Regs. Sec. 1.170A-13(c)(3)(ii).

41 Rev. Proc. 2009-26, 2009-19 I.R.B. 935.

42 Rev. Proc. 2009-19, 2009-14 I.R.B. 747.

43 Sec. 172(b)(1)(H)(iv).

44 Pate, T.C. Memo. 2008-272.

45 Notice 2008-104, 2008-51 I.R.B. 1298.

46 Notice 2006-69, 2006-2 C.B. 107.

47 Rev. Rul. 2003-43, 2003-1 C.B. 935.

48 Notice 2007-2, 2007-2 I.R.B. 254.

49 Madalin, T.C. Memo. 2008-293.

50 Haubrich, T.C. Memo. 2008-299.

51 IRS Letter Ruling 200901020 (1/2/09).

52 IRS Letter Ruling 200912004 (3/20/09).

53 Technical Advice Memorandum 200602034 (1/13/06).

54 Chief Counsel Advice 200911006 (3/16/09).

55 Newark Morning Ledger Co., 507 U.S. 546 (1993).

56 Ocmulgee Fields, Inc., 132 T.C. No. 6 (2009).

57 Rev. Proc. 2008-24, 2008-13 I.R.B. 684.

58 Notice 2003-51, 2003-2 C.B. 361.

59 IRS Letter Ruling 200906009 (2/6/09).

60 Samueli, 132 T.C. No. 4 (2009).

61 Lantz, 132 T.C. No. 8 (2009).

62 CC-2009-012 (4/17/09).

63 Porter, 132 T.C. No. 11 (2009).

64 CC-2009-021 (6/30/09).

65 IRS Fact Sheet FS-2008-25 (August 2008).

66 For example, see,,id=204335,00.html.

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