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This article covers recent developments affecting taxation of individuals, including the health care reform and other legislation, regulations, cases, and IRS guidance. The items are arranged in Code section order.
Sec. 25A: Hope and Lifetime Learning Credits
The Government Accountability Office (GAO) has suggested that Congress grant the IRS the authority to use prior-year tax returns to verify a taxpayer’s eligibility for the Hope credit. 1 In addition, the GAO has made the following recommendations to the IRS to reduce taxpayer confusion and increase compliance with the eligibility requirements for higher education benefits:
- Determine the feasibility of using current information reported on Form 1098-T, Tuition Statement, such as school location and taxpayer identification number or Social Security number, in the IRS’s compliance programs; and
- Revise Form 1098-T to improve the usefulness of information on qualifying education expenses.
Sec. 32: Earned Income Credit
The Tax Court held that an individual who was incarcerated at a maximum security correctional facility was not entitled to an earned income credit. 2 Sec. 32(c)(2)(B)(iv) excludes wages earned while an individual is an inmate at a penal institution from the definition of earned income for purposes of the credit. In addition, the taxpayer was liable for the accuracy-related penalty. He did not have reasonable cause to believe that he was entitled to the credit and did not act in good faith within the meaning of Sec. 6664(c)(1) in claiming the credit.
Sec. 36: First-Time Homebuyer Credit
A series of letters issued by the IRS in April clarified various issues related to the first-time homebuyer credit. The Office of Chief Counsel advised that the Sec. 6111 general interest rules applicable to overpayments of tax apply to the first-time homebuyer credit. 3
The Homebuyer Assistance and Improvement Act of 2010, 4 enacted July 2, extended the deadline to qualify for the first-time homebuyer credit from June 30, 2010, to September 30, 2010. Under Sec. 36 (before amendment), the credit was available only to qualifying homebuyers who bought a principal residence on or after April 9, 2008, and on or before April 30, 2010, or who entered into a written binding contract on or before April 30, 2010, to close on the purchase of a principal residence on or before June 30, 2010. Because of delays due to a number of reasons largely outside their control, many qualifying homebuyers who entered into binding contracts on or before April 30 were unable to close on their residences by the original June 30 deadline. The act extended the deadline for closing to September 30 (but it did not change the April 30, 2010, contract deadline).
Sec. 36B: Refundable Credit for Coverage Under a Qualified Health Plan
The Patient Protection and Affordable Care Act 5 (Patient Protection Act) provides for a refundable tax credit that eligible taxpayers can use to help cover the cost of premiums for health insurance purchased through a state health benefit exchange (which each state is required to establish under the act). Under new Sec. 36B, an eligible individual will enroll in a plan offered through an exchange and report his or her income to the exchange. Based on the information provided to the exchange and his or her income, the individual will receive a premium assistance credit. Treasury will pay the credit amount directly to the insurance plan in which the individual is enrolled. The individual will then pay to the plan in which he or she is enrolled the dollar difference between the premium tax credit amount and the total premium charged for the plan. Alternatively, eligible individuals can pay for the insurance out of pocket and then claim the credit on their tax returns.
Eligibility for the premium assistance credit is based on the individual’s income for the tax year ending two years prior to the enrollment period. The premium assistance credit is available for individuals (single or joint filers) with household incomes between 100% and 400% of the federal poverty level (for the family size involved) who do not receive health insurance through an employer or a spouse’s employer. The credit amount is determined by the secretary of Health and Human Services, based on the amount by which premiums exceed a threshold amount. The threshold rises from 2% of income for those at 100% of the federal poverty level for the family size involved to 9.5% of income for those at 400% of the federal poverty level for the family size involved.
The Health Care and Education Reconciliation Act of 2010 6 (Reconciliation Act) provides for an inflation adjustment in the starting and ending percentages for years after 2014. The adjustment will be based on the rate of premium growth for the preceding calendar year over that year’s rate of income growth.
After 2018, the inflation adjustment will be based on the rate of premium growth for the preceding calendar year over that year’s consumer price index growth, but only if the aggregate amount of premium assistance tax credits and cost-sharing reductions (under Section 1402 of the Patient Protection Act) for the preceding calendar year exceeds an amount equal to 0.504% of the gross domestic product for the preceding calendar year.
The premium assistance credit will be available for years ending after December 31, 2013.
Sec. 36C: Adoption Expenses
The health care reform legislation 7 made changes to the adoption credit and the exclusion for adoption assistance programs (and redesignated the adoption expenses Code section, formerly Sec. 23, as Sec. 36C). The maximum adoption credit for 2010 increased to $13,170 per eligible child from $12,170 for both nonspecial-needs adoptions and special-needs adoptions. The credit is also made refundable. Both the new dollar limit and the phaseout of the credit are adjusted for inflation in tax years beginning after December 31, 2010. The Economic Growth and Tax Relief Reconciliation Act of 2001 8 (EGTRRA) sunset for the adoption credit is delayed for one year, becoming effective for tax years beginning after December 31, 2011.
The maximum exclusion for adoption assistance programs for 2010 is increased to $13,170 per eligible child from $12,170 for both nonspecial-needs adoptions and special-needs adoptions. Both the new dollar limit and the income limitation of the employer-provided adoption assistance exclusion are adjusted for inflation in tax years beginning after December 31, 2010. The EGTRRA sunset for the exclusion is delayed for one year, becoming effective for tax years beginning after December 31, 2011.
The provisions generally are effective for tax years beginning after December 31, 2009.
Sec. 45R: Employee Health Insurance Expenses of Small Employers
The Patient Protection Act provides tax credits for small businesses and individuals designed to increase levels of health insurance coverage as part of the Sec. 38 general business credit. Small businesses—defined as businesses with 25 or fewer employees and average annual wages of less than $50,000—are eligible for a credit of up to 50% of nonelective contributions the business makes on behalf of its employees for insurance premiums (new Sec. 45R). Tax-exempt organizations would get a 35% credit against payroll taxes.
Employers with 10 or fewer employees and average wages of less than $25,000 will get 100% of the credit; for other eligible employers, the credit will be reduced based on the number of employees over 10 and the excess of the employees’ average wages over $25,000. The $25,000 average annual wages figure will be indexed for inflation after 2013.
This credit is available for tax years beginning after December 31, 2009, and is phased in from 2010 through 2013. During the phase-in years, the maximum credit is 35% of the employer’s eligible premium expense (25% for tax-exempt employers). After 2013, the credit will be available for a maximum of two consecutive years, beginning with the first year the employer offers a qualified plan through a state insurance exchange (Sec. 45R(e)(2)).
Small businesses claiming the credit will include it as part of the general business credit on their tax returns and attach new Form 8941, Credit for Small Employer Health Insurance Premiums. Tax-exempt small employers, who do not normally file income tax returns, will attach Form 8941 to their Form 990-T, Exempt Organization Business Income Tax Return, which will be revised for the 2011 filing season to enable eligible tax-exempt organizations to claim the credit.
Sec. 56: Adjustments in Computing AMT
Beginning after 2012 (after 2016 for taxpayers over 65), the medical expense deduction will be subject to 10% of the AGI floor (increased from 7.5%). This will eliminate the alternative minimum tax (AMT) adjustment for medical deductions because the floor for deductibility of medical expenses will be the same for both regular tax and AMT purposes.
Sec. 61: Gross Income Defined
General welfare exclusion: A private letter ruling involved whether funds received by individuals from a county for various programs—including a job training one and one available to county employees—were excludible under the general welfare exclusion to Sec. 61. 9 The IRS ruled that the payments were excludible but emphasized that the general welfare exclusion applies only where the government payments are made out of a welfare fund based on the recipients’ identified need; they are not excludible when made as compensation for services.
Another, heavily redacted, ruling involved a state program established to help address some economic condition. 10 Grants were given to help mostly low-income individuals purchase some type of property (not specified in the letter ruling, but likely a dwelling because it was to be occupied within a few days after purchase). The grant-giving entity argued that the grants were not gross income to the recipients, because they either were purchase price reductions or were covered under the general welfare exclusion. The IRS ruled against the purchase price argument because the grant-giving entity was not a party to the sales transactions and the grants did not affect the amount received by the seller, lender, broker, or any other party to the transaction. The IRS also ruled against the general welfare exception argument because the grants were not made to recipients based on their financial need, but were intended to benefit all state residents by stimulating the economy.
Gambling winnings: In 2005, married taxpayers withdrew $500 from their bank account to take to a casino. 11 The husband won a $2,000 jackpot on a slot machine. The husband and wife each took $200 of these winnings in order to continue playing slot machines. They left the casino with $1,600, which they deposited in a bank account. On their 2005 return, they reported $0 gambling winnings and claimed the standard deduction. The IRS held that the taxpayers had $2,000 of unreported gambling income.
The Tax Court said a “casual gambler . . . 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 was in line with a recent IRS Chief Counsel memorandum on the subject. 12
The court calculated gambling income of “$1,100 ($2,000 jackpot winnings less $500 brought to the casino for gambling and less $400 taken from the jackpot for additional gambling).” The taxpayers argued that they should be able to offset this with other gambling losses and that the law should treat casual and professional gamblers similarly. The court disagreed.
Sec. 104: Compensation for Injuries or Sickness
In a Tax Court case, the taxpayer was a New Jersey state trooper. 13 In 1988, he suffered workplace discrimination that resulted in physical injuries. In 2002, the taxpayer filed a lawsuit, but there was no mention of physical injuries in the complaint, and the settlement award did not specify what specific claims it was satisfying. In 2005, he received a lump-sum settlement award in which nothing was allocated to physical injuries. The taxpayer’s CPA advised him to treat the award as nontaxable under Sec. 104(a)(2). The IRS disagreed, imposing a $50,066 assessment plus an accuracy-related penalty of approximately $10,000 under Sec. 6662(a).
The court held that the award was not excludible under Sec. 104(a)(2) because the taxpayer was unable to prove that any part of the settlement was received for personal physical injuries or physical sickness. The court said that in the case of a settlement agreement, “the nature of the claim that was the actual basis for settlement controls whether those damages are excludable under section 104(a)(2).” 14 For an award to be excludible under Sec. 104, “damages must arise from personal injury or personal sickness other than emotional distress or the symptoms thereof.” However, the court did not impose an accuracy-related penalty because the taxpayer “reasonably and in good faith relied on the advice of a C.P.A.”
In another case, decided by the Sixth Circuit, the taxpayer purchased a used car from a dealer. 15 Because the car immediately broke down, she asked her bank to place a stop payment on her check. The bank mistakenly marked the check “NSF” for insufficient funds. The dealer then brought an action against the taxpayer, and she was arrested and jailed for approximately 24 hours. The taxpayer suffered no physical injury from her arrest and detention, but she underwent psychological treatment for several weeks. She brought a lawsuit against the bank and car dealer, and the bank settled the case for $49,000.
The taxpayer received the award in 2002 and did not report it on her return because her attorney, the bank’s attorney, and the mediator all told her it was not taxable. The IRS issued a notice of deficiency and assessed a penalty under Sec. 6662. The Tax Court agreed with the IRS that the award was taxable, but found that the penalty did not apply.The taxpayer appealed.
The Sixth Circuit agreed that the award was taxable gross income and not excludible under Sec. 104. The court agreed with the Tax Court that the award was based on a “tort or tort type rights” because the taxpayer sued due to the ordeal of being arrested and sent to jail; however, the court did not find that Sec. 104’s second requirement, that the award be on account of physical injuries, was met. The taxpayer did not suffer any physical injury from the arrest; she sought damages for emotional distress and damage to reputation. Damages for such injuries are not excludible under Sec. 104.
The taxpayer argued that false imprisonment automatically involves physical injury due to restraint. The court did not agree, and it also noted that under Kentucky law, false imprisonment claims do not require physical injury. Since the taxpayer did not claim any physical injury, the award was not excludible under Sec. 104.
Another case involved workplace discrimination and a settlement award from the taxpayer’s employer. 16 Although the taxpayer received a Form 1099-MISC reporting the $50,000 received, she omitted the award from her return because her personal injury lawyer told her it was not taxable. The taxpayer told her preparer that the award was reimbursement for medical costs she had incurred to treat physical ailments that were a result of the emotional distress caused by the discrimination. The taxpayer’s settlement agreement did not note personal physical injury or sickness or any particular claim. Therefore, the court found that the award was fully taxable. However, the court waived the Sec. 6662 penalty, finding that the taxpayer acted reasonably and in good faith in relying on her preparer and because she believed the settlement was for physical injuries due to her medical expenses.
Sec. 108: Income from Discharge of Indebtedness
Loan repayment program: There is an existing exclusion for certain government and nongovernment student loans where the debt discharge is under a loan provision that requires the student to work for a certain period of time in certain professions. Loan repayment programs, in which a third party makes payments on a participant’s student loans in return for public service, generally result in taxable income. However, the repayments do not have to be included in income if they are received under a state program described in Section 3381 of the Public Health Service Act or under the National Health Service Corps Loan Repayment Program.
A new provision of the health care legislation extends these exclusions to include amounts received under any state program that is intended to increase the availability of health care services in areas that the state determines are underserved. 17 This provision is effective for amounts received after December 31, 2008. There may be an opportunity to file amended returns if 2009 amounts were reported as income and now qualify for exclusion.
A charitable organization requested a ruling regarding the tax treatment of its loan repayment program. 18 The program paid the student loans for participants who agreed to work for two years as primary care physicians for community health care centers. The ruling was requested before the change in the law described above. The tax-exempt entity presumably wanted to ensure that its program qualified under the old exclusion even though it is not a state-run program. The conclusion was that all amounts were not includible in taxable income or subject to withholding.
LLC interest as real property: The taxpayer, a partnership for tax purposes, requested a ruling to determine if debt forgiveness related to a loan secured by ownership interests in a limited liability company (LLC) can qualify for the real property business indebtedness exclusion under Sec. 108(a)(1)(D). 19 Sec. 108(c)(3) describes the criteria for a debt to be qualified real property business indebtedness, which includes the requirement that the debt be secured by the property. According to the ruling, neither the statute nor the legislative history contains any explanation of or definition for the term “secured by real property.” The ruling also noted that real estate investment trusts are allowed to treat debt secured indirectly by real property as secured by the underlying property where the lender can acquire the property upon default. Accordingly, the ruling states that the debt does qualify for the real property business debt exclusion. The amount of the exclusion is limited under Sec. 108(c)(2)(A) to the excess of the loan principal over the property’s fair market value (FMV).
Credit card debt: In a case decided by the Eighth Circuit, the taxpayers tried to argue that forgiven credit card debt should be treated as a reduction of the purchase price of the goods acquired under Sec. 108(e)(5); however, this exclusion applies only to direct agreements between the purchaser and the seller. 20
Sec. 152: Dependent Defined
Physical custody: A couple that had never been married both claimed a dependency exemption, a child care tax credit, and a child tax credit for a child of whom they share joint custody. 21 The Tax Court determined that the mother could claim the child as a dependent on her 2004 federal tax return as a result of overall “physical custody,” which was measured by the number of hours or number of nights the child spent with the mother compared with the father.
Release of claim: In another case, the father, who was the noncustodial parent, was denied a dependency exemption for his daughter (as provided by the Sec. 152(e) provision for noncustodial divorced parent) on his 2006 federal tax return because he did not attach to his return Form 8332, Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent, or similar exemption release from the mother. 22 Although the divorce decree (which was attached to his Form 1040) provided that the taxpayer would be entitled to an exemption for the year as long as he was current on his child support obligations (which he was), the Tax Court ruled that the decree was not controlling and could not serve as a form/release substitute because it was not unconditional and did not contain the parties’ Social Security numbers or the date of the mother’s signature.
In a similar case decided by the Tax Court, the father, who was the noncustodial parent, was denied a dependency exemption for his two children (as provided by the Sec. 152(e) provision for the noncustodial divorced parent) on his 2005 federal tax return because (1) he did not substantiate the amount of support both parents provided to the child and (2) he did not attach to his return any Form 8332 or other exemption release from the mother. 23 The mother and the two children lived with the children’s maternal grandparents, who provided the majority of support for the children.
Sec. 162: Trade or Business Expenses
Health care reform: As part of the health care reform legislation, after December 31, 2013, employers offering minimum essential health coverage through an eligible employer-sponsored plan and paying a portion of that coverage will have to provide qualified employees with a voucher, the value of which can be applied to purchase a health plan through a state insurance exchange. Payments for these free-choice vouchers for employees will be deductible as compensation. The amount of the voucher will not be includible in the employee’s income, to the extent it does not exceed the amount paid for the qualified health plan. 24
Effective March 30, 2010, self-employed taxpayers can deduct the cost of health insurance premiums paid for any child who has not reached age 27 by the end of the tax year, even if the person is not a dependent.
Deductions but no business: In a case decided by the Tax Court, the taxpayer deducted on Schedule C more than $14,000 of meals and entertainment expenses in addition to advertising, home office rent, and utilities expenses. 25 He presented no receipts or canceled checks but did have a printout of a self-created computer record of his meals and entertainment expenses. He argued that the 50% deduction limit did not apply. He classified some of the meals and entertainment as advertising. The taxpayer was an employee of Intel and did not seem to have a business that could generate the other deductions claimed. The court disallowed the deductions.
Employee medical reimbursement plan: In another case, a husband had engaged in farming activities since 1978; his wife began assisting on the farm in 1982 but prior to 2001 received no compensation. 26 In 2001, the husband engaged a CPA who advised him that if he employed his wife, he could qualify for an employee medical reimbursement plan. The CPA helped the couple fill out a preprinted application for AgriPlan/BIZPLAN, a medical reimbursement plan. The plan listed the wife as the only eligible employee. The wife opened a checking account in her name into which she deposited the $100-a-month salary her husband began paying her from the couple’s joint checking account. The wife paid medical expenses, including medical insurance premiums, and the medical reimbursement plan reimbursed her for some of these. Their Schedule F, Profit or Loss from Farming, showed deductions for her salary and for employee benefit programs.
The court did not recognize the wife as an employee and thus denied the deduction for the employee benefit programs. In the eyes of the court, the wife’s tasks on the farm had not changed, and it was not convinced that anything had happened to materially change the couple’s economic relationship. However, the court concluded that the couple reasonably relied on the advice of the CPA and did not levy an accuracy-related penalty.
Substantiation: In a third case, because of lack of substantiation, the husband, a retired federal employee, and wife were denied deductions related to his greenhouse activities and her stamping activities. 27 The notice of deficiency did not include the gross income from these activities in the couple’s gross income; thus, in effect they received deductions equal to the amount of gross income ignored. The husband stated that his records had been destroyed by flooding of his basement. He presented tax returns that he contended were copies of or reconstructions of timely filed returns.
The court concluded that the couple did not file timely returns for 2001–2004. It did not accept the taxpayer’s argument that the IRS had lost these returns.
Personal expenses: In another Tax Court decision, the taxpayer was an insurance representative who had his wife form a corporation to provide services to his Schedule C insurance business. 28 An extensive paper trail of management agreements and the like was created by an attorney, but no financial expert or CPA was involved in either the formation or the operation of the corporate entity. The taxpayer paid over $100,000 for “management services” to the corporation in each of three years under examination. The IRS and the court ruled these payments were not deductible as trade or business expenses, stating that they were merely made for tax avoidance purposes—avoiding employment tax on payments to his wife and allowing the corporation to pay the family’s personal expenses and deduct them as business expenses.
Observation: One interesting aspect of this case is that the IRS also examined the corporation’s tax returns for the years in question and issued a no-change letter for all three. If the expenses deducted by the corporation were legitimate, why was the taxpayer accused of running personal expenses through the corporation? A review of the claimed expenses leads to the conclusion that the IRS issued the no-change letter in error. The taxpayer lost anyway because the court found that the corporation did not provide any services to his Schedule C business.
Fraud restitution: In another husband and wife saga, the husband was a dentist whose wife kept the books and handled the billing. 29 Over a six-year period, the wife (without her husband’s knowledge) filed false claims with one of the insurance carriers accepted by the dental practice. Once she was caught and admitted to her actions, the insurance carrier demanded repayment from the dental practice. The wife pleaded guilty to fraud and was sentenced to a prison term, but she was assessed no fine or criminal restitution. As a condition of her sentencing, she was required to adhere to a separate civil settlement requiring payment of $600,000 to the insurance company (the actual fraud amount was $550,000). The taxpayers deducted this payment as a business expense on the dentistry practice’s Schedule C, generating a net operating loss (NOL), which they carried back three years, generating tentative refunds issued by the IRS. The IRS followed up with a notice of deficiency denying the deduction and NOL.
The IRS argued that restitution is never deductible as a trade or business expense and that, even if it had been, the payment related to the business of fraud, not dentistry. They further objected to the wife getting the benefit of the deduction for her misdeeds.
The court rejected all these arguments. First it made clear that civil restitution may be deductible if its purpose is compensatory, not punitive. The facts in this case clearly supported such a conclusion. Second, it ruled that the husband credibly testified that the payment was essential to his ability to continue to operate his dental practice. Losing the ability to accept patients covered by the insurance carrier would have been devastating. Finally, while the court was sympathetic to the IRS’s reluctance to allow the wife a tax benefit, the fact that she was filing a joint claimed clearly allowed it, based on the Supreme Court’s ruling in Helvering v. Janney. 30 The court did note that it would have found differently if the husband had been involved and found guilty of the actual fraud. Finally, the court went out of its way to find that even if the IRS had prevailed on the deficiency, there was no basis for a negligence penalty because “the facts of this case are so unusual and their legal treatment so uncertain.”
Sec. 164: Taxes
For tax years beginning after December 31, 2012, taxpayers with wages and/or self-employment income above a certain amount will incur an additional Medicare tax of 0.9%. 31 This additional tax will not be eligible for the deduction for one-half the amount of the self-employment tax. 32
Sec. 165: Losses
In a Tax Court summary opinion, the taxpayer claimed a casualty loss of $33,629 for damage to his truck that arose from an accident in which he was arrested for drunk driving. 33 His insurance company denied his claim. The IRS denied the taxpayer’s deduction because (1) the loss resulted from gross or willful negligence or (2) to allow the loss would be contrary to public policy. The court noted that “[a]lthough negligence may not be a bar to a casualty loss deduction, courts have held that gross negligence may be.” 34 The court also noted that under Regs. Sec. 1.165-7(a)(3), an automobile may be the subject of a casualty loss only “when the damage is not due to the willful act or willful negligence of a taxpayer.”
The court found in this case that there was no gross or willful negligence and allowed the loss. The court noted that the taxpayer did not drive immediately after drinking and that there was no evidence that the taxpayer knew his behavior would cause injury. The taxpayer’s blood alcohol level was slightly over the legal limit. The court found that the taxpayer’s “level of intoxication and the manner in which he drove do not suggest that he was consciously indifferent to the hazards of drunk driving.”
The court also found that there was no public policy issue with the taxpayer’s claiming a loss deduction: “Where the taxpayer is reasonably unaware that he is doing something wrong, it is less likely that allowance of a casualty loss deduction would so severely frustrate public policy as to require disallowance.”
Sec. 170: Charitable Contributions and Gifts
In one Tax Court decision, the taxpayer conducted a dry cleaning business as a C corporation. 35 The corporation made contributions directly to the taxpayer’s church, and the taxpayer deducted them on his joint individual return, along with contributions he made directly. The court held that the couple could deduct only the contributions they made directly.
In another case, the taxpayers donated diagnostic and laboratory equipment to charitable organizations in 2001 and again in 2002. 36 Each year they deducted approximately $218,000 as charitable contribution deductions. They included Forms 8283, Noncash Charitable Contributions, with their tax returns; however, the forms did not include all the required information. For one contribution, they did not even obtain an appraisal. Appraisals that had been done stated generic versus detailed, specific descriptions of the donated items. Moreover, the forms did not list the cost basis in the items contributed, and one of the donees did not state that it provided the taxpayers with no goods or services.
The court concluded that the taxpayers were not entitled to a deduction because they failed to “strictly or substantially comply” with the regulations and did not provide the contemporaneous written acknowledgments required. The IRS levied a negligence penalty, which the court upheld. The taxpayers argued that because they relied on a CPA, they should not incur a penalty. The court pointed out that the mere fact that a tax adviser is a CPA “does not necessarily make him a competent tax adviser.” The record indicated that the taxpayers withheld some important information from the CPA.
Another case involved charitable contributions made by a partnership, but it addressed a situation (valuation and the basis of the portion sold in a bargain sale context) applicable to individual taxpayers. 37 The partnership (CIG) owned undeveloped land, several acres of which the Ohio Turnpike Commission (OTC) sought for right of way for a highway interchange. The IRS’s first argument was that the consideration received was equal to the FMV of the property given up, and its backup argument was that it was incorrect for CIG to allocate all its basis in the acres given up to the sale portion of the transaction.
Four appraisals were completed, and three were admitted by the court as expert reports. All three used the sales comparison approach to determine the FMV of what the taxpayer owned before and after the transaction. All experts agreed that the amount the OTC paid was less than the value of what CIG gave up, and thus there was a bargain sale. The court allowed a charitable contribution deduction of approximately $641,000, about the same amount that one of the experts for CIG had calculated. It was not concerned that the appraisal was made about five months before the date of the transaction instead of not more than 60 days before, as required by Regs. Sec. 1.170A-13(c)(3)(i)(A). The court agreed with the IRS that the basis of the acres given up had to be allocated between the sale and the gift portions of the transaction. Thus, the amount of the reported gain was increased.
Practice tip: The discussion in this case of the appraisal approaches is valuable for practitioners who have clients in similar situations.
Another case, involving charitable contributions made by an S corporation, also addressed a situation that individual taxpayers could encounter. 38 A firm established in Iowa in 1870 began acquiring land in New Mexico in 1919 and by 2001 owned about 9,800 acres outside Taos. About 2,581 acres are known as the Taos Valley Overlook (TVO), and these acres were the subject of the case. A total tax of over $1.2 million was in question.
The corporation’s position was that it had made a series of bargain sales of the acreage with a resulting charitable contribution in each of three years. The IRS argued that the sales should be collapsed into a single sale under the step-transaction doctrine and that there was no charitable contribution deduction because the aggregate sales price equaled the FMV of the property at the time of the first disposition.
The corporation had entered into an agreement with the Trust for Public Land, a charitable organization whose mission was to protect open space. The trust’s approach was to acquire land and later transfer it to other organizations. Its funding was from the federal government and some private donors. The agreement divided the land into three tracts of 860.33 acres each, phases 1, 2, and 3. The trust received an option to buy each phase over a series of years. It could not acquire phase 2 until after it had acquired phase 1 and could not acquire phase 3 until after it had acquired phase 2. The price for the property for each phase was less than the FMV and was based on the amount of funds the trust thought it would have available. The trust eventually acquired all 2,581 acres.
The court addressed the three tests for the step-transaction doctrine—the binding commitment test, the interdependence test, and the end result test. It refused to apply the step-transaction doctrine because there was no guarantee that the trust would receive the funds to pay for all 2,581 acres. The claimed charitable contribution deductions were sustained because the parties had agreed that if the court found the step-transaction doctrine inapplicable, the petitioners would be entitled to the deductions claimed.
Haiti donations: Taxpayers are entitled to deduct cash contributions made for earthquake relief in Haiti on either their 2009 or 2010 tax returns if made after January 10, 2010, and before March 1, 2010. Taxpayers who made their contributions by text message can use their phone bill as documentation if the bill shows the name of the donee organization, the date, and the amount. 39
Sec. 183: Activities Not Engaged in for Profit
In a case involving legal fees, the taxpayer was a financial adviser working for Merrill Lynch and was treated as an employee during his time there. 40 He was fired and sued Merrill for wrongful termination. He was awarded nearly $400,000 in arbitration and paid his lawyer $120,000. The taxpayer formed a partnership with his former assistant at Merrill and filed a Schedule C showing income of $1,717 (representing interest on the arbitration award) and expenses of $120,000 (the legal fees). The IRS disallowed the Schedule C deduction but allowed the Schedule A deduction as an unreimbursed employee expense. The Tax Court concurred, finding that the taxpayer had always been treated as an employee by Merrill, he had received a Form W-2 from them for the arbitration award, and the legal fees were not connected to any trade or business.
Sec. 196: Deduction for Certain Unused Business Credits
Sec. 45R(a) allows a credit for small employer health insurance for amounts paid or incurred in tax years beginning after December 31, 2009 (see the Sec. 45R discussion above). Employers can receive a deduction for the unused portion of the credit beginning in their first tax year after the last tax year for which the credit could have been allowed as a credit.
Sec. 213: Medical Expenses
The nondeductible floor for unreimbursed medical expenses rises from 7.5% to 10% in general for tax years beginning after December 31, 2012. However, for tax years beginning after December 31, 2012, and before January 1, 2017, the floor remains at 7.5% if the taxpayer or the taxpayer’s spouse is at least age 65 before the close of the tax year. 41
In vitro fertilization: In a case decided by the First Circuit, the taxpayer, a divorced man who had produced children with his former wife, incurred and deducted expenses to father children by in vitro fertilization with eggs from anonymous donors. 42 The court disallowed the deductions on the grounds that the procedures were not for “the purpose of affecting any structure or function of his body.” It pointed out that he had no underlying medical conditions and that the “gestational carriers” were not his dependents. The court also ruled that the expenses were nondeductible personal expenses under Sec. 262.
Sec. 280A: Home Office Expenses
In a rare taxpayer win, especially in a case with stipulated facts, the Tax Court held that a taxpayer did in fact maintain a home office for the convenience of his employer and that overall he satisfied the requirements of Sec. 280A with respect to business use of the home. 43 The taxpayer created a self-contained office in one-half of his basement and used it exclusively for businesses purposes. His employer did not furnish the taxpayer with an office; therefore, his use of the home office was for the convenience of the employer and not “purely a matter of personal convenience, comfort, or economy.” 44
Sec. 280F: Limitation on Depreciation for Luxury Automobiles
The IRS announced that the optional mileage allowance for owned or leased autos (including vans, pickups, or panel trucks) is 50¢ per mile for business travel in 2010, 45 down 5¢ from the 55¢ allowance for business mileage during 2009. Further, the rate for using a car to get medical care or in connection with a move that qualifies for the moving expense deduction is 16.5¢ per mile for 2010, down 7.5¢ from the 24¢ per mile allowance for 2009.
The IRS released the 2010 maximum FMVs for employer-provided autos, trucks, and vans whose personal use can be valued for fringe benefit purposes at the mileage allowance rate (50¢ per mile for 2010) in Rev. Proc. 2010-10. 46 The revenue procedure also contained the 2010 maximum fleet-average vehicle FMVs for autos, trucks, and vans for purposes of the annual lease value fringe benefit valuation method.
The IRS released the inflation-adjusted depreciation limits for business autos, light trucks, and vans (including minivans) placed in service in 2010 and the annual income inclusion amounts for such vehicles first leased in 2010 in Rev. Proc. 2010-18. 47
In a technical advice memorandum, 48 the IRS concluded that two LLCs owned by a husband and wife, respectively, were not in the business of leasing aircraft (due to the lack of leases to unrelated parties), and therefore the depreciation on the aircraft was subject to the 50% qualified business use test as provided by Sec. 280F(b).
Sec. 1001: Determination of Amount of and Recognition of Gain or Loss
The Office of Chief Counsel advised in an information letter that Defense Department Housing Assistance Program (HAP) payments to employees and members of the armed forces are taxable. 49 The American Recovery and Reinvestment Act of 2009 50 (ARRA) had expanded the categories of individuals eligible for the payments. While earlier HAP payments were excludible from income under Sec. 132(n), ARRA did not expand the list to include payments to the new categories of recipients.
In a case decided by the Tax Court, the taxpayers increased the basis in property they sold by the amount of a payment they made to satisfy a judgment from personal litigation; this addition to basis was denied. 51 The taxpayers argued that paying the judgment allowed them to secure release of a lien and clear the property’s title. The court held that the origin of the judgment (regarding attorneys’ fees in civil litigation) was personal and not related to the property, so its payment was a personal expense that could not be used to increase basis in the property.
Sec. 1031: Like-Kind Exchanges
The Tax Court denied like-kind exchange treatment where the taxpayers did not prove intent, at the time of the exchange, to hold the newly acquired property for investment or productive use in trade or business. 52
The Office of Chief Counsel advised that an exchange of property with a related party did not qualify for nonrecognition treatment under Sec. 1031 due to a subsequent lease to an unrelated party within two years. 53
The IRS has provided a safe-harbor method to report gain or loss by taxpayers who are unable to complete a deferred like-kind exchange solely due to a qualified intermediary (QI) that defaults on its obligation to acquire and transfer replacement property. As long as four specified conditions are met, gain need be recognized only on disposition of relinquished property as required by the gross profit ratio method provided in this guidance. 54
Sec. 1033: Involuntary Conversions
The IRS ruled that the timing of the receipt of proceeds from property condemnation determined the start of the three-year replacement period under Sec. 1033(g)(4). 55
In another situation, the taxpayer transferred stock to a state unclaimed property fund, which ultimately sold it. In a letter ruling, the IRS allowed replacement within two years from the date the state made the sales proceeds available to the taxpayer, due to involuntary conversion. 56
In another ruling, the eminent domain rights in property taken by a state agency resulted in involuntary conversion. 57 The IRS ruled that the taxpayer had the right to purchase replacement property and defer gain in accordance with Sec. 1033.
The taxpayer owned land held for investment and development purposes. A state agency brought eminent domain proceedings, asserting a right to acquire fee title to the taxpayer’s land. The state agency gained the right to condemn, but did not actually condemn the land. Meanwhile, the taxpayer reached agreement with another party for commercial development of the land. Then, another state agency with a superior right over the first state agency determined that it might need rights in the taxpayer’s property. The parties negotiated an agreement where the second agency received temporary easement rights for a period of years as well as a permanent easement interest in the land with payment to the taxpayer. The first agency’s rights also continued.
The taxpayer sought a ruling that gain could be deferred under Sec. 1033 for the “putative involuntary conversion from the taking of certain real estate interests by a public authority.” The IRS ruled that Sec. 1033 applied. The IRS found that the conversion was due to “circumstances beyond the taxpayer’s control.” Acquisition of other property to develop meets the Sec. 1033 standard because the taxpayer “plans to use the fee simple property that it acquires with the proceeds from the takings of the temporary easements for the same purpose that it has used Property, i.e., holding for commercial development.”
In applying the like-kind standard of Sec. 1033(g), a leasehold interest is of like kind to a fee interest if the lease term is at least 30 years. However, if the taxpayer is instead using the “similar or related in service or use” standard, a lease does not have to have a 30-year minimum term.
Sec. 1041: Transfer of Property Incident to Divorce
The IRS ruled that a described division of the taxpayer’s ex-wife’s restricted stock was a nontaxable event under Sec. 1041 if the division occurred in the context of a judicial proceeding that was formalized in a divorce decree. 58
Sec. 1402: Self-Employment Income
State subsidy: In a summary opinion, the Tax Court decided a case where the taxpayers were caring for their granddaughter and received a $16,974 subsidy from the state of Illinois for providing that care. 59 The payments from the state were made under a state-sponsored program designed to provide low-income working families with access to child care. They were not qualified foster care payments, which would be excludible from income under Sec. 131(a). The court held that the taxpayers were not carrying on a trade or business when they provided the childcare and had no profit motive. Therefore, while the payments were subject to income tax, they were not subject to self-employment tax.
Dissolved corporation: With the current economic climate, practitioners should pay close attention to Chief Counsel Advice (CCA) 200852001, 60 in which the IRS advised that owners of dissolved corporations could be liable for the self-employment tax depending on the type of payments that are made to them post-dissolution. In the situation discussed in the CCA, a husband and wife were sole proprietors of a business that was incorporated in a community property state. After its administrative dissolution for failure to file an initial report with the secretary of state, the business became a disregarded entity under Regs. Sec. 301.7701-2(a). As such, the owners were liable for the employment taxes of the businesses.
Funneling earnings through trusts: In a case before the Tax Court, some attorneys attempted to use trusts to funnel the profits from their law firm through passthrough entities to trusts and on to the attorneys and thus avoid the self-employment tax. 61 The court held that the trusts lacked economic substance and had to be disregarded for tax purposes. The taxpayers served as trustees, distributed all earnings to themselves as a matter of course, were the sole beneficiaries of the trusts, did not honor any trust restrictions, and had the same relationship to trust property/passthrough entity interests and firm income both before and after the trusts’ creation. Thus, the court held, the taxpayers’ share of firm income really represented net earnings from self-employment and was taxable to them.
Sec. 1411: Unearned Income Medicare Contribution
The health care legislation imposes a new 3.8% Medicare contribution surtax after 2012 on net investment income of individuals, estates, and trusts over certain threshold amounts. 62 For married individuals filing a joint return and surviving spouses, the threshold amount is $250,000; for married taxpayers filing separately it is $125,000; and for other individuals it is $200,000. For estates and trusts, the tax equals 3.8% of the lesser of undistributed net investment income or AGI over the dollar amount at which the highest trust and estate tax bracket begins.
Sec. 1411(c) defines net investment income as investment income reduced by deductions properly allocable to that income. Investment income includes income from interest, dividends, annuities, royalties, rents, and net gains from disposition of property, other than such income derived in the ordinary course of a trade or business. However, income from passive activities and from a trade or business of trading in financial instruments or commodities is included in the definition of net investment income. In the case of the disposition of a partnership interest or stock in an S corporation, only net gain or loss attributable to property held by the entity that is not property attributable to an active trade or business is taken into account. Income, gain, or loss on working capital are not treated as derived from a trade or business. Investment income does not include distributions from a qualified retirement plan or amounts subject to self-employment tax.
Sec. 3121: FICA Definitions
The IRS announced that it will accept that medical residents are exempt from FICA taxes under the student exception in Sec. 3121(b)(10) for periods ending before April 1, 2005. 63 The IRS will contact hospitals, universities, and medical residents who have filed FICA refund claims for those periods with more information. Under Sec. 3121(b)(10), a student enrolled at a school, college, or university is exempt from FICA taxes on wages paid for services performed for that school, college, or university. The IRS has argued that, as a matter of law, the student exception can never apply to medical residents. The IRS has been holding FICA refund claims that predate its regulations on the student exception 64 from both employers and medical residents because there was a dispute over whether the student exception applied. The IRS has now conceded on this point for suspended refund claims that predate the regulations and will process those claims for refund.
Sec. 6015: Innocent Spouse Relief
The Office of Chief Counsel provided direction for handling cases docketed with the Tax Court when the petitioner requested equitable relief under Sec. 6015(f) more than two years after the first collection. 65 Notice CC-2009-012, which was issued following the Tax Court’s decision in Lantz, 66 provided interim guidance for Chief Counsel attorneys in handling cases in which the petitioner’s claim for relief under Sec. 6015(f) was untimely. That guidance has been updated following the Seventh Circuit’s decision in the case, which upheld as valid the two-year limitation period in Regs. Sec. 1. 6015-5(b)(1). 67 Appeals involving this issue are pending in other circuits. 68
The notice provides that as an issue designated for litigation, the IRS will continue to deny claims for relief under Sec. 6015(f) as untimely and will not settle or concede this issue. No administrative appeal of a Sec. 6015(f) claim will be provided if the two-year rule issue is present in either docketed or nondocketed status. The Chief Counsel will not settle or concede the issue in any docketed case, although other issues may be settled or conceded (e.g., the merits of the Sec. 6015(f) claim) depending on the facts of the case. Chief Counsel attorneys will remove cases from the small tax case process under Tax Court Rule 171(c) and are instructed to oppose requests to designate cases as small tax cases where the two-year deadline is at issue.
On September 22, in Hall, 69 a case appealable to the Sixth Circuit, the Tax Court further muddied the waters by again holding that the regulations were invalid. The Hall case is discussed further in Tax Trends on p. 810.
Footnotes
1 Government Accountability Office, 2009 Tax Filing Season (GAO-10-225) (December 10, 2009).
2 Bomer, T.C. Summ. 2010-54.
3 PMTA 2009-162.
4 Homebuyer Assistance and Improvement Act of 2010, P.L. 111-198.
5 Patient Protection and Affordable Care Act, P.L. 111-148.
6 Health Care and Education Reconciliation Act of 2010, P.L. 111-152.
7 The Patient Protection and Reconciliation Acts.
8 The Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16.
9 IRS Letter Ruling 201001013 (1/8/10).
10 IRS Letter Ruling 201004005 (1/29/10).
11 Shollenberger, T.C. Memo. 2009-306.
12 Chief Counsel Memorandum AM 2008-011.
13 Longoria, T.C. Memo. 2009-162.
14 Id., citing Burke, 504 U.S. 229 (1992).
15 Stadnyk, No. 09-1485 (6th Cir. 2/26/10), aff’g T.C. Memo. 2008-289.
16 Espinoza, T.C. Memo. 2010-53.
17 Sec. 108(f)(4).
18 IRS Letter Ruling 201016043 (4/23/10).
19 IRS Letter Ruling 200953005 (12/31/09).
20 Payne, No. 08-2396 (8th Cir. 12/22/09), aff’g T.C. Memo. 2008-66.
21 Bjelland, T.C. Memo. 2009-297.
22 Thomas, T.C. Memo. 2010-11.
23 Sheikh, T.C. Memo. 2010-33.
24 Sec. 139D.
25 Natkunanathan, T.C. Memo. 2010-15.
26 Shellito, T.C. Memo. 2010-41.
27 Adler, T.C. Memo. 2010-47.
28 Vlock, T.C. Memo. 2010-3.
29 Cavaretta, T.C. Memo. 2010-4.
30 Helvering v. Janney, 311 U.S. 189 (1940).
31 Sec. 3101(b)(2). For joint returns, the income threshold for imposition of the additional tax is $250,000; in all other cases it is $200,000.
32 Sec. 164(f).
33 Rohrs, T.C. Summ. 2009-190.
34 Id., citing Heyn, 46 T.C. 302 (1966).
35 Rosser, T.C. Memo. 2010-6.
36 Friedman, T.C. Memo. 2010-45.
37 Consolidated Investors Group, T.C. Memo. 2009-290.
38 Klauer, T.C. Memo. 2010-65.
39 Haiti Assistance Income Tax Incentive Act, P.L. 111-126.
40 Purdy, T.C. Memo. 2010-27.
41 Sec. 213(f).
42 Magdalin, No. 09-1153 (1st Cir. 12/17/09), aff’g T.C. Memo. 2008-293, cert. denied, S. Ct. Dkt. 09-1136 (U.S. 4/26/10).
43 Ding, T.C. Summ. 2009-186.
44 Id., quoting Sharon, 66 T.C. 515 (1976), aff’d 591 F.2d 1273 (9th Cir. 1978).
45 Rev. Proc. 2009-54, 2009-51 I.R.B. 930.
46 Rev. Proc. 2010-10, 2010-3 I.R.B. 300.
47 Rev. Proc. 2010-18, 2010-9 I.R.B. 427.
48 TAM 200945037 (11/6/09).
49 INFO 2009-0253 (12/31/09)
50 American Recovery and Reinvestment Act of 2009, P.L. 111-5, §1001.
51 Chow, T.C. Memo. 2010-48.
52 Goolsby, T.C. Memo. 2010-64.
53 Chief Counsel Advice 201013038 (4/2/10).
54 Rev. Proc. 2010-14, 2010-12 I.R.B. 456.
55 IRS Letter Rulings 200944012 (10/30/09) and 200945020 (11/6/09).
56 IRS Letter Ruling 200946006 (11/13/09).
57 IRS Letter Ruling 201015015 (4/16/10).
58 IRS Letter Ruling 201016031 (4/23/10).
59 Steele, T.C. Summ. 2009-45.
60 CCA 200852001 (12/26/08).
61 Smith, T.C. Memo. 2008-275.
62 Reconcilation Act §1402.
63 IR-2010-25.
64 T.D. 9167, under which an institution qualifies for the student exception only if its primary purpose is to serve as a school, college, or university.
65 CC-2010-011 (6/18/10) and CC-2010-005 (3/12/10), amplifying and clarifying CC-2009-012 (4/17/09).
66 Lantz, 132 T.C. 131 (2009).
67 Lantz, No. 09-3345 (7th Cir. 6/8/10), rev’g 132 T.C. 131 (2009).
68 Coulter, No. 10-680 (2d Cir.), appeal docketed February 12, 2010; Mannella, No. 10-1308 (3d Cir.), brief filed May 10, 2010.
69 Hall, 135 T.C. No. 19 (2010).
EditorNotes
Art Auerbach is a tax director with Goodman & Company in Tysons Corner, VA. Ellen Cook is 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. Edward Gershman is a partner with Deloitte & Touche LLP in Chicago, IL. Janet Hagy is a shareholder in Hagy & Associates PC in Austin, TX. Jonathan Horn is a sole practitioner specializing in taxation in New York, NY. Annette Nellen is a professor in the Department of Accounting and Finance 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. The authors are members of the AICPA’s Individual Income Tax Technical Resource Panel. For more information about this article, contact Prof. Cook at edcook@louisiana.edu.
