Individual Tax Update

By Karl L. Fava, CPA; Edward A. Gershman, CPA; Janet C. Hagy, CPA; Jonathan Horn, CPA; Daniel T. Moore, CPA; Annette Nellen, J.D., CPA; Dennis Newman, CPA; Teri E. Newman, CPA; Kenneth L. Rubin, CPA; and Amy M. Vega, CPA




  • The Tax Court held that for purposes of calculating the qualified residence interest limitations under Sec. 163(h)(3), the limitations apply on a per residence, not a per taxpayer, basis.
  • Until it issues up-to-date regulations under Sec. 163, the IRS announced that taxpayers may use any reasonable method to allocate excess mortgage debt.
  • The Seventh Circuit disallowed a couple’s charitable contribution for donating their house to a fire department because the fair market value of the house did not exceed the value of the benefits they received in having the house demolished.
  • A taxpayer whose bar was condemned while he was in prison was permitted to establish the basis of the building using his testimony and the testimony of bar employees and neighbors.

This article covers recent developments affecting individual taxation. The items are arranged in Code section order.

Sec. 32: Earned Income

In Santana, 1 the Tax Court once again addressed the thorny issue of the child exemption for divorced parents. The child resided with Mr. Santana’s ex-wife, but he had a mediation agreement stating that they would claim the exemption in alternate years provided he remained current on his child support payments. The agreement did not specify which parent would go first, but Mr. Santana’s ex-wife took the exemption in odd-numbered years, and in 2008, while current with his child support payments, he claimed the exemption. He and his new wife had net earnings from self-employment of $17,433 and adjusted gross income of $18,949. Claiming the child as a dependent made them eligible for the earned income tax credit (EITC).

Unfortunately for Mr. Santana, he did not obtain or attach to his return a signed Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents, or an equivalent. The court explained that, even if Mr. Santana had attached the mediation agreement, it would not have been an equivalent because it was unclear on precisely which years he was entitled to take the exemption and did not indicate which parent would go first in the alternating sequence.

The court stated that,

We are not unsympathetic to petitioners’ position. We also realize that the statutory requirements may seem to work harsh results to taxpayers, such as Mr. Santana, who are current in their child support obligations and who are entitled to claim the dependency exemption deductions under the terms of a child support order. However, we are bound by the statute as it is written and the accompanying regulations when consistent therewith. 2

Sec. 61: Gross Income Defined

In Walker , 3 the Tax Court found that allocation of 99% of the income from a dental practice to a family-owned LLC was an improper assignment of income. The court found that the LLC’s only purpose was to avoid income and employment tax and that it lacked economic substance. The substantial understatement of tax penalty was upheld against the dentist (the father of other LLC members).

Sec. 103: Interest on State and Local Bonds

In DeNaples, 4 the taxpayer’s land was condemned by the state. The parties reached an agreement for the state to pay the landowner with a five-year note. The taxpayer excluded the interest income from the note from his income per Sec. 103. The IRS disagreed, finding that Sec. 103 did not apply to the note, and the Tax Court agreed with the IRS.

The Third Circuit, however, found that Sec. 103 applied and reversed the Tax Court, stating that,

[W]hen the state pays interest at a fixed rate pursuant to a statutory or judicial command, it is plainly not excludable under Section 103 of the Internal Revenue Code. On the other hand, when the government’s obligation to pay interest arises out of voluntary bargaining, the interest exclusion may play an important role in allowing the state to reduce its borrowing costs. This implicates the state’s borrowing authority and may be excludable under Section 103. 5

The court also noted that “the purpose underlying Section 103 was well served in this case.”

Sec. 104: Compensation for Injuries or Sickness

In Sewards , 6 the taxpayer, a sheriff, retired after he became disabled. He received payments under a plan that was called a service-connected disability retirement and did not report these payments on his tax return, claiming they were nontaxable disability payments. The court, however, held that, to the extent the payments were increased based on the taxpayer’s length of service, they could not be excluded under Sec. 104: “Section 104(a)(1) does not apply, however, to the extent the payments are determined by reference to the employee’s age or length of service or the employee’s prior contributions, even if the employee’s retirement is occasioned by occupational injury. Sec. 1.104-1(b), Income Tax Regs.” 7

Sec. 107: Rental Value of Parsonages

In Driscoll, 8 the court overturned a Tax Court decision and held that the exclusion for parsonage allowances under Sec. 107 applied to only one home rather than two. More specifically, the court found that under the rules of statutory construction “home” meant a single home, and that this interpretation was supported by the legislative history dating back to 1921. The court also noted that income exclusions should be “narrowly construed.”

Sec. 108: Income From Discharge of Indebtedness

In Brooks, 9 the court addressed the issue of forgiven interest on an employment-related loan. Mr. Brooks, a stockbroker, received a loan of more than $500,000 from his employer (Dain) in March 1998 with the proviso that if he remained employed for five years, both the principal and the accrued interest would be forgiven. In 2003, Dain reported the amount of the forgiven principal and interest (approximately $650,000) as income to Brooks on his Form W-2, Wage and Tax Statement. Brooks reported the full amount on his return and paid the income tax on it.

The IRS issued a notice of deficiency to Brooks about other matters on his 2003 return, which the parties settled, but Brooks now claimed that the interest should be excluded under Sec. 108(e)(2), which excludes from cancellation of debt income any amount that would have given rise to a deduction. He argued that the interest would have been deductible under Sec. 212 as an expense for the production of income, namely for stock purchases to prove his ability as a stockbroker to Dain. The IRS argued, and the court agreed, that the taxpayer did not attempt to trace the flow of funds received from Dain to prove their usage. The court further noted that, even if the interest could be traced to the stock purchases, its deductibilty would be limited as investment interest expense under Sec. 163(d). The court denied Brooks’s claim of income exclusion for the forgiven interest.

In T.D. 9557, the IRS added Regs. Sec. 1.108-8, addressing the transfer of a partnership interest to satisfy a debt. The regulations provide instructions and an example to calculate the amount of debt forgiven when a partnership exchanges an equity interest for outstanding debt.

Sec. 131: Certain Foster Care Payments

In Stromme, 10 the taxpayers excluded from income approximately $550,000 in foster care payments from the state of Minnesota during tax years 2005 and 2006. The IRS decided that the payments were not excludable under Sec. 131 and, after allowing some business expense deductions, issued a deficiency for more than $140,000.

The Strommes owned two homes, one that appeared to be their primary residence and a second that was used to house individuals with developmental disabilities. Although they maintained an office at this second property, spent significant time there, and occasionally slept over, the court determined that they were unable to exclude the payments from gross income because they did not live in that house. However, the court disagreed with the IRS’s imposition of an accuracy-related penalty: “[G]iven the ambiguity in this area of law, we find the Strommes’ confusion reasonable and honest.” 

Sec. 162: Trade or Business Expenses

In Porch, 11 an IRS audit revealed that the taxpayers understated Schedule C income by roughly $50,000 a year in 2005 and 2006. They also failed to report a small capital gain and took a number of unsubstantiated business expenses. It was not an unusual case except that their defense was that they used a tax return preparer who did not sign the returns. They further argued that the return preparer was elderly and failed to include the additional income on their returns. Not only did the court uphold the IRS deficiency determinations, but it also upheld the IRS’s imposition of the fraud penalty under Sec. 6663.

Failing to file for six years, fictitious net operating losses (NOLs), unreported rental income—none of these make Esrig 12 worth noting. Two elements separate this case from the run of the mill, though. First, one of the taxpayers claimed home office expenses for a large fish tank in the foyer of their home where business contacts would sit and wait for meetings. The second was their claim that their returns were not filed because their accountant had been sent to prison for murdering her husband and that her staff had made many mistakes. The taxpayers presented “no evidence to support this lurid tale,” so the court rejected it as a reasonable cause defense to penalties.

The court agreed with IRS determinations of income, deductions, and gain on returns for the years 1998 through 2000 that were filed so late that the IRS prepared substitute returns. On the taxpayers’ returns, they claimed NOLs, underreported their rental income, and overreported the basis of assets sold. They did not substantiate any of their expenses for their real estate rental and repair business and failed to provide credible testimony at the trial.

In Hand, 13 a real estate broker tried to claim flight training was a necessary expense for his business. The court found that he failed to produce any evidence of a direct or proximate relationship between the flying lessons and the skills he required as a commercial realtor.

Cibotti, 14 a relatively typical case primarily involving substantiation requirements for certain business expenses, had an interesting sideline issue. A mortgage loan officer claimed that even though he received a Form W-2 from a business in which he was a minority shareholder, he was actually an independent contractor and was entitled to deduct his expenses on Schedule C and was not subject to the 2% floor on miscellaneous itemized deductions on Schedule A. Somewhat surprisingly, the Tax Court agreed after reviewing the usual set of factors. The court’s analysis is interesting because this case involves the opposite of the usual employee vs. independent contractor disagreement.

Mobasher 15 might belong under Sec. 183, but the activity really cannot be called a hobby. The taxpayer worked full time in a sign manufacturing business that he had started, but he also claimed to be a real estate agent (an activity his brother engaged in and had convinced him to try). While he did get a license and training from RE/MAX, he reported no income from his real estate activities and claimed expenses averaging almost $10,000 a year on Schedules C for tax years 2004, 2006, and 2007. Because there was no evidence that his real estate activity was a trade or business activity, the Schedule C expenses were disallowed.

Sec. 163: Interest

In Sophy, 16 the Tax Court declared that for purposes of calculating the qualified residence interest limitations under Sec. 163(h)(3), the limitations apply on a per-residence basis, even if two co-owners are unrelated parties. See Tax Trends, “Qualified Residence Interest Limits Apply on a Per Residence Basis,” 43 The Tax Adviser 354 (May 2012), for a detailed discussion of this case.

In Chief Counsel Advice (CCA) 201201017, 17 the IRS discussed allocation of excess mortgage debt under Temp. Regs. Sec. 1.163-10T, which was issued in 1987. Until the IRS issues updated regulations, taxpayers may use any reasonable method of allocating excess mortgage debt, including the exact and simplified methods outlined in the temporary regulations. Furthermore, if the taxpayer is using the simplified method, he or she is permitted to allocate excess interest under the interest tracing rules of Temp. Regs. Sec. 1.163-8T without making the election in Temp. Regs. Sec. 1.163-10T(o)(5) to treat the debt as not secured by a qualified residence. The election under Temp. Regs. Sec. 1.163-10T(o)(5) applies to the entire debt.

Sec. 164: Taxes

The IRS issued an Information Letter 18 clarifying that real property taxes “may, depending on the facts and circumstances, be deductible as real property taxes even though they are not imposed on an ad valorem basis.” As a result, California, which conforms to federal law on the deductibility of real property taxes, explained that its earlier position was wrong and that it would revise California’s forms and instructions once the IRS did. 19

Sec. 170: Charitable Contributions and Gifts

The Seventh Circuit upheld the Tax Court’s decision in Rolfs 20 that a couple’s donation of their home to a local fire department for demolition had zero value and thus they could not claim a charitable contribution. The court’s decision effectively ends the precedent set in Schar f 21 by establishing that a donor is only entitled to a charitable contribution to the extent the fair market value (FMV) of contributed property exceeds the FMV of the benefits received by the donor (in this case, the cost of demolishing their home to allow construction of a new one).

Underscoring the increasing number of Tax Court cases involving donations of conservation easements under Sec. 170(h)(4)(A), the IRS in late November 2011 issued an Audit Techniques Guide (ATG) devoted to the issue. 22 ATGs serve as a road map for practitioners and IRS examiners of the proper procedures to follow when considering a particular transaction that frequently draws IRS scrutiny.

Colorado was the location for conservation easements of land parcels in two cases in which the IRS prevailed. In Esgar, 23 three taxpayers claimed charitable contributions of more than $2.27 million combined, claiming that the best predonation use of the land was as a gravel mine. The Tax Court agreed with the IRS that its best use was actually agricultural and reduced the value of the donations to under $100,000. In Carpenter, 24 the court found that the taxpayers did not satisfy the requirement that the easement be granted in perpetuity. The deeds contained a provision that if the “circumstances arise . . . that render the purpose of this Conservation Easement impossible to accomplish,” the easement would be terminated. The court wrote, “We do not find that petitioners intended to donate their property . . . with a general charitable purpose.”

In another conservation easement case, 25 this one on Martha’s Vineyard, the Tax Court upheld the IRS’s disallowance of a $4.5 million charitable contribution because of deficiencies in the acknowledgment letter from the recipient, the Nature Conservancy. Unlike a slew of previous cases where a gift letter was not provided or provided late, in this case the Nature Conservancy left out some of the consideration it provided the donors. The court believed that this precluded a finding of a good-faith effort to comply with the requirements of Sec. 170(f)(8).

As of the end of April 2012, there were 216 docketed cases in the Tax Court involving this issue.

Sec. 183: Activities Not Engaged in For Profit

In Strode, 26 the taxpayer was a successful attorney, earning around $175,000 a year. He also claimed business deductions on a Schedule C for an “international consulting” business of around $80,000 a year with no income reported for the business. This pattern existed for tax years 2003 through 2008. For some undisclosed reason, either the IRS assessed deficiencies (or the taxpayer challenged them) only for tax years 2005 and 2007. The taxpayer failed to testify at trial or make much of a case, claiming he “could not spare the time.” To no one’s surprise, he lost the case, and the court also upheld a 20% accuracy-related penalty.

In Bronson, 27 the IRS won a horse-breeding case. Over 11 years, the taxpayers had gross receipts from horse breeding of just $25,000 while racking up losses of more than $837,000. Meanwhile, the husband was a successful attorney with an average net income of more than $200,000 a year. This case provides a near-perfect guide to what not to do if you want to claim horse breeding as a trade or business.

Sec. 213: Medical, Dental Expenses

In Gaerttner, 28 the taxpayers jointly filed their 2005 income tax return, claiming a medical and dental expense deduction of $20,915. They contended they were entitled to the full deduction of their medical and dental expenses, including expenses from a 2002 automobile accident, dental expenses, and prescription drug co-payments. The Tax Court determined that the taxpayers were not entitled to the deduction for medical expenses from the accident because an insurance settlement was received. Additionally, the taxpayers were not entitled to deductions for expenses that they failed to substantiate. To substantiate the expenses, the taxpayers had submitted photocopied adding machine tapes, which were unreadable and contained handwritten notations.

Sec. 215: Alimony Payments

In LaPoint, 29 the taxpayer, a professional baseball player, entered into a postnuptial agreement. The agreement assigned to his spouse his interest in any funds he received from the resolution of an arbitration between the Major League Baseball Players Association and the owners of 26 MLB clubs. Additionally, he agreed to deposit $50,000 annually into a bank account for his spouse, so long as he received compensation from playing baseball, and he agreed to maintain health insurance for his spouse and any children born to them.

In the event of divorce, his spouse was entitled to retain ownership of the MLB proceeds and the $50,000 annual payments. Also included in the postnuptial agreement was a provision indicating that it was “binding on heirs”—meaning, it would inure to the benefit of, and be binding upon, the parties, their heirs, executors, legal representatives, and assigns.

The couple divorced in 2005. Because the obligation to make the payments to the taxpayer’s spouse would have survived her death, the payments were not considered alimony for federal income tax purposes per Secs. 71(b) and 215(b) and therefore were not deductible.

Sec. 217: Moving Expenses

In Olagunju, 30 a husband and wife were denied a deduction they claimed for moving expenses because they were not job-related. On their jointly filed 2008 income tax return, the taxpayers deducted $8,600 of moving expenses, yet they did not explain why they were entitled to the deduction. They introduced into evidence a freight bill from a moving company, an estimate from a moving company, and a $49 vendor receipt.

Sec. 217(a) provides that “there shall be allowed as a deduction moving expenses paid or incurred during the taxable year in connection with the commencement of work by the taxpayer as an employee or as a self-employed individual at a new principal place of work.” Because the taxpayers failed to offer sufficient and credible evidence that their move was job related, the deduction was denied.

Sec. 263: Capital Expenditures

Bailey, 31 a complicated, 143-page Tax Court opinion with a table of contents and proposed deficiency exceeding $4 million over nine years, involved F. Lee Bailey. Bailey was the sole owner of an S corporation called Palm Beach Roamer (PBR), through which Bailey intended to remanufacture small planes and sell them for less than new airplanes. He called these remanufacturing efforts “Project 288,” which the IRS and Tax Court determined he engaged in for profit from 1994 to 1996, despite its failure to generate a profit.

PRB created only a prototype and did not develop manufacturing processes. Thus, the IRS claimed that expenses for the project were not currently deductible, but were instead either startup expenses or capital expenditures under Sec. 263(a)(1). If the expenditures were intended to build a specified asset, such as the prototype plane, those expenditures would be considered part of the basis for that specific asset. The court ruled that because there was insufficient evidence to support that the expenses Bailey claimed were for a purpose other than the development of a prototype, these were capital expenditures and part of basis. Some of the expenditures were deductible in the year the project was terminated.

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

In Ong, 32 the Tax Court denied the taxpayer a deduction for various expenses of two houses that she claimed she used for business: One was her principal residence, and the other was her son’s principal residence. The court denied the deductions for the house the taxpayer lived in because the taxpayer made personal use of the house and failed to prove that any part of the house was used exclusively for business. With regard to the house her son lived in, the court noted that if a family member of a taxpayer lives in a house, that family member’s personal use of the house would be attributable to the taxpayer. Thus, because she was deemed to have made personal use of the house and failed to establish that she had used any part of the house exclusively for business, the Tax Court denied the deductions for the house.

Sec. 469: Passive Activity Losses and Credits Limited

In Iversen, 33 the taxpayers argued that they were entitled to deduct losses from a cattle ranching activity because they materially participated in the activity. They claimed they spent more than 500 hours working on the ranch and the husband served as the day-to-day manager. The taxpayers did not offer evidence to support those claims, and the facts indicated otherwise. The husband worked as president and founder of a medical equipment manufacturing company, the taxpayers lived in another state, and the ranch had a full-time manager.

The court held for the IRS, finding that the taxpayer’s work for the ranch fell more into the investor category and, as such, did not count toward satisfying the more than 500 hours of material participation test. 34 The court did not uphold the accuracy-related penalty, however, finding that the taxpayers reasonably relied on their CPA’s advice. The “accountant should have known better, particularly if the accountant was shown no more evidence and documentation than was shown to us.”

In Langille, 35 the taxpayer maintained a law practice as well as real estate rentals, which she argued were “one single activity” for purposes of Sec. 469. She also argued that she was entitled to the special rule for real estate professionals under Sec. 469(c)(7), but the Eleventh Circuit agreed with the Tax Court’s holding that the taxpayer did not spend over half of her time or more than 750 hours “in real property trades or businesses.” The court also found that the taxpayer’s real estate and law practice activities did not qualify as a single activity.

In Vandegrift, 36 the taxpayers owned nine real estate properties. The husband worked as a salesman for an unrelated company, earning a salary of $120,000. Although the taxpayers argued that the husband qualified as a real estate professional, the Tax Court concluded that the husband’s estimate of the time he spent in those activities was suspect because of his full-time job and the lack of contemporaneous time records. The court held that lack of records meant that the burden of proof did not shift to the IRS and the taxpayers’ losses were disallowed. The taxpayers did prevail on their other claim, that all of their real estate activities were one activity for which the gains and losses had to be netted.

In Iovine, 37 the taxpayers worked for American Airlines as a pilot and flight attendant. The husband had an Illinois real estate brokers’ license, and he and his wife owned a number of properties, which they rented. They deducted the losses on their return, taking the position that these rental real estate losses were nonpassive because the husband qualified as a real estate professional.

The IRS and Tax Court found that he did not qualify in 2005 since he did not prove he met the time requirements because his time logs were not contemporaneously kept and were at best a “ballpark guesstimate.” For 2006, the court agreed that the husband spent more than half of his time in the real property trades or businesses, but he did not meet the material participation test for all of the properties, which meant that the time spent on those rentals had to be subtracted from his total hours. With that reduction, he did not work the required number of hours to be a real estate professional under Sec. 469(c)(7). In addition, the taxpayers could not treat the rentals as a single activity for measuring material participation because they had not elected to do so.

In Samarasinghe, 38 the taxpayers owned a commercial office building that they rented to the husband’s wholly owned medical corporation starting in 1980. The taxpayers reported the rental income as passive and offset passive losses from other activities against it, but the IRS assessed a deficiency against the taxpayers with respect to the rental income for the years 2005 through 2007, claiming that the rental income from the commercial building was self-rental income under Regs. Sec. 1.469-2(f)(6), which required it to be recharacterized as nonpassive income.

The taxpayers argued that the self-rental rule did not apply because they were entitled to transitional relief under Regs. Sec. 1.469-11(c)(1)(ii) for rental income “pursuant to a written binding contract entered into before February 19, 1988.” To qualify for this relief, a taxpayer must prove that the rental income was paid under a written lease entered into before Feb. 19, 1988, that was still in effect. The court concluded that in 2005 through 2007, the taxpayers and the medical corporation did not pay much attention to the terms of the 1980 lease. The court described the lease as “a meaningless document that was simply not followed” in those years by the parties. Therefore the taxpayers were subject to the self-rental income recharacterization rule.

Three cases 39 involved similar fact patterns where taxpayers participated in micro-utility activities, claiming losses and Sec. 48 business energy investment credits on their returns. The IRS disallowed the losses because they arose either from an activity in which the taxpayers did not materially participate or from a rental activity, which is automatically a passive activity. The taxpayers countered that their micro-utility businesses were not a passive rental activity and that they materially participated. While the taxpayers were the sole owners of the micro-utility activity, they had contracted with a company to handle most day-to-day administrative work, such as collecting payments and sending invoices. The Tax Court found that the contractor’s work caused the taxpayers to not meet any material participation test. Thus, the losses were passive activity losses.

Sec. 1011: Adjusted Basis for Determining Gain or Loss

Wilson 40 is a colorful case of reconstruction of events to determine the basis of a commercial property. The case provides a road map for reconstruction of basis based on corroborated testimony. In 2000, while a bar owner was serving a prison sentence, his bar property was condemned and acquired by the city of Des Moines, Iowa, for airport expansion. The owner had made significant improvements to the bar property over the years, including installing a parking lot, replacing the bar building’s roof after it collapsed, and later rebuilding the bar building after a major fire. The taxpayer’s testimony and that of bar employees and neighbors, along with tax appraisals, convinced the court of the amounts spent for improvements that could be included in basis.

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

Replacement property in a like-kind exchange ultimately became the taxpayers’ personal residence, but the Tax Court found it qualified as replacement property under Sec. 1031 because the owners proved investment intent at the time of the exchange. 41 When the owners applied for a real estate loan to purchase the replacement property, they indicated it was for investment and tried unsuccessfully to rent the property for several months after purchasing it. After property values fell significantly in the area (Lake Tahoe), they decided it was financially more beneficial to sell their primary residence and move to the replacement property. However, based on the testimony at the trial, the court found that at the time of the exchange, the taxpayers intended to hold the replacement property as an investment and not to use it as a residence.

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

In a Tax Court case, the court held that the taxpayers’ investment of qualified small business stock sale proceeds into a jewelry and gem business did not qualify under Sec. 1045 because the new business did not meet the active business test, which requires that at least 80% of the assets of the new corporation be used in an active trade or business. 42 Of the more than $1.9 million invested, only $147,000 of inventory was purchased, and all but 8% of the sales proceeds were held in cash.

Sec. 1234: Options to Buy or Sell

Settlement of put contracts with borrowed shares closes the transactions for tax purposes, the IRS ruled in a technical advice memorandum. 43 The fact that the borrowed shares’ ultimate value is indeterminable at the time of a put contract settlement does not support open transaction treatment.

Sec. 1256: Contracts Marked to Market

In Wright, 44 the taxpayers, through their wholly owned LLC, deducted losses on foreign currency options when the options were assigned to another entity, taking the position that the assignment resulted in a termination of a contract. The market value of the options at the time of transfer was less than the basis. The Tax Court determined that the rules of Sec. 1256 do not apply to foreign currency options because foreign currency options are not foreign currency contracts as defined in Sec. 1256(g)(2). Options may never be exercised, whereas contracts require actual delivery of the currency under contract.

Sec. 6015: Relief From Joint and Several Liability on Joint Return

In Melot, 45 the taxpayer attempted to claim innocent spouse relief in a collection case, in which the basis of the tax liability came from returns the IRS prepared. Since Ms. Melot did not file a joint return with her husband, a district court held that she was ineligible for relief under Sec. 6015.

In Miles, 46 the taxpayer attempted to claim innocent spouse relief for the first time in her court filings. The U.S. District Court properly stated that a taxpayer claiming innocent spouse relief must first exhaust all remedies with the IRS. Ms. Miles never filed a Form 8857, Request for Innocent Spouse Relief, and thus the district court was unable to consider her claim.

In Zaher, 47 the court dealt with a particularly unpleasant intervening ex-spouse. Even the IRS acknowledged at trial that the husband’s egregious misconduct weighed in favor of relief for the petitioner. The husband sold his gas station in 2006 and deposited the proceeds into a joint account. One week before his wife filed for divorce in 2007, he transferred those funds first to his separate business account and then to his brother to distribute to other family members. The couple failed to file their 2006 return timely and did not pay the tax due on the return. As an intervening party in his wife’s case, the husband tried to claim that his wife should pay the entire outstanding liability.

Sec. 6654: Failure by Individual to Pay Estimated Income Tax

Under Sec. 6654(a), for tax years beginning after Dec. 31, 2012, the addition to tax now includes tax under Chapter 2A (the Sec. 1411 3.8% Medicare tax). 48

In McLaine, 49 the taxpayer and his former spouse reported a tax liability of $3,276,333 on their 1999 federal tax return, no withholding, total payments of $1.6 million, and an amount due of $1,676,333, which was not remitted with the return. Payments of $1.6 million were made in July and October of 2001, and a penalty for failure to pay estimated taxes was assessed in the amount of $101,872. The former spouse requested and received joint liability relief.

The taxpayer argued that the addition to tax assessed under Sec. 6654 “would be against equity and good conscience” within the meaning of Sec. 6654(e)(3)(A). Sec. 6654(e)(3)(A) states that “No addition to tax shall be imposed under subsection (a) with respect to any underpayment to the extent the Secretary determines that by reason of casualty, disaster, or other unusual circumstances the imposition of such addition to tax would be against equity and good conscience.”

The taxpayer argued undue hardship on the ground that he lacked the ability to ascertain his 1999 tax liability despite good-faith attempts to do so. The taxpayer also argued that he paid as much of the income tax as possible despite the financial hardship that the payments caused him. As his third and final argument, the taxpayer argued that his alcoholism constituted reasonable cause for failure to timely file his 1999 tax liability. The court ruled that the evidence of undue hardship and alcoholism did not support a finding that the assessment of the Sec. 6654(a) addition of tax “would be against equity and good conscience” within the meaning of Sec. 6654(e)(3)(A).

In Dykema, 50 the Eighth Circuit upheld a ruling of the Tax Court that dismissed a taxpayer’s petition challenging a notice of deficiency issued by the IRS, upheld the assessments, and imposed sanctions against the taxpayer for asserting frivolous arguments. The taxpayer received the notice of deficiency for the 2006 through 2008 tax years and argued that his income from self-employment during those years was not income because he was not “privileged to receive ‘wages’ or ‘income’ as defined by the Code” because he was not in public office. Sec. 7701(a) states that “a trade or business” includes “the performance of a public office.” The court argued that this cannot be interpreted to mean that it is limited to “performance of a public office,” as the taxpayer argued.

In Trupp, 51 the IRS prepared a substitute for return (SFR) for a taxpayer who failed to file a tax return for 2005. According to the SFR, the taxpayer had a tax liability of $93,841, and he was assessed additions to tax under Secs. 6651(a) and 6654. The taxpayer, an attorney, claimed that he was entitled to various deductions that were not included on the SFR, including cellphone expenses, client storage expenses, travel expenses, accounting expenses, and expenses incurred as part of the taxpayer’s “equine industry law marketing campaign.”

The taxpayer’s two arguments were that his equestrian activities and legal practice were a single activity and that the equestrian-related expenses were deductible, as the activity was engaged in for a profit. Under Regs. Sec. 1.183-1(d)(1), multiple undertakings of a taxpayer may be treated as one activity if they are sufficiently interconnected.

The most important factors in making the determination are the degree of organizational and economic interrelationship of the activities, the business purpose served by carrying on the activities together, and the similarity of the activities. After reviewing the evidence submitted, the court found that the taxpayer’s characterization of his equestrian activities and his legal practice as one activity was unreasonable and disallowed the equestrian-related expenses because the equestrian activity was not engaged in for profit.


1 Santana, T.C. Memo. 2012-49.

2 Id. at *9.

3 Walker , T.C. Memo. 2012-5.

4 DeNaples, T.C. Memo. 2010-171, rev’d, 674 F.3d 172 (3d Cir. 2012).

5 DeNaples, 674 F.3d 172, slip op. at 10.

6 Sewards , 138 T.C. No. 15 (2012).

7 Id. at *5–*6.

8 Driscoll, 669 F.3d 1309 (11th Cir. 2012), rev’g 135 T.C. 557 (2010), cert. denied, Sup. Ct. Dkt. 12-153 (10/1/12).

9 Brooks, T.C. Memo. 2012-25.

10 Stromme, 138 T.C. No. 9 (2012).

11 Porch, T.C. Summ. 2012-25.

12 Esrig, T.C. Memo. 2012-38.

13 Hand, T.C. Summ. 2012-1.

14 Cibotti, T.C. Summ. 2012-21.

15 Mobasher, T.C. Summ. 2012-14.

16 Sophy, 138 T.C. No. 8 (2012).

17 CCA 201201017 (11/1/11).

18 Information Letter Number 2012-0018 (2/6/12).

19 See California Franchise Tax Board information on the real estate deduction.

20 Rolfs, 668 F.3d 888 (7th Cir. 2011), aff’g 135 T.C. 471 (2010).

21 Scharf, T.C. Memo. 1973-265.

22 IRS, Conservation Easement Audit Techniques Guide (Jan. 3, 2012).

23 Esgar Corp., T.C. Memo. 2012-35.

24 Carpenter, T.C. Memo. 2012-1.

25 Cohan, T.C. Memo. 2012-8.

26 Strode, T.C. Memo. 2012-59.

27 Bronson, T.C. Memo. 2012-17.

28 Gaerttner, T.C. Memo. 2012-43.

29 LaPoint, T.C. Memo. 2012-107.

30 Olagunju, T.C. Memo. 2012-119.

31 Bailey , T.C. Memo. 2012-96.

32 Ong, T.C. Memo. 2012-114.

33 Iversen , T.C. Memo. 2012-19.

34 Temp. Regs. Sec. 1.469-5T(f)(2)(ii)(B).

35 Langille, No. 10-15130 (11th Cir. 2011).

36 Vandegrift, T.C. Memo. 2012-14.

37 Iovine , T.C. Summ. 2012-32.

38 Samarasinghe , T.C. Memo. 2012-23.

39 Wilson, T.C. Memo. 2012-101; Uyemura, T.C. Memo. 2012-102; and Lum, T.C. Memo. 2012-103.

40 Wilson, T.C. Summ. 2011-132.

41 Reesink, T.C. Memo. 2012-118.

42 Owen, T.C. Memo. 2012-2.

43 TAM 201214021 (4/6/12).

44 Wright, T.C. Memo. 2011-292.

45 Melot, No. 09-752 JCH/WPL (D.N.M. 3/21/12).

46 Miles, No. CV 10-2398 CW (N.D. Cal. 3/30/12).

47 Zaher, T.C. Memo. 2012-11.

48 Health Care and Education Reconciliation Act, P.L. 111-152 (3/30/10).

49 McLaine, 138 T.C. No. 10 (2012).

50 Dykema, 447 Fed. Appx. 757 (8th Cir. 2012).

51 Trupp, T.C. Memo. 2012-108.



Karl Fava is a principal with Business Financial Consultants Inc. in Dearborn, Mich. Edward Gershman is a partner with Deloitte Tax LLP in Chicago. Janet Hagy is a shareholder with Hagy & Associates PC in Austin, Texas. Jonathan Horn is a sole practitioner specializing in taxation in New York City. Daniel Moore is with D.T. Moore & Co. LLC, in Salem, Ohio. Annette Nellen is a professor in the Department of Accounting and Finance at San José State University in San José, Calif. Dennis Newman is a tax manager with Sharrard McGee & Co. PA, in Greensboro, N.C. Teri Newman is a partner with Blackman Kallick in Chicago. Kenneth Rubin is a partner with RubinBrown LLP in St. Louis. Amy Vega is a senior tax manager with Grant Thornton LLP in New York City. Prof. Nellen is chair and the other authors are members of the AICPA Individual Income Tax Technical Resource Panel. For more information about this article, contact Prof. Nellen at


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