This article covers recent developments affecting individual taxation. The items are arranged in Code section order.
Sec. 1: Tax Imposed
Notice 2011-64, 1 which amplifies and supersedes Notice 2006-101, 2 updates the list of U.S. tax treaties that meet the requirements for obtaining reduced capital gains rates under Sec. 1(h)(11)(C)(i)(II) on some dividend payments, as provided for under the Jobs and Growth Tax Relief Reconciliation Act of 2003. 3
Sec. 2: Definitions and Special Rules
The Tax Court denied a divorced father/noncustodial parent head-of-household filing status for the year during which he was in divorce proceedings and lived outside the marital home and apart from his two minor children. 4 The court found that Sec. 2(b)(1)’s requirement to maintain the principal place of abode for a qualifying child or dependent was not met and the taxpayer had not filed Form 8332, Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent. The court also denied the child tax credit.
Sec. 24: Child Tax Credit
On September 1, 2011, the Treasury Inspector General for Tax Administration (TIGTA) issued a report 5 stating that unauthorized workers received $4.2 billion in the refundable additional child tax credit (ACTC) in 2010. The report found that claims for the credit by workers who lack proper documentation have risen 354.5% from $924 million in 2005. TIGTA made six recommendations, some of which the IRS will address.
The IRS will work with Treasury’s Office of Tax Policy to seek clarification on whether refundable tax credits (or the refundable portion of tax credits) such as the ACTC may be paid to those who are not authorized to work in the United States. If these credits may not be paid, math error authority is needed for the IRS to disallow associated claims for the credits. Based on claims made in processing year 2010, disallowance of the ACTC to filers without a valid Social Security number would reduce federal outlays by approximately $8.4 billion over two years.
In a Tax Court case, 6 the taxpayer had a divorce agreement allowing him to claim one child every year and a second child in odd numbered years as long as he was current with his child support payments. The children lived with the former spouse who refused to sign Form 8332. The taxpayer was denied the dependency exemption and was not allowed to claim a child tax credit under Sec. 24. The court sympathized with the taxpayer but was bound by statute.
Sec. 25A: Hope and Lifetime Learning Credits
On August 24, 2011, the Congressional Research Service issued Higher Education Tax Benefits: Brief Overview and Budgetary Effects. 7 The report provides a brief overview of the higher education tax benefits that are currently available to students and their families. It contrasts higher education tax benefits with traditional student aid, presents a brief history of higher education tax policy over the past 60 years, summarizes key features of the available tax benefits, and provides Joint Committee on Taxation (JCT) estimates of revenue losses resulting from individual tax provisions.
A comprehensive table is included that provides information on various aspects of each tax benefit including the type of benefit (credit, deduction, etc.), the annual dollar amount of the benefit, what expenses qualify for the benefit, what level of education the benefit can be claimed for, income levels at which the benefit phases out, and any aspects of the benefit that are expiring during the 112th Congress.
Secs. 25C and 25D: Nonbusiness Energy and Residential Energy-Efficient Property Credits
In Letter Ruling 201130003, 8 the IRS approved a taxpayer’s proposed methodology for allocating the costs of qualified energy-efficiency improvements to his home, enabling him to maximize his energy credits (under Secs. 25C and 25D). The expenses eligible for these credits must be made on or in connection with a dwelling unit located in the U.S. and owned and used by the taxpayer as his principal residence (as defined in Sec. 121), and originally placed in service by the taxpayer.
Sec. 31: Tax Withheld on Wages
The Tax Court upheld tax fraud penalties for a taxpayer who failed to remit payroll tax withholding through his closely held corporation. 9 He filed his Form 1040, U.S. Individual Income Tax Return, and claimed credit for taxes withheld from a Form W-2, Wage and Tax Statement, from the company he owned. Since the taxpayer knew the taxes were not paid to the government, the Tax Court held he had fraudulently underpaid his tax by claiming a credit for taxes withheld from his wages.
Sec. 36: First-Time Homebuyer Credit
The Tax Court held that a first-time homebuyer was entitled to a tax credit under Sec. 36 even though the seller held title until all installment payments had been made, and did not occupy the house for the year the credit was claimed because it needed renovations. 10 The court held that the benefits and burdens had shifted to the buyer when he signed the contract for deed, and that Sec. 36 required a prospective analysis of whether a home will be occupied by the taxpayer as his principal residence for qualification.
Under Sec. 36, the term “principal residence” has the same meaning as used in Sec. 121, which excludes a limited amount of gain on the sale of a home if, during the five-year period ending on the sale or exchange, it has been owned and used by the taxpayer as his principal residence for periods aggregating two or more years.
The Tax Court differentiated between the Sec. 121 retrospective analysis, which considers whether the taxpayer has occupied a primary residence for two years or more, and the Sec. 36 prospective analysis, which considers whether the taxpayer will occupy a home as his or her principal residence.
Sec. 36B: Refundable Credit for Coverage Under a Qualified Health Plan
In August 2011, the IRS published proposed regulations 11 relating to the health insurance premium tax credit enacted by the Patient Protection and Affordable Care Act 12 and the Health Care and Education Reconciliation Act of 2010 13 as amended. The regulations provide guidance, including a number of examples, to individuals who enroll in qualified health plans through affordable insurance exchanges and claim the premium tax credit and to exchanges that make qualified health plans available to individuals and employers.
Sec. 61: Gross Income Defined
Letter Ruling 201139003 14 involved a consolidated group, G, in the mortgage lending business. Certain members of G engage in mortgage servicing activities. These members of G provide an interest subsidy to members of the military, under which they make interest payments on behalf of the military borrowers to the mortgage owners. The borrowers are fully liable on the loan if G becomes insolvent. The IRS ruled that this arrangement was not a debt modification under Regs. Sec. 1.1001-3 because the subsidy arrangement does not modify the legal relationship between the owner of the mortgage and the borrower.
In addition, the IRS, following the reasoning of Rev. Rul. 76-75 15 and the particular facts, held that the subsidy is income to the borrowers under Sec. 61 and represented deductible interest under Sec. 163 to G.
The IRS further ruled that under Sec. 6041, if the subsidy is $600 or more, G must issue a Form 1099. G must also issue a Form 1098, Mortgage Interest Statement, for the interest expense under Sec. 6050H.
Sec. 71: Alimony and Separate Maintenance Payment
The Grosjean case involved a $50,000 payment from an ex-husband to his ex-wife to help her qualify for a mortgage on the marital home in her own name. 16 The ex-husband treated the payment as alimony. The ex-husband also obtained an arbitration award finding that the payment was for maintenance rather than child support. The Tax Court held that the payment was not alimony. Under Sec. 71(b) and case law, the taxpayer must receive payments per a written divorce or separation instrument for them to be alimony. Here, the $50,000 payment was not called for by the written documents. The court also noted that state court adjudications retroactively received are “generally disregarded” for federal tax purposes.
Sec. 108: Income from Discharge of Indebtedness
The IRS issued Prop. Regs. Sec. 1.108-9 that would provide guidance in applying Sec. 108 bankruptcy and insolvency exclusions for cancellation of debt (COD) income to grantor trusts and disregarded entities. The proposed regulations would clarify the meaning of the term “taxpayer” as used in Sec. 108, with regard to a grantor trust or disregarded entity. The regulations would apply to COD income occurring on or after the date they are published as final regulations.
In Chief Counsel Advice (CCA) 201135030, 17 the IRS concluded that, under Regs. Sec. 1.446-4, a taxpayer could not defer the recognition of the part of the unamortized hedge gain from an anticipatory interest rate hedge allocable to repurchased debentures, where the taxpayer elected to defer the recognition of COD income realized on the repurchase of the debentures under Sec. 108(i).
The Tenth Circuit held that the insolvency exception did not apply to the taxpayers’ discharge of indebtedness income attributable to the termination of a variable life insurance policy. 18 The court rejected the taxpayers’ claim that their insolvency had been stipulated and found that the taxpayers were not insolvent at the time of the termination of the policy.
Sec. 117: Qualified Scholarships
In CCA 201117026, 19 the IRS reaffirmed an earlier CCA 20 concluding that amounts paid by a university to postdoctoral fellows under research grants, other than the National Research Service Award (NRSA) grants, were subject to Federal Insurance Contributions Act (FICA) taxes. The facts indicated the existence of an employment relationship between the university and the non-NRSA fellows.
Under Sec. 117(a), gross income does not include any amount received as a qualified scholarship by an individual who is a candidate for a degree at an educational organization. Sec. 117(c) provides that this exclusion does not apply to any amount that represents payment for teaching, research, or other services by the student required as a condition for receiving the qualified scholarship or fellowship.
In the CCA, the IRS concluded that the critical consideration was not the primary purpose of the university’s research training program but, rather, the terms and conditions of the relevant sponsored research award and the facts and circumstances relating to the disbursement of funds under the award.
A series of private letter rulings 21 addressed exempt organization/private foundation’s procedures for granting scholarships to comply with Sec. 4945(g). The IRS found in each case that the awards granted in accordance with the procedures did not constitute taxable expenditures under Sec. 4945(d)(3), and the awards made under those procedures were excludible from recipients’ gross income under Sec. 117(c)(2).
Sec. 131: Certain Foster Care Payments
In Letter Ruling 201131007, 22 the IRS ruled that adult foster care payments received by an S corporation were properly treated as payments received by the corporation’s sole shareholder/care provider and were excludible from the shareholder’s income under Sec. 131.
Sec. 162: Trade or Business Expenses
The optional standard mileage rate for business use remains at 55½ cents per mile, and the depreciation component increases to 23 cents per mile for 2012. 23
The Tax Court decided a case in which a self-employed accountant attempted to deduct wages he claimed to have paid to his 17- and 20-year-old daughters. 24 The taxpayer had an M.S. in accounting and spent seven years working at the IRS as both a revenue agent and Appeals officer before starting his own tax preparation business. In 2007, he deducted payments to his daughters for administrative expenses. However, neither daughter was issued a paycheck, a Form 1099-MISC, Miscellaneous Income, or a Form W-2. Furthermore, no income tax was withheld from these supposed payments. The taxpayer claimed that he was paying his daughters for work performed by paying their credit card bills. Yet, he failed to provide evidence to substantiate the amounts of those payments. To top it off, he listed the supposed wages as “cost of goods sold” to hide their character. The Tax Court upheld the notice of deficiency.
Sec. 163: Interest
The 2011–12 Priority Guidance Plan issued by Treasury in September 2011 includes guidance under Sec. 163(h) for mortgage interest limitations. 25
In Rose, T.C. Summ. 2011-117, the Tax Court held that a couple could deduct qualified residence interest on a vacation home that was never built because they could not get construction financing due to a crisis in the credit markets. The court held that construction began for purposes of the qualified residence interest rules when the sellers demolished the existing home on the property as required by the sales contract. It also concluded that the fact that the home was never built did not prevent the taxpayers from deducting residence interest incurred during the 24-month “under construction” period sanctioned by the regulations.
In Letter Ruling 201136005, 26 married taxpayers were granted a 60-day extension from the date the IRS issued the letter to elect to include qualified dividend income in net investment income under Sec. 163(d)(1) and Sec. 163(d)(4)(B). The IRS found that the taxpayers had reasonable cause for failing to make the election on time because they had relied on the advice of a tax professional who did not advise them to make the election, they were unaware of the need for the election, and they promptly requested relief upon discovering their error.
Sec. 165: Losses
Schroerlucke 27 involved the question of whether a $6.7 million stock loss generated in 2002, when a longtime WorldCom employee sold 128,758 shares of WorldCom stock, should be treated as ordinary or capital. The taxpayer treated the loss as capital, using $3,000 of it on the 2002 return, but in April 2006 amended his 2002 return to treat the stock loss as a theft loss (ordinary) because the loss was caused by “theft by deception” as defined under Georgia law. The change resulted in a loss carryback and refunds of $2,661,550, based on a 2002 unreimbursed theft loss of $6,530,047. The IRS denied the refunds.
The court noted that a theft loss requires intent to deprive and does not arise from “fraudulent inducements to hold a publicly traded stock while it declines in value.” The IRS noted that WorldCom did not receive anything from the taxpayer, and thus it could not have taken anything from the taxpayer, which is necessary for a theft. The court held for the IRS.
Sec. 166: Bad Debts
In Dagres, 28 the Tax Court found that entities that served as general partners of venture capital fund limited partnerships were engaged in the trade or business of managing venture capital funds. The Tax Court held that the taxpayer, a venture capitalist, was entitled to a deduction for a business bad debt loss of $3.6 million for a loan he made to a business associate that was not fully repaid. The court concluded that the general partner entities at issue were engaged in a trade or business of managing venture capital funds and then attributed that activity to the taxpayer as member-manager of the entities. The court found that his loss was proximately related to his trade or business, given that the 20% profits interest he received from the funds yielded him more income than his salary or his personal investment in the funds.
Sec. 170: Charitable Contributions and Gifts
The Tax Court allowed a charitable contribution for unreimbursed expenses incurred in support of a charitable organization in Van Dusen, 29 which has received substantial publicity. The case involved a taxpayer who cares for feral cats as a volunteer for an organization that traps, neuters, and offers feral cats for adoption. Four months later, a summary opinion was issued in Bradley 30 that used the principles laid down in Van Dusen to allow a taxpayer to deduct the costs of a pizza party and vehicle mileage while volunteering as a football league cheerleader coach. In each case, although the taxpayer did not have the required documentation, she did substantially comply with the requirements. The records she provided contained the same information that would have been found on canceled checks.
A Tax Exempt and Government Entities Directive (TE/GE Directive) the IRS issued regarding fundraising by sports booster clubs could cost some taxpayers their charitable contributions. 31 The directive makes it clear that contributions to a booster club are only deductible to the extent that the amount of the contributions exceeds the value of benefits the club provides in return. According to the directive, booster clubs typically provide substantial benefits in return for contributions and thus the contributors may not qualify for the charitable contribution deduction.
The IRS has issued guidance that formalizes the extent an individual may depend on Publication 78, Cumulative List of Organizations Described in Section 170(c) of the Internal Revenue Code of 1986, when making a charitable contribution. 32 Because the IRS no longer publishes a paper version of Publication 78, the guidance relies heavily on notices issued through the IRS website or in the Internal Revenue Bulletin. Further clarification is needed on when a taxpayer’s deduction may be denied due to prior knowledge of an organization’s revocation before public notice occurs or partial responsibility for such revocation.
Sec. 179: Election to Expense Certain Depreciable Business Assets
In a Sec. 179 expensing case, the owner of an over-the-road trucking business classified as an S corporation purchased an aircraft for potential use as transport for replacement drivers to ensure the business was able to make time-critical deliveries. 33 The owner’s husband, an employee of the S corporation, took flying lessons, but did not advance beyond a student license. No other employee of the business held a pilot’s license during the tax year in question, and the plane was not used other than for the husband’s flying lessons. The business took the maximum $125,000 Sec. 179 deduction for the aircraft’s purchase, which it passed through to the owner.
The IRS disallowed the deduction because the plane was not used for business purposes. The owner and her husband attempted to justify the deduction using the “idle asset” rule, but provided no evidence to support their claim that “stand-by” pilots were available or that the plane was otherwise available for use for its stated business purpose. However, the Tax Court held that the couple was not liable for an accuracy-related penalty because they had consulted a competent tax adviser (their CPA), supplied all relevant information, and relied on the adviser’s professional judgment.
Sec. 183: Activities Not Engaged in for Profit
In Weller, 34 after being laid off from Boeing, the taxpayer bought a glider and started offering flight instruction and rides in the aircraft. He later obtained full-time employment elsewhere and eventually Boeing rehired him. During the years involved in this case, he was employed full time and worked in the glider business on weekends only. Each year, he reported substantial losses, caused by his decision to depreciate the aircraft over seven years.
The IRS determined that he was not in a trade and business because, among other things, his outside full-time employment precluded a second trade or business. Despite the fact that he had not maintained proper books and records, had shown a loss for all the years involved, and had not previously undertaken a successful similar enterprise, the Tax Court ruled that he had clearly “engaged in the glider activities with the primary purpose and intent of realizing an economic profit independent of tax savings” and allowed the Schedule C expense deductions.
Sec. 212: Expenses for Production of Income
An individual purchasing and selling securities was classified as an investor, not a trader; therefore, the expenses were deductible under Sec. 212, not Sec. 162. 35 Legal and professional expenses were not deductible, as there was no evidence that they pertained to matters involving the investor’s portfolio.
An individual invested in a program in which he leased a breeding animal with the proceeds of a loan. 36 The individual claimed ownership of the animal and sought to deduct the expenses associated with breeding the animal. The Tax Court found that the documents detailing the expenses associated with the animal’s breeding did not substantiate the deductibility of those expenses, either as a Sec. 162 deduction or as a Sec. 212 deduction and disallowed any Sec. 212 deduction because the correct amount of the taxpayer’s expenses related to the activity could not be ascertained.
Sec. 213: Medical, Dental, etc. Expenses
The Tax Court disallowed a deduction for supplies paid to caregivers claimed by a decedent’s estate because the estate failed to establish that any amount paid to the caregivers for supplies was paid for medical care. 37 However, the court held that costs for other medical care for the decedent and caregiver costs (for two individuals) that were incurred before the decedent’s death did qualify for the deduction.
The decedent was chronically ill, and the court found that the services provided to her were in accordance with a plan of care as prescribed by a licensed health care practitioner; therefore, they constituted qualified long-term-care services. Such services included the amounts paid to the physicians for diagnosis, cure, mitigation, treatment, or prevention of disease (not reimbursed by insurance or otherwise) and the amount paid to the caregivers for their medical care services.
Sec. 215: Alimony, etc. Payments
In a Tax Court case, the alimony deduction a taxpayer claimed for payments made to his ex-spouse, when the ex-spouse sold the marital home, were disallowed. 38 Under the terms of the couple’s divorce decree, the taxpayer’s support obligation terminated only by satisfying the mortgage on the marital home or reimbursing the ex-spouse for the mortgage payoff amount when the marital home was sold. The Tax Court found that the termination of the payments was, in fact, tied to the mortgage payoff period and not to the ex-wife’s need for the funds. Thus, the payments did not satisfy the requirements of Sec. 71(b)(1)(D) because the obligation did not terminate on death.
Sec. 280E: Expenditures in Connection with the Illegal Sale of Drugs
Sec. 280E denies any deduction or credit relating to the trafficking in controlled substances. In Information Letter 2011-0005, 39 the IRS responded to inquiries from six members of Congress to confirm that Sec. 280E applies to sales of marijuana intended for medical purposes in states where such sales are legal.
Observation: The Small Business Tax Equity Act of 2011, H.R. 1985, which was introduced in May, would add an exception to Sec. 280E for the sale of marijuana for medical purposes in states that allow such sales. The bill has been referred to the House Ways and Means Committee.
Sec. 469: Passive Activity Losses and Credits Limited
Rev. Proc. 2011-34 40 allows taxpayers to make late elections to treat all interests in rental real estate as a single rental activity, by attaching a statement required by Regs. Sec. 1.469-9(g)(3) to an amended return for the prior tax year and mailing the amended return to the IRS service center where that taxpayer will file its current tax return.
Prior to the release of Rev. Proc. 2011-34, taxpayers had to apply for Regs. Sec. 301.9100 relief in this situation. There were several such rulings issued in 2011. For example, in Letter Ruling 201131002, 41 the taxpayer was in the real property business and was qualified under Sec. 469(c)(7)(B) to elect to treat all interests as a single rental real estate activity, but failed to include in her tax return the necessary election statement. The taxpayer requested an extension of time to file this election. The letter ruling concluded that the requirements of Regs. Secs. 301.9100-1 and 301.9100-3 were satisfied, and the taxpayer was granted a 60-day extension to make the election. 42
In Harnett, 43 the taxpayer argued that he was entitled to the Sec. 469(c)(7) real estate exception to the per se passive activity loss rule because he materially participated and spent more than 750 hours managing the properties during the year and therefore, his losses should be allowed. The taxpayer did not maintain a contemporaneous log and attempted to reconstruct the time spent.
The court found that the taxpayer had failed to provide documentation that credibly supported his estimates. Although the court concluded that the taxpayer spent some time dealing with various properties, it was not convinced that he performed more than 750 hours of services due to several factors. He was in ill health and held an important job at a bank; the properties were widely dispersed geographically; and he relied upon various agents, brokers, lawyers, and contractors, as well as his wife, to manage the properties in question.
In Miller, 44 the taxpayer argued that he and his wife were entitled to the Sec. 469(c)(7) real estate exception to the per se passive activity loss rule for rental real estate because they materially participated and spent more than 750 hours. Therefore, he contended that the losses should be allowed for all of his properties. Although the taxpayer held a job piloting commercial seagoing vessels, testimony and contemporaneous logs showed that he met the 750-hour requirement where he completed a number of significant construction projects, both as contractor and landlord, and performed additional real estate tasks, including researching and bidding on properties, finding tenants, collecting rent, and performing maintenance work.
Although the court concluded that the taxpayer was a qualified real estate professional, the court also had to consider whether he materially participated in these rental activities. Since the taxpayer did not make an election to treat all real estate interests as a single activity, the court had to consider whether the taxpayer materially participated with respect to each rental real estate activity. The court held that the taxpayer participated in activities at two out of six rental properties for over 100 hours and that his participation was not less than the participation of any other individual. The taxpayer, however, did not meet the 100-hour requirement or show that his participation in the remaining four properties constituted substantially all of the participation.
In Hill, 45 the taxpayers argued they were entitled to the Sec. 469(c)(7) real estate exception to the per se passive activity loss rule. The Tax Court held that the taxpayers failed to establish that they were entitled to deduct the real estate losses claimed. The Fifth Circuit affirmed the Tax Court’s decision and agreed that the taxpayers were not entitled to rental real estate activity loss deductions because the wife’s estimate of real estate activities under Sec. 469(c)(7) was not reasonable or credible and their adjusted gross income (AGI) exceeded the Sec. 469(i) limitation.
Sec. 1001: Determination of Amount and Recognition of Gain or Loss
A sale of transferable state tax credits was found to constitute the sale of a capital asset rather than the generation of ordinary income. 46 However, the holding period of the real property donation that created the credits did not carry over to the credits themselves and thus were classified as short-term rather than long-term capital gains.
A taxpayer lost the argument that a 90% loan against closely held stock was not a constructive sale of the stock at the time of the loan. 47 The transaction constituted a sale because there was no expectation of repayment of the loan, the title to the stock was transferred to the promoter, and an unrestricted right of transfer was granted to the promoter.
Wickersham 48 provides a road map for allocating the basis of mixed-use property between residential and business use. The case also highlights factors useful in determining whether a property is a principal residence qualifying for Sec. 121 gain exclusion. The taxpayers owned mixed-use property subject to a lease that included a purchase option. During the period of the lease, the county sought to purchase the property for highway construction. After threatening condemnation, the county obtained a permanent right-of-way across both the business and personal sections of the property. The Tax Court found that the grant of the permanent easement was a sale of a partial interest in the property and therefore was a realization event. After the sale of the easement, the lessee exercised his purchase option. The taxpayers prevailed in supporting a higher personal-use portion and in qualifying for Sec. 121 exclusion of gain.
T.D. 9538 clarifies that a nonassigning counterparty is not considered to exchange derivative contracts solely because a dealer in securities transfers or assigns the contract to another dealer in securities, provided that the transfer or assignment is permitted by the terms of the contract.
Sec. 1012: Basis of Property—Cost
Notice 2011-56 49 contains interim guidance on a taxpayer’s changing from the broker’s default average-cost-basis method to the cost-basis method for regulated investment company (RIC) or dividend reinvestment plan (DRP) shares. Proposed regulations are expected to provide that the taxpayer has to elect to change the basis method of all shares by the earlier of (1) one year from the date of receiving notice of the broker’s default method or (2) the date of the first sale, transfer, or disposition. Otherwise, the election will only apply to subsequently acquired shares.
Sec. 1016: Adjustments to Basis
The taxpayer claimed that expenditures for his rental property were currently deductible repairs. 50 The Tax Court determined that the expenditures were capital improvements that increased the property’s basis.
Sec. 1031: Like-Kind Exchange
The owner of the Hard Rock Café brand exchanged an aircraft for another aircraft to be used in his business of promoting the brand. 51 Funds from the transfer where inadvertently deposited into the business’s account rather than the account of the qualifying intermediary. Although the funds were transferred to the qualifying intermediary, the IRS sought to overturn the 1031 exchange. The court held that the deposit error did not invalidate the qualifying exchange. However, additional questions were raised as to the personal vs. business use of the aircraft and whether the aircrafts were actually used for productive use in a trade or business. The court denied a refund of $9,755,483 pending further evidence of the business use of the aircrafts.
Sec. 1035: Tax-Free Exchanges of Insurance Policies
Notice 2011-68 52 provides interim guidance that life insurance policies, qualified long-term-care contracts, annuities, and endowments may be exchanged for each other in a tax-free exchange.
Rev. Proc. 2011-38 53 modified guidance in Rev. Proc. 2008-24 54 to reduce the 12-month waiting period to 180 days. Thus, a transfer of an annuity will be treated as a tax-free exchange if no amount, other than an amount received as an annuity for a period of 10 years or more or during one or more lives, is received under either the original contract or the new contract during the 180 days beginning on the date of the transfer (in the case of a new contract, the date the contract is placed in-force).
Sec. 1058: Transfer of Securities Under Certain Agreements
Taxpayers’ attempted use of Sec. 1058 to defer gain on a complex securities lending arrangement failed due to the restrictions on termination of the arrangement. 55 The restrictions impeded the taxpayers’ opportunity for gain and thereby nullified the application of Sec. 1058.
Sec. 1211: Limitation on Capital Losses
A taxpayer failed to establish ownership and basis in an entity for which he claimed capital loss deductions. 56 A purported stock certificate showed that another entity actually owned the stock. A second claimed capital loss for his expenditures for hotels and restaurants, purported to be an investment in his girlfriend’s hair salon business, was denied due to lack of substantiation of business purpose.
A taxpayer was found not to be a dealer in securities entitled to make a mark-to-market election. 57 His trading losses were limited to a net capital loss of $3,000, and he was not entitled to a net operating loss deduction for losses incurred as an investor rather than as a dealer. The Tax Court reached a similar result for a taxpayer who was an infrequent trader and did not seek to profit from short-term market volatility. 58
The Tax Court upheld most of a taxpayer’s additions to basis for improvements to his home, even though they were paid for by his wholly owned, though inactive, corporation and some receipts were missing. 59 The taxpayer had deposited refinancing receipts and other rental income into the corporate account to cover the expenditures, and the court characterized it as just a “piggybank” for the taxpayer. The Tax Court applied the Cohan 60 rule to allow the expenditures for which there was other documentation but no receipts. The court also allowed the taxpayer a short-term capital loss for an uncollected lawsuit judgment because documentary evidence and the taxpayer’s credible testimony established the loss and the IRS failed to rebut this evidence.
Sec. 1221: Capital Asset Defined
Married taxpayers sold stock in exchange for cash and notes payable from a business owned by the taxpayer-husband. 61 The notes were considered to be a cash equivalent valued at face value. The Fifth Circuit upheld the Tax Court’s decision that the taxpayers were required to report the sale of the stock.
A real estate contractor successfully argued that the sale of multifamily real estate lots was investment-motivated rather than of property held primarily for sale to customers. 62 He had bought, developed, and sold many properties over 26 years that constituted property held primarily for sale to customers. However, the properties in question were determined to have been purchased for the production of rental income, but had to be sold for financial reasons.
In another case, the Ninth Circuit ruled that the sale of corporate goodwill constituted a sale of a corporate asset owned by the dental practice personal service corporation rather than a long-term gain personal asset owned by the individual dentist. 63 The dentist worked for the corporation under an employment agreement with a noncompete covenant, while he owned the corporation and continued to work for the buyer through the corporation after the sale. In an interesting sidelight, the taxpayer attempted to argue that the employment contract and noncompete covenant were canceled upon the sale. The court noted that, if this were true, the release of the contracts would have generated a dividend to the taxpayer in the amount of the agreed-upon goodwill.
Secs. 1401 and 1402: Tax on Self-Employment Income
As a follow-up to the Renkemeyer 64 case, Janine Cook, deputy division counsel/associate chief counsel, IRS Tax-Exempt and Government Entities Division, spoke at the Employment Taxes session of the Section of Taxation of the American Bar Association meeting. Cook called the decision “an extra gift to the IRS.” According to Cook, the court determined the general partner status under state law, but it also looked at the facts and found that the partner was acting as a general partner. But it is not clear whether it was both factors or either one independently that led the court to its conclusion. She said the decision is “a little murky” with respect to the determination. 65
Regulations proposed in 1997 would have created a functional test whereby, if a person had personal liability for the partnership’s debts, could contract on behalf of the partnership, or participated in the partnership’s trade or business for more than 500 hours per year, he or she could not be considered a limited partner. According to the IRS, those proposed regulations have never been withdrawn, and practitioners can rely on them.
In commenting on Renkemeyer and other cases, Stewart Karlinsky 66 suggested that Temp. Regs. Sec. 1.469-5T(e) rules could be applied to LLCs and to partnerships to differentiate investment earnings from active earnings for net self-employment purposes as well as losses. If a limited liability partner had the benefit of claiming a loss given that the passive activity rules do not apply, then income should also be considered active and therefore subject to self-employment tax.
Sen. Bernard Sanders, D-Vt., introduced S. 1558, the Keeping Our Social Security Promises Act, which would apply payroll taxes to remuneration and earnings from self-employment up to the contribution and benefit base ($110,100 in 2012), as well as to remuneration in excess of $250,000.
In e-mailed advice, the IRS concluded that amounts paid to an elected member of an Indian tribal council for services rendered in his official capacity are not subject to FICA, Self-Employment Contributions Act (SECA), or income tax withholding. 67 Based on Rev. Rul. 59-354, 68 remuneration paid to the tribal council member is not subject to FICA taxes or income tax withholding. Amounts paid to a tribal council member for services rendered as an elected tribal council member are also not subject to the taxes imposed under SECA.
Sec. 3101: Employment Taxes
On October 19, the Social Security Administration announced inflation-indexing modifications scheduled for the program, including an increase in January 2012 of the maximum amount of earnings subject to Social Security tax from $106,800 to $110,100. Additionally, monthly Social Security and Supplemental Security Income (SSI) benefits will increase 3.6% due to a cost-of-living adjustment.
Sec. 3509: Determination of Employer’s Liability for Certain Employment Taxes
A new initiative by the IRS allows small businesses to properly reclassify their workers as employees, rather than independent contractors, while paying minimal back taxes and avoiding all interest and penalties. 69 The Voluntary Classification Settlement Program (VCSP) seeks to get small businesses to become compliant with their worker classifications. The VCSP is open to businesses that have treated workers as nonemployees in the past, have filed Forms 1099-MISC for the previous three years, and are not currently under a worker classification audit by the IRS, the Department of Labor (DOL), or a state agency.
Businesses must agree to prospectively treat the class of workers as employees for future tax periods and pay 10% of the employment tax liability that may have been due on the compensation paid to the workers for the most recent tax year at rates determined under Sec. 3509. They will not be liable for any penalties or interest.
This program is different from the Classification Settlement Program (CSP) that the IRS introduced in March 1996. The CSP is available only to businesses that are undergoing an IRS examination of worker classification. To participate in the VCSP, a taxpayer must submit an application, Form 8952, Application for Voluntary Classification Settlement Program. The taxpayer should file the application at least 60 days before the date it wants to begin treating its workers as employees.
A memorandum of understanding between the IRS and the DOL signed in September 2011 is intended to improve compliance with laws and regulations administered by the IRS and DOL. The sharing of information will help reduce the incidence of misclassification of employees as independent contractors, reduce abusive tax schemes, and improve compliance with labor and tax laws.
Sec. 6015: Relief from Joint and Several Liability on Joint Return
Notice 2011-70 70 formally removes the two-year deadline for requests for equitable relief under Sec. 6015(f) and provides that authority until the Sec. 6015(f) regulations are amended. The following transitional rules apply:
- Future requests: After July 25, 2011, the effective date of the notice, equitable relief under Sec. 6015(f) may be filed without regard to when the first collection activity was taken.
- Pending requests: There is no need to reapply for relief. The IRS will consider relief without regard to the two-year period as long as the period of limitation under Sec. 6502 or 6511 was open when the request was initially filed.
- Requests that were initially denied for untimeliness and not litigated: Individuals in this situation may reapply for relief by filing a new Form 8857, Request for Innocent Spouse Relief. Any amount for which a refund was available as of the date of the original filing and any amount subsequently collected are eligible for refund if other criteria for equitable relief are met. The IRS can only grant relief with respect to unpaid liabilities if the period of limitation on collection, under Sec. 6502, remains open as of the date of reapplication for relief.
- Requests in litigation: For any case in litigation where relief was denied by the IRS as untimely or if equitable relief was raised for the first time in litigation and the two-year rule was applied as a defense, the IRS will take appropriate action in the case consistent with the position in this notice. There is no need for individuals in this situation to reapply.
- Requests that were in litigation and are now final: If the IRS stipulated in the court proceeding that relief would have been granted had the request been timely, the IRS will not seek, effective July 25, 2011, to collect any portion of the underlying liability for which equitable relief would have been granted. There is no need to reapply for relief. The decision not to collect is prospective only, and no refunds or credits will be available.
The IRS also issued Notice 2012-8, 71 which contains a proposed revenue procedure that would supersede Rev. Proc. 2003-61 72 when it is finalized. Rev. Proc. 2003-61 has the IRS’s current rules for granting equitable innocent spouse relief under Sec. 6015(f). The biggest changes in the new proposed rules, which taxpayers may choose to apply immediately, are (1) the availability of a streamlined procedure under which, in appropriate cases, the IRS will grant relief in “the initial stage of the administrative process” (which the notice does not define), (2) a much broader view of how a requesting spouse’s being subjected to financial control or abuse affects the various prerequisites for relief and (3) the availability of refunds in more cases.
In Akopian, 73 a return preparer was denied Sec. 6015(b) relief from joint liabilities arising from unreported income from personal use of her husband’s movie production/investment corporation’s funds. The evidence in the case showed that the taxpayer knew her husband had an ownership interest in a movie production/investment corporation and she knew her husband was “taking care of some expenses” with corporate money because she and her tax preparation company received checks from the corporation; and she actually prepared the couple’s returns, relying only on her husband’s oral claims that he had no income, which she should have known were untrue due to her experience as a tax return preparer. Therefore, the court held she did not meet the requirements of Sec. 6015(b)(1).
Sec. 6654: Estimated Tax Payments
In Wheeler, 74 the Tax Court determined that an individual was liable for additional income tax and penalties for what the court ruled to be frivolous positions. The court also determined that the taxpayer was liable for an addition to tax under Sec. 6654 for failure to pay estimated tax. The Tax Court found that the addition to tax was supported by substitute returns prepared by the IRS and by additional evidence that the taxpayer did not meet any of the exceptions for payment found in Sec. 6654(e). The Tenth Circuit affirmed the Tax Court’s finding. 75
In Fernandez, 76 a taxpayer was liable for an addition to tax under Sec. 6654 for failure to pay estimated taxes because the taxpayer made no required estimated tax payments and none of the statutory exceptions applied. A Sec. 6654 addition to tax is imposed on an individual taxpayer who fails to make timely payments of estimated taxes unless one of the exceptions of Sec. 6654(e) applies.
1 Notice 2011-64, 2011-37 I.R.B. 231.
2 Notice 2006-101, 2006-2 C.B. 930.
3 Jobs and Growth Tax Relief Reconciliation Act of 2003, P.L. 108-27.
5 TIGTA, Individuals Who Are Not Authorized to Work in the United States Were Paid $4.2 Billion in Refundable Credits (2011-41-061) (July 7, 2011).
6 Nixon, T.C. Memo. 2011-249.
7 CRS, Higher Education Tax Benefits: Brief Overview and Budgetary Effects (R41967) (August 24, 2011).
8 IRS Letter Ruling 201130003 (7/29/11).
9 May, 137 T.C. No. 11 (2011).
10 Woods, 137 T.C. No. 12 (2011).
11 REG-131491-10, 76 Fed. Reg. 50931 (8/17/11).
12 Patient Protection and Affordable Care Act, P.L. 111-148.
13 Health Care and Education Reconciliation Act of 2010, P.L. 111-152.
14 IRS Letter Ruling 201139003 (9/30/11).
15 Rev. Rul. 76-75, 1976-1 C.B. 14.
16 Grosjean, T.C. Summ. 2011-75.
17 CCA 201135030 (9/2/11).
18 McGowen, 438 Fed. Appx. 686 (10th Cir. 9/2/11).
19 CCA 201117026 (4/29/11).
20 CCA 200944027 (10/30/09).
21 IRS Letter Rulings 201113038 (4/1/11), 201113039 (4/1/11), 201114032 (4/8/11), 201114033 (4/8/11), 201114034 (4/8/11), 201115027 (4/15/11), 201126031 (7/1/11), 201126032 (7/1/11), 201126033 (7/1/11), 201136026 (9/9/11), 201136028 (9/9/11), 201140026 (10/7/11), 201140027 (10/7/11), and 201143025 (10/28/11).
22 IRS Letter Ruling 201131007 (8/5/11).
23 IR 2011-116; Notice 2012-1, 2012-1 I.R.B. 260.
24 Bulas, T.C. Memo. 2011-201.
25 Treasury Dep’t, 2011–2012 Priority Guidance Plan.
26 IRS Letter Ruling 201136005 (9/9/11).
27 Schroerlucke, 100 Fed. Cl. 584 (2011).
28 Dagres, 136 T.C. 123 (2011).
29 Van Dusen, 136 T.C. No. 25 (2011).
30 Bradley, T.C. Summ. 2011-120.
31 PMTA-2011-004 (11/24/10).
32 Rev. Proc. 2011-33, 2011-25 I.R.B. 887.
33 Douglas, T.C. Memo. 2011-214.
34 Weller, T.C. Memo. 2011-224.
35 Van der Lee, T.C. Memo. 2011-234.
36 Van Wickler, T.C. Memo. 2011-196.
37 Estate of Lilian Baral, 137 T.C. No. 1 (2011).
38 Moore, T.C. Memo 2011-200.
39 Information Letter 2011-0005 (12/16/10).
40 Rev. Proc. 2011-34, 2011-24 I.R.B. 875.
41 IRS Letter Ruling 201131002 (8/5/11).
42 See also IRS Letter Rulings 201128009 (7/15/11), 201126016 (7/1/11), 201126026 (7/1/11), 201125002 (6/24/11), and 201117011 (4/29/11).
43 Harnett, T.C. Memo. 2011-191.
44 Miller, T.C. Memo. 2011-219.
45 Hill, 436 Fed. Appx. 410 (5th Cir. 8/12/11).
46 McNeil, T.C. Memo. 2011-109.
47 Landow, T.C. Memo. 2011-177.
48 Wickersham, T.C. Memo. 2011-178.
49 Notice 2011-56, 2011-29 I.R.B. 54.
50 Oglesby, T.C. Memo 2011-93.
51 Morton, 98 Fed. Cl. 596 (Fed. Cl. 4/27/11).
52 Notice 2011-68, 2011-44 I.R.B. 691.
53 Rev. Proc. 2011-38, 2011-30 I.R.B. 66.
54 Rev. Proc. 2008-24, 2008-1 C.B. 684.
55 Samueli, 661 F.3d 399 (9th Cir. 11/1/11).
56 Rahall, T.C. Memo 2011-101.
57 Kay, T.C. Memo 2011-159.
58 Van der Lee, T.C. Memo 2011-234.
59 Greenwald, T.C. Memo. 2011-239.
60 Cohan, 39 F.2d 540 (2d Cir. 1930).
61 Felt, 433 Fed. Appx. 293 (5th Cir. 7/21/11).
62 Gardner, T.C. Memo. 2011-137.
63 Howard, No. 10-35768 (9th Cir. 8/29/11).
64 Renkemeyer, Campbell & Weaver, LLP, 136 T.C. No. 137 (2011).
65 See Nash, “Partners’ Limited Liability and Self-Employment Tax,” 42 The Tax Adviser 476 (July 2011), for additional information on Renkemeyer.
66 Karlinsky, “Self-Employment Taxes and PALs: The Case of LLCs,” 132 Tax Notes 1391 (September 26, 2011).
67 CCA 201119032 (5/13/11).
68 Rev. Rul. 59-354, 1959-2 C.B. 24.
69 Announcement 2011-64, 2011-41 I.R.B. 503.
70 Notice 2011-70, 2011-32 I.R.B 135.
71 Notice 2012-8, 2012-4 I.R.B.
72 Rev. Proc. 2003-61, 2003-2 C.B. 296.
73 Akopian, T.C. Memo. 2011-237.
74 Wheeler, T.C. Memo 2010-188.
75 Wheeler, No. 10-9005 (10th Cir. 11/1/11).
76 Fernandez, T.C. Memo. 2011-216.
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 at Lafayette, LA. Karl Fava is a principal with Business Financial Consultants Inc. in Dearborn, MI. Edward Gershman is a partner with Deloitte Tax 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. Daniel Moore is with D.T. Moore & Co., LLC, in Salem, OH. Annette Nellen is a professor in the Department of Accounting and Finance at San José State University in San José, CA. Dennis Newman is a tax manager at Sharrard McGee & Co., PA, in Greensboro, NC. Teri Newman is a partner with Blackman Kallick in Chicago, IL. Kenneth Rubin is a partner with RubinBrown LLP in St. Louis, MO. Amy Vega is a senior tax manager with Grant Thornton LLP in New York, NY. Prof. Nellen is chair and the other authors are members of the AICPA’s Individual Income Tax Technical Resource Panel. For more information about this article, contact Prof. Nellen at email@example.com.