Individual Taxation: Recent Developments

This article covers recent developments in the area of individual taxation, including cancellation-of-debt (COD) income; a hobby loss case where the taxpayer prevailed with the IRS, but not with the state taxing authority; theft and casualty losses; and a number of home office deduction cases. The items are arranged in Code section order.

Sec. 24: Child Tax Credit

The Eighth Circuit held that income tax refunds attributable to additional child tax credits are protected from creditors in bankruptcy because they are meant to be welfare payments, which are exempt from the bankruptcy estate under applicable Missouri state law.¹

Sec. 61: Gross Income Defined

In Announcement 2015-22, the IRS stated that an individual whose personal information may have been compromised in a data breach will not have to include in gross income the value of identity protection services provided by the entity that experienced the data breach. Additionally, the IRS stated that an employer whose employees’ data may have been compromised will not have to include the value of identity protection services in the employees’ gross income. This announcement does not apply to identity protection services received for reasons other than a data breach or to cash received in lieu of identity protection services.

Editor’s note: The IRS later expanded the guidance provided in Announcement 2015-22 to include identity protection services provided to employees or other individuals before a data breach occurs (see Announcement 2016-2).

Sec. 62: Adjusted Gross Income Defined

The taxpayer in Cutler,² a principal in a law firm, took the position he could deduct on his Schedule E, Supplemental Income and Loss, the state nonresident income taxes paid on his share of his partnership’s income. The Tax Court agreed with the IRS that the taxes must be deducted on Schedule A, Itemized Deductions, as the taxpayer failed to show that the taxes were either expressly or constructively imposed on the partnership itself.

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

In Letter Ruling 201532026, the taxpayer, who was a nonspouse beneficiary under two separate annuity contracts, elected a 10-year payout option and timely provided the relevant election forms to the companies that issued the contracts. However, due to a competing claim from a second beneficiary and the resulting legal dispute, the two annuity companies froze the distributions. The alternative claim was resolved more than a year after the death of the annuity owner. As such, although the taxpayer timely elected the 10-year payout option, since the annuity companies did not begin distributions until more than a year after the annuity owner’s death, the letter ruling concluded that the entire proceeds payable to the taxpayer as a designated beneficiary must be paid out within five years of the annuity owner’s death.

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

Proposed regulations³ would eliminate the requirement that a copy of the taxpayer’s Sec. 83(b) election be submitted with his or her individual tax return for the year the property is transferred. This change was made because commercial software for e-filing does not always allow taxpayers to submit a Sec. 83(b) election. According to the preamble to the regulations, the service center that receives the election already generates an electronic copy, which eliminates the need for the taxpayer to submit a copy with the return.

Sec. 108: Income From Discharge of Indebtedness

In Dunnigan,⁴ the taxpayer was unable to pay back amounts borrowed on a line of credit for his appraisal business. The credit agreement provided that the taxpayer was both individually, and on behalf of his appraisal business, jointly and severally liable, and the taxpayer promised to pay all loans and all other debts, obligations, and liabilities of every kind and description arising out of all account transactions authorized by the taxpayer.

The taxpayer received a Form 1099-C, Cancellation of Debt, from the creditor reporting COD income, and he included it with his return along with a written note stating that the creditor told him that he was not liable for repayment of the canceled debt. He noted that he had explained to the creditor that he had a serious cancer problem and that he was 76 years old; thus, the creditor marked “no” in box 5 of the Form 1099-C indicating that the taxpayer was not personally liable for the debt. The taxpayer also noted that the local IRS office suggested that he explain the situation at the time of filing and that the IRS told him it would likely come under “hardship” rules. Therefore, he did not include the COD income on his return.

The Tax Court concluded that the credit agreement provided that the taxpayer was individually and severally liable for repayment of the credit line, not withstanding the contrary box 5 indication. Further, the court found the taxpayer’s reliance on alleged statements of the creditor and IRS employees was not persuasive. Moreover, the court held that the taxpayer’s hardship was not the type that permitted excluding COD income, and that he had not proved he was insolvent or bankrupt, which would have allowed him to exclude the income. Therefore, the court held the taxpayer was taxable on the COD income.

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

In DeBough,⁵ the taxpayer excluded gain on the installment sale of his personal residence under Sec. 121 and later reacquired the property after the buyers defaulted. The Tax Court determined that, under Sec. 1038, the taxpayer must recognize long-term capital gain on the reacquisition equal to the amount of installment payments received less the amount of gain previously recognized to “[ensure] that tax treatment of the transactions matches the underlying economic reality.” None of the gain that was excluded under Sec. 121 could be excluded under this calculation. The Tax Court pointed out that Sec. 1038 provided a limited exception from gain recognition where the residence was resold within one year of reacquisition, which did not apply to the taxpayer.

On appeal, the taxpayer argued that limiting the “special rule”to only those taxpayers who resell a principal residence within one year of reacquisition was unduly harsh. However, the Eighth Circuit disagreed and affirmed the Tax Court’s decision, finding that the taxpayer was not entitled to the principal-residence exclusion because he had not resold the property within one year.⁶

Sec. 122: Certain Reduced Uniformed Services Retirement Pay

In Taylor,⁷ the taxpayer originally included in taxable income all military retirement income reported as taxable on his Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., on his 2006, 2007, and 2008 income tax returns. However, after advice from an acquaintance and before he filed his 2009 tax return, he filed amended returns for 2006, 2007, and 2008 excluding a portion of this pay. On each amended return, the taxpayer claimed a refund by treating the taxable amount as excludable from income. Included with each amended return was a statement showing how the amount of the exclusion was computed. The taxpayer based his refund claims on Sec. 122, which excludes the amount of any reduction in an individual’s military retirement pay pursuant to the individual’s survivor’s annuity election under the Retired Serviceman’s Family Protection Plan under 10 U.S.C. Section 1431. The IRS paid the refunds, and there is no record of an attempt to recover them.

On the taxpayer’s self-prepared 2009 federal income tax return, the taxpayer’s military retirement pay reported as taxable on Form 1099-R was shown but not included in the income reported as taxable on that return. For the years 2006-2009, the taxable portion of the taxpayer’s military retirement pay did not include his disability income or the amount paid to his former spouse pursuant to their divorce. Further, the taxpayer had not previously made a survivor’s annuity election as required under Regs. Sec. 1.122-1(d). Therefore, the Tax Court found that Sec. 122 and its corresponding regulations did not permit the exclusion that the taxpayer claimed.

However, the Tax Court held that the taxpayer was not liable for the 20% accuracy-related penalty under Sec. 6662 for a substantial understatement of income tax. Even though there was no basis for the claimed exclusion, the court noted that the IRS’s having allowed the refund claims for 2006, 2007, and 2008 could lead a reasonable person to believe that the basis for the exclusion had merit.

Sec. 162: Trade or Business Expenses

In Letter Ruling 201536006, the IRS determined that a taxpayer’s litigation costs attributable to patent infringement were deductible as ordinary and necessary expenses. The taxpayer filed a patent infringement suit against a company it believed infringed its affiliate’s patent. The finding that the legal expenses were currently deductible was based on the fact that they were incurred pursuant to a legal obligation related to the trade or business.

The ruling differentiated when legal costs are deductible or when they must be capitalized. Patent infringement costs are capital costs if they are incurred for the defense or perfection of the patent. When the costs are incurred to protect against an infringement of a patent, they become deductible.

In Espaillat,⁸ the taxpayers, who had their own landscaping business, also worked in the husband’s brother’s scrap metal business and lent the business substantial amounts of money. At their CPA’s advice, they claimed “other expenses” on Schedule C, Profit or Loss From Business (Sole Proprietorship), on their tax return for the $359,000 they gave to the brother’s business. Under examination, the taxpayers could not show that they were carrying on a business because they did not own the scrap metal business and the business was a C corporation for which losses and deductions remain at the corporate level. Despite substantiating their expenses, they could not show that they carried on an independent business other than their landscaping business.

Sec. 162 allows the deduction of ordinary and necessary expenses of carrying on a trade or business. If there is no valid business, then there are no deductible expenses. The taxpayers also alternatively claimed deductions for losses on worthless securities and business bad debts, which are discussed below, under Sec. 165 and Sec. 166.

Sec. 163: Interest

Bruce Voss and Charles Sophy were two unmarried individuals who were co-owners of real property. Each claimed mortgage interest on $1 million of acquisition mortgage borrowing and $100,000 of home-equity borrowing on their separate income tax returns. In 2012, the Tax Court held that the taxpayers were allowed in total the interest on $1.1 million of borrowing to be allocated between them. The Ninth Circuit overturned the Tax Court and allowed each individual to deduct the interest on the mortgage borrowing up to the statutory limit.⁹

Although the result only applies to taxpayers residing in the Ninth Circuit, this has been a hotly contested issue in recent years. The result is a reversal of the IRS’s position that two unmarried individuals co-owning and occupying a residence had to apply the interest deduction limits of a married couple.

Sec. 164: Taxes

A taxpayer in the state of Washington was allowed to treat an excise tax paid to the state as a reduction in the amount realized from the sale of marijuana.¹⁰ Sec. 280E, which is discussed below, prohibits deductions and credits being allowed against the sale of illegal substances. The Chief Counsel Advice (CCA) determined that the excise tax could be treated under Sec. 164(a) as a reduction in the amount realized, thereby reducing income from the sale.

With more states allowing the sale of marijuana for medical or recreational use, the CCA takes on more importance. The federal government still considers marijuana to be an illegal controlled substance, and, as such, expenses incurred in the business are disallowed under Sec. 280E despite its being a legal activity within the state.

Sec 165: Losses

The IRS Chief Counsel advised that, for a taxpayer that operates a rental car business, collisions are a normal part of the business and do not rise to the level of a casualty loss.¹¹ Crashes and collisions were not extraordinary or nonrecurring.

In Haff,¹² the taxpayers claimed a theft loss from an investment in a partnership that turned out to be a Ponzi scheme. The loss included the investment made in the partnership and money owed the taxpayer for services. The loss of the invested amount was allowed, but the loss from nonpayment for services was disallowed because the fees for services rendered had never been included in the taxpayer’s income.

Theft losses are limited to the basis of the property taken. In this case, it represented only the actual amount invested in the partnership. In addition, the safe-harbor provision of Rev. Proc. 2009-20 did not apply because the fees had not been previously reported as income.

In Greenberger,¹³ a couple said they should get a theft loss because while the couple bought a stock from a broker on the open market, not from the fraudsters directly, the husband had direct contact with a corporate officer who lied and misled him. That is not enough, the court ruled.

In Wideman,¹⁴ costs to repair sinkhole damage from faulty construction were not casualty losses because the sinkholes were not a sudden, independent, or unusual event.

In Espaillat,¹⁵ the taxpayers, who had their own landscaping business, gave the husband’s brother’s scrap metal business substantial amounts of money. When they did not succeed in taking the loss as a business deduction because the brother’s business was a C corporation, which precluded a deduction on the taxpayers’ Schedule C, they tried two alternative arguments. First, the taxpayers argued that they were entitled to a loss for worthless securities in the amount they had given to the brother’s business. But, since the business was still operating during the year they claimed the deductions, they did not prove that the stock was worthless at that point, which is a prerequisite for the loss deduction. The second alternative argument they made was that they were entitled to a bad debt deduction, which is discussed in the next section.

Sec. 166: Bad Debts

In Espaillat,¹⁶ the taxpayers lent the husband’s brother’s scrap metal business substantial amounts of money. The court stated that much of the evidence in the case suggested that the money they gave the brother was a loan, which should entitle them to a bad debt deduction. But, as was the case for the worthless securities deduction, because the debt was not worthless in the year they took the deduction, they did not get to take it. Even though the brother’s company had filed for bankruptcy, it continued to operate during the year at issue.

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

In Wesley,¹⁷ a minister of a community outreach program was denied a charitable deduction to the ministry due to lack of substantiation. The taxpayer admitted at trial that he “manufactured” the written acknowledgments three years after the contributions had supposedly been made.

In Estate of Cape,¹⁸ charitable deductions claimed by a deceased S corporation shareholder and his wife were denied. The charitable contributions were taken based on Schedules K-1 that the court was unable to determine were final. The court noted that the taxpayers did not need to substantiate charitable deductions shown on their Schedule K-1; however, the S corporation was unable to provide the necessary substantiation to support the deduction.

Sec. 179: Election to Expense Certain Depreciable Business Assets

In WSK & Sons, Inc.,¹⁹ a corporation was denied a Sec. 179 deduction for a vehicle, primarily because there was no evidence the corporation owned the truck or that it was used in its business. There were also other substantiation issues, discussed under Sec. 274 below.

Sec. 183: Activities Not Engaged in For Profit

A recent Massachusetts case shows that a taxpayer can prevail under federal tax audit but lose in a state audit.²⁰

The taxpayer bought three horses over several years. She trained them and allowed an Olympic-level rider to use them in the Pan Am Games. The taxpayer’s plan was to sell the horses at a substantial profit after they did well in competition; however, the plan did not work out, and she had losses of $466,366 over three years. The taxpayer was examined by the IRS and found to be operating in a businesslike manner and, therefore, was allowed to deduct her expenses and losses.

Massachusetts then examined the same issue and found her activities did not rise to the level of a trade or business, and it disallowed the expenses under Sec. 183 as a hobby. The taxpayer appealed to the Massachusetts Appellate Tax Board, offering into evidence the IRS audit file. The board found that the IRS’s determination was not dispositive for Massachusetts purposes and assessed the tax.

Sec. 212: Expenses for Production of Income

Married taxpayers were denied rental real estate losses for two properties that were both deemed not to be held as part of a trade or business or for the production of income under Sec. 212. The first property was the taxpayers’ former residence, which had not been rented for about 10 years, including the tax years in question. Only minimal efforts were made to sell the property during that time.

The second property was a house that the taxpayers had purchased for their daughter because she could not obtain a loan for the home. The taxpayers received rental income from their daughter and claimed various deductions on Schedule E for this property in excess of rental income received. The Tax Court held that this property was purchased as an accommodation to the daughter and as an estate-planning device, but that the taxpayers did not engage in a real estate activity as a trade or business or hold the properties for the production of income.²¹ Essentially, the court maintained that the taxpayers could not create a deductible loss on their Schedule E for paying their daughter’s living expenses.

In a separate case, married taxpayers were also denied rental real estate deductions for their property because they were deemed never to have converted the property to a rental property and, consequently, it was not held for the production of income. In this instance, the taxpayers (after ceasing personal use of the property) claimed to have signed a one-year agreement with a realty company to rent the property, which they had originally used as a seasonal home. During the agreement period, the property was never rented out.

The Tax Court found that there was minimal effort on the realty company’s part to rent the property.²² The realty company’s efforts were limited to featuring the property in a portfolio kept in the company’s office and telling prospective buyers it was available when showing it as a model. The taxpayers did not provide evidence of any other efforts expended to rent out the property. Therefore, the Tax Court denied the taxpayers’ deductions under Sec. 212 because they did not make a bona fide attempt to rent out the property or convert the property to one held for the production of income.

In another Tax Court case, an individual purchasing and selling securities for personal investment was deemed to be an investor, not a dealer or trader; therefore, he was entitled to deduct some of his investment activity expenses under Sec. 212.²³ The Tax Court found that the taxpayer was engaged in an income-producing activity in which he incurred wiring fees, brokerage fees, and other fees related to this investment activity. Although the taxpayer did not have the proper documentation for these expenses, his spreadsheets summarizing his bank records provided a reasonable basis to estimate the expenses.

Sec. 213: Medical, Dental, etc., Expenses

In Flying Hawk, the Tax Court disallowed a taxpayer’s claimed deduction on Schedule C for “other expenses,” which consisted of health maintenance items and cultural supplies.²⁴ The health maintenance items consisted of various vitamins and nutritional supplements that the taxpayer purchased for personal use. The cultural supplies consisted of ti leaves and other plants that the taxpayer claimed were consumed for medical purposes and given to clients as gifts. The court deemed the vitamins and nutritional supplements personal expenses under Sec. 213, which treats vitamins or organic foods purchased and consumed under a self-imposed regimen rather than under a physician’s order as nondeductible medical expenses. In addition, the court also deemed the cultural supplies nondeductible personal expenditures and disallowed deductions for business gifts given to clients because the taxpayer did not keep contemporaneous records of the gifts.

In another case, the Tax Court found that a taxpayer could not take a deduction for medical transportation costs under Sec. 213.²⁵ The taxpayer suffered an on-the-job injury in which his company paid for his medical costs but not his medical transportation costs. The taxpayer’s argument that he was entitled to deduct his transportation costs was not upheld in court because he failed to substantiate (i.e., provide receipts or mileage logs) the miles driven, tolls, and parking expenses. The taxpayer did provide a handwritten ledger detailing some of his transportation costs, but the court deemed the ledger to be unreliable, in part because it was not written contemporaneously. Additionally, the taxpayer claimed a per diem allowance for each day he traveled to the hospital, using Publication 1542, Per Diem Rates, as authority, which is meant to be used only by employers to reimburse costs incurred while traveling to receive medical care. Since the taxpayer is an individual, this per diem allowance does not apply to him.

Sec. 215: Alimony, etc., Payments

Alimony was taxable to an ex-wife and tax-deductible to an ex-husband when paid in the form of mortgage payments on the ex-wife’s behalf on their former marital home awarded solely to the wife in a divorce decree.²⁶ The decree stated that she would be fully responsible for the mortgage, but the IRS argued that because the ex-husband continued to co-own the residence, he remained liable. The court, however, held that he had no equitable interest in the house and that all his payments on the mortgage were deductible alimony, despite the IRS’s argument that part of the payments should be allocated to child support.

In another case, the Tax Court disallowed a deduction for past-due spousal support payments.²⁷ The taxpayer defaulted on his obligation under the separation agreement and divorce decree to pay spousal support and started incurring interest related to the deficiency. During the tax year in question, the taxpayer paid his ex-wife past-due spousal support, which the taxpayer deducted, in full, on his personal tax return as alimony payments.

While Sec. 215 states that individuals should be allowed a deduction for alimony or separate maintenance payments paid during the tax year, in this case, the spousal payments did not satisfy the requirements of Secs. 71(b)(1)(A) and (D) because the liability did not terminate on death. Unlike future support payments that would cease upon death of the recipient, spousal support in arrears would remain enforceable even upon the recipient’s death.

In a separate case, the Tax Court determined that a taxpayer’s lump-sum payment to his ex-wife for attorneys’ fees and the division of marital assets was considered a property settlement and was not considered alimony.²⁸ Therefore, this payment was deemed nondeductible as alimony on the taxpayer’s personal tax return, and it was not picked up as income on his ex-wife’s personal tax return.

Similar to the case above, while Sec. 215 states that individuals should be allowed a deduction for alimony or separate maintenance payments paid during the tax year, in this case, the lump-sum payment was not considered alimony under Sec. 71(b)(1)(D) because the liability did not terminate on death. Under the state law applicable to the taxpayer’s case, a lump-sum payment is a vested right to the recipient, and the obligation does not terminate upon death.

Sec. 262: Personal, Living, and Family Expenses

In Chen,²⁹ expenses paid from the taxpayers’ LLC on Schedule C to various vendors were mostly considered personal expenses. The taxpayers presented as evidence a self-created spreadsheet of expenses, listing vendors, such as department stores and trade schools. The taxpayers could not substantiate that the expenses were incurred in connection with their trade or business and, in fact, admitted the employee benefit expenses were actually expenses for day care for their children, their travel and entertainment expenses were expenses for educating their children, and their depreciation expenses were for the children’s musical instruments. In addition to those expenses, the taxpayers also deducted wages paid to their 11-year-old twins for office cleaning and office organizing. As there was no proof that the children actually performed any work or that the LLC actually made the payments, the court found that these expenses were not only mostly personal in nature but also that the taxpayers had failed to substantiate the expenses properly.

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

In Chen,³⁰ discussed above, the taxpayers formed a new company from their home. They deducted automobile expenses, claimed a home office deduction, deducted child-care services as employee benefits, and claimed depreciation on, among other items, their children’s musical instruments. They also paid their 11-year-old twins wages.

The taxpayers failed to document the business automobile use, including mileage driven, time and place of automobile use, or the business purpose, and, therefore, the car and truck expenses were disallowed. They also failed to show how the musical instruments belonging to their children were ordinary and necessary expenses for the conduct of the business.

In WSK & Sons, Inc.,³¹ a corporation was denied mileage deductions for two vehicles purportedly used in its business. No mileage logs or other contemporaneous records were maintained to establish the business use of the vehicles. As such, the taxpayer did not meet the heightened substantiation requirements of Sec. 274(d). The Tax Court noted that it is not permitted to estimate allowable deductions that are otherwise subject to the strict requirements of Sec. 274(d) and therefore the deduction was disallowed in full.

Practitioners should be aware that the IRS continues to challenge deductions that are not carefully and fully substantiated. Time and time again the IRS is denying auto and truck expenses when the strict requirements of Sec. 274(d) are not met. It comes down to keeping a log designating the above-noted requirements if auto expenses are to be allowed. As many recent cases highlight, adequate records must be kept if expenses are to be allowed as deductions.

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

The taxpayers in Chen,³² discussed in the previous two sections, were also disallowed a home office deduction for the taxpayers’ LLC on Schedule C. Although the taxpayers did not specifically deduct business expenses for the use of their home, many of the Schedule C expenses were considered home office expenses, such as utilities, and were therefore subject to the guidelines under Sec. 280A. The taxpayers claimed they used their entire house to operate the business but failed to show that any part of the dwelling was exclusively used on a regular basis.

As a general rule, a taxpayer may not deduct personal living expenses related to the taxpayer’s residence unless a specific room or area of the home is exclusively and regularly used as the taxpayer’s principal place of business as required in Sec. 280A(c)(1). The taxpayers argued they used their entire home to operate the business, but their argument was unpersuasive and the business records listed a different office address. The court disallowed the home office expenses because the taxpayers could not establish that any portion of the home was used exclusively and regularly in their business.

In Flying Hawk,³³ also discussed under Sec. 213, an accountant who provided bookkeeping and tax return preparation services was not entitled to home office deductions she split between her two residences. Her principal place of business, where she performed the majority of the work, was at an office she rented and received a deduction for. She also claimed home office expenses for two residences she claimed she used in connection with her trade and business. She would meet with clients at their places of business or residence and then prepare the accounting work for them at the residences she owned.

The home office deduction is closely scrutinized, and the taxpayer should have known that to take the home office deduction she needed to satisfy one of the requirements of Sec. 280A(c)(1): that the home office was a principal place of business, a place of business used to meet clients, or a separate structure used for trade or business purposes. The principal place of business requirement was not met as the principal place of the taxpayer’s business was the taxpayer’s rented office. As no specific portion of either residence was used as the principal place for business, nor was either used to meet with clients, the deductions related to the use of the home were disallowed.

In Okonkwo,³⁴ the court disallowed large losses attributable to a house the taxpayer and his wife rented to their daughter for less than fair rental value. The taxpayers constructed the house on a lot they had purchased. As attempts to sell the house failed, they rented the house to an unrelated tenant for $6,000 per month. Later on, they rented the house to their daughter for $2,000 per month and argued they needed to keep leasing the house because their homeowners’ policy required them to keep the house occupied. During this time, they continued their effort to sell the house.

For tax year 2008, the taxpayers claimed rental income of $24,000 and total rental expenses of $158,360 for mortgage interest, taxes, insurance, and depreciation on their Schedule E. Then for tax years 2009 and 2010, the taxpayers reported the rental activity on their Schedule C and described their business as real estate developers. The taxpayers later amended the 2008 tax return to report the rental losses on Schedule C instead of Schedule E.

The Tax Court disallowed the losses per Secs. 280A(d)(1) and Sec. 280A(d)(2)(C), under which a residence is treated as having been used personally by the taxpayer if the residence is rented to someone at less than fair rental value for greater than 14 days or 10% of the number of days during a year a residence is rented at fair rental value. Because the taxpayer rented the home to his daughter and did not collect a fair rent, the court agreed with the IRS that the rental expenses were limited under Sec. 280A(c)(5) to rental income.

Sec. 280E: Expenditures in Connection With the Illegal Sale of Drugs

In Beck,³⁵ the Tax Court held that the taxpayer, who operated a medical marijuana dispensary business as a sole proprietor, was not entitled to deduct various expenses. The taxpayer routinely destroyed his records and, as a result, was not able to properly substantiate expenses. The court stated that even if the taxpayer had been able to substantiate the claimed expenses, the deductions would still be disallowed under Sec. 280E, which bars deductions for expenses paid or incurred in connection with trafficking in controlled substances. Since the taxpayer could not show that his dispensary sold any nonmarijuana goods or what portion of the sales was attributable to services, and not to marijuana sales, the court disallowed all expenses.

Sec. 469: Passive Activity Losses and Credits Limited

Under Sec. 469(a), net passive losses of individuals are limited, unless the taxpayers materially participate in the activity by being involved in the operation of the activity on a regular, continuous basis.³⁶ In Kline,³⁷ the Tax Court upheld the deduction on the taxpayers’ 2007 and 2008 tax returns for a nonpassive loss in a boat chartering business. The taxpayer filed a return in 2007 using a single filing status, and a joint return in 2008 after he married. Both spouses were employed full time, one as an airline pilot and the other as a nutritionist, throughout both years. The IRS denied the loss upon audit for both years, finding that the taxpayers did not meet the material participation requirements for a nonpassive loss.

The taxpayers presented evidence documenting 470 hours of work on the boat chartering activity in 2007, and 732 hours in 2008 (when they were married). Their sole support for meeting the material participation requirement was under Temp. Regs. Sec. 1.469-5T(a)(3), which looks at whether the taxpayers have more than 100 hours of work during the tax year, and their participation in the activity is not less than any other individual’s.

The IRS maintained that charters in which the taxpayers had friends and acquaintances as passengers were personal and that hours associated with those charters should not count toward material participation. The court stated that that theory was belied by the evidence.

The IRS also argued in its post-trial brief that the taxpayers’ activities should be split into two different activities, but the court would not consider that argument since it was not raised in the IRS’s notices of deficiency to the taxpayers, in its pretrial memorandum, or at trial, and to allow it to be raised for the first time on brief would be prejudicial to the taxpayers. The court only considered whether the taxpayers had provided sufficient and adequate support for the hours of participation, as the IRS did not argue the activity was not a business.

The importance of communicating to clients their need to keep well-supported logs for their business activities has been well-established. In Simmons-Brown,³⁸ the taxpayers’ ability to document that time spent to maintain areas of the rental property on which they lived was separate and not included in their participation hours was critical to their success in having the Tax Court allow them to deduct nonpassive rental losses as a real estate professional.

Joe Brown worked as a construction contractor in the years 2010 and 2011, and his wife, Doris Simmons-Brown, separately owned a residential building with tenants, in which they also lived. The rental property had a loss in both years, and the taxpayers deducted the loss in full on their returns.

Upon audit, the IRS denied deductions as passive rental losses for the years 2010 and 2011, maintaining they did not meet the material participation requirements under Sec. 469(a) because Mr. Brown was not a real estate professional. During the audit, Mr. Brown provided documentation showing he worked 780 hours as a construction contractor, which he argued qualified him as a real estate professional. He also provided documentation proving he spent 1,100 hours on the rental building, with the hours reduced for the hours Mr. Brown spent maintaining the couple’s personal living area and a percentage of the common areas. The Tax Court found the taxpayers’ evidence persuasive and allowed the deductions in full.

Sec. 1012: Basis of Property—Cost

The Ninth Circuit in Youngquist³⁹ affirmed a district court’s ruling in favor of the IRS, finding that the taxpayer failed to present sufficient evidence to establish cost basis in his stock for which he claimed a capital loss of $5,677.34. The court found that the taxpayer had the burden to prove the cost basis of the stock sales and to show that the tax basis was not zero and had failed to do so. The taxpayer did not produce any records from the broker or any contemporaneous records to establish his own cost basis for stock purchased through the broker. Instead, the taxpayer tried to establish his basis by showing only bank records that showed deposits in excess of withdrawals.

In Hughes,⁴⁰ a district court found that the assessments for tax years 1999, 2000, 2002, 2003, 2004, and 2006 that were issued after the taxpayer had failed to file returns from 1999 to 2006 were erroneous because they were based in part on the sales of securities that the IRS asserted had zero basis. After the IRS prepared substitute returns and issued deficiency notices for the above years, the taxpayer hired a CPA to prepare his own substitute returns and testify as an expert in the case.

The court found that “the burden reverts to the IRS to show that its determination was correct,” after the CPA introduced brokerage statements, including receipts of individual transactions, monthly investment reports, annual investment reports, buy/sell documents, and gain/loss statements to rebut the IRS. The taxpayer cited the lower court decision in Youngquist, which states that there is no requirement that the taxpayer submit profit/loss statements from brokerage houses to establish cost basis in securities.⁴¹

Sec. 1014: Basis of Property Acquired From a Decedent

The IRS announced in Notice 2015-57 that it was delaying the due dates for statements that are required to be provided by executors to the IRS and to beneficiaries that acquire any interest in property included in a decedent’s gross estate for federal estate tax purposes. As originally enacted, statements were required to be furnished to the IRS and to beneficiaries within 30 days of the estate tax return’s due date, so for estates that had returns due Aug. 1, 2015, the statements were originally due by Aug. 31, 2015. The statement is required to identify the value of each interest as reported on Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, and other information as the Treasury secretary may prescribe. The effective date was delayed until Feb. 29, 2016, for returns filed after July 31, 2015. Furthermore, executors and other persons required to file a statement should not do so until Treasury issues forms or further guidance.

Sec. 1015: Basis of Property Acquired by Gifts and Transfers in Trust

Hughes⁴² involved the basis in shares of stock (founder’s shares) that the taxpayer, an accounting firm partner who was a founder of the firm’s spun-off consulting business, received in the new consulting business. These founder’s shares were later gifted to the taxpayer’s nonresident alien wife (a U.K. citizen). The taxpayers claimed zero basis on their original return, but later amended their 2001 return to change the treatment of an unrelated transaction and then claimed a basis in the founder’s shares.

The rationale for claiming basis in the founder’s shares was that the taxpayer thought he realized long-term capital gains when he made gifts of the founder’s shares to his wife, who was a nonresident alien. The Tax Court noted that Sec. 1041 is a nonrecognition provision, but it does not apply when property was transferred by gift. The Tax Court also noted that even if Sec. 1041 were to apply, there was no gain to be recognized as this was an interspousal property transfer that takes the form of a gift and, under Sec. 1015(a), the shares had a zero basis when they were sold.

Sec. 1033: Involuntary Conversions

The IRS announced in Notice 2015-69, issued Sept. 30, 2015, that it would grant a one-year extension to the replacement period for livestock sold on account of drought in specified counties. This extension applies to a taxpayer who qualified for a four-year replacement period for livestock sold or exchanged on account of drought and whose replacement period was scheduled to expire at the end of 2015 (or Aug. 31, 2015, if the taxpayer’s fiscal year includes Aug. 31, 2015). The taxpayer may determine whether exceptional, extreme, or severe drought has been reported for any location by reference to U.S. Drought Monitor maps.

Sec. 1038: Certain Reacquisitions of Real Property

In DeBough,⁴³ the Eighth Circuit affirmed the Tax Court’s decision that disallowed the taxpayer to claim the principal residence exclusion under Sec. 121 (see discussion above). The taxpayer sold his principal residence in 2006 and claimed the principal residence exclusion. In 2009, the buyers of the property defaulted and the taxpayer reacquired the property. The taxpayer treated the event as a reacquisition of property in full satisfaction of indebtedness under Sec. 1038. The taxpayer furthermore claimed the principal residence exclusion. The IRS disallowed the exclusion, and the taxpayer petitioned the Tax Court.

The Tax Court found that the taxpayer was not entitled to the exclusion as he did not resell the property within one year. The taxpayer unsuccessfully argued that the statute was silent on the question of whether the principal-residence exclusion remains available, even when a reacquired principal residence is not resold within the year. The taxpayer also unsuccessfully argued that there was nothing in Sec. 1038 that requires a taxpayer to recognize gain that was previously excluded under Sec. 121.

Sec. 1041: Transfers of Property Between Spouses or Incident to Divorce

In Mehriary,⁴⁴ the Tax Court held that the transfer of property from a divorced individual to her spouse did not qualify for a loss deduction and was instead a transfer of property incident to divorce, which does not allow gain or loss to be recognized. The Tax Court found that the transfer of property took place within one year after the marriage ceased, a requirement for the transfer to be considered to have been made incident to divorce.

Sec. 1092: Straddles

In Letter Ruling 201543008, the IRS privately ruled that the taxpayer would be granted an extension of time to file the mixed straddle account election under Sec. 1092(b). The taxpayer was in the business of investing in various securities that trade U.S. and foreign financial securities. The taxpayer also provided investment management services to those entities. The IRS ruled that there was reasonable cause for failing to make the proper and timely elections because the taxpayer relied on a tax professional who failed to make the election on Form 6781, Gains and Losses From Section 1256 Contracts and Straddles, under Temp. Regs. Sec. 1.1092(b)-4T(f)(2)(i).

Sec. 1221: Capital Asset Defined

In Patrick,⁴⁵ the Seventh Circuit affirmed the Tax Court’s decision that the taxpayer did not properly report his qui tam award as ordinary income, but instead reported it as capital gain. The taxpayer claimed that the information he compiled for his qui tam suit was “property” and he had a right to stop other employees from using that information. The court found that the information contained in those documents related to the fraudulent practices was available to other employees who could have filed their own suits. Because the taxpayer had no right to stop anyone else from using the information, it cannot be his property.

Secs. 1401-1403: Self-Employment Tax

In Methvin,⁴⁶ the Tax Court held that the taxpayer was liable for Self-Employment Contributions Act tax on net income from his oil and gas interests. The taxpayer argued that his lack of industry knowledge, his lack of active involvement, and his ownership interest comprising only 2%-3% should preclude him from being treated as carrying on an active trade or business subject to self-employment tax. The taxpayer also argued that the operating agreement included a Sec. 761(a) election to not be treated as a partnership.

The Tax Court cited Cokes⁴⁷ for the proposition that making a Sec. 761(a) election “does not operate to change the nature of the entity” and that the “exclusion simply prevents the application of subchapter K.” The court also cited Burlington Northern R.R. Co.,⁴⁸ refuting the taxpayer’s argument that the “Commissioner’s administrative concession of an issue for one tax year does not preclude his pursuing the same issue for a different tax year.”

The IRS did not agree with the Eighth Circuit decision in Morehouse⁴⁹ that Conservation Reserve Program (CRP) payments from the federal government to a nonfarmer are excluded from net earnings from self-employment under Sec. 1402(a)(1) as rentals from real estate.⁵⁰ The court cited Rev. Rul. 60-32 and Rev. Rul. 65-149 in making its decision that CRP “payments made to non-farmers constitute rentals from real estate and are excluded from the self-employment tax.” The IRS views this as a misinterpretation of the revenue rulings and cites a dissenting opinion in the case that states that the court did not factor in Morehouse’s intent to make a profit from the CRP payments.

Sec. 1411: Net Investment Income Tax

The IRS has started issuing correspondence audit notices related to the year 2013 tax filings for net investment income tax. Practitioners have noted that the Service’s proposed adjustments may include in net investment income passthrough income that has been reported as nonpassive subject to self-employment tax. One recommendation to avoid such adjustments is to consider including Form 8960, Net Investment Income Tax—Individuals, Estates, and Trusts, with every return in which there is gross investment income that could trigger a calculation by the IRS, so that all deductions and classifications of income are reported.

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

In November, the IRS issued proposed regulations governing innocent spouse relief.⁵¹ The proposed rules make a number of significant changes to the existing regulations. One significant change the proposed rules make is to provide additional guidance on the application of res judicata in innocent spouse cases. The doctrine of res judicata prevents a spouse from requesting innocent spouse relief when Sec. 6015 relief was at issue in a prior court proceeding or the requesting spouse meaningfully participated in a prior proceeding in which relief under Sec. 6015 could have been raised.

Under Sec. 6015(g)(2), there is an exception to res judicata when a requesting spouse did not meaningfully participate in the prior court proceeding. The proposed rules provide guidance on what meaningful participation entails, giving a nonexclusive list of acts to be considered in making a facts-and-circumstances determination of whether the requesting spouse meaningfully participated in a prior proceeding. The rules also say that a requesting spouse will not be considered to have meaningfully participated in a prior procedure if the requesting spouse established that he or she performed the acts due to abuse by the other spouse or the other spouse maintained control over the requesting spouse, and the requesting spouse did not challenge the other spouse because of fear of retaliation.

The regulations also propose a definition of underpayment or unpaid tax under Sec. 6015(f), which provides for relief where it would be “inequitable to hold the individual liable for any unpaid tax or any deficiency.” The regulations propose that “unpaid tax” and “underpayment” would have the same meaning: On a joint return, it is the balance shown as due reduced by the tax paid with the return on or before the due date for payment (without considering any extension of time to pay). It is determined after applying credits for withholding, estimated tax payments, payments made when requesting an extension, and other credits. Generally, if there is no unpaid tax due, no relief is available under Sec. 6015(f).

The proposed regulations provide detailed rules on credits and refunds in innocent spouse cases, explain how any credit or refund that may be available to a requesting spouse is determined, and provide for allocation of refunds in certain cases. The proposed regulations would also amend the rule for credit or refund in equitable relief cases to clarify that credits or refunds of tax are available in both underpayment and deficiency cases.

Another significant portion of the regulations expands the rule that penalties and interest are not separate items from which relief can be obtained in underpayment cases. Relief will be determined based on the amount of relief from the underpayment to which the requesting spouse is entitled. So, if a requesting spouse remains liable for a portion of the underpayment after having been granted equitable relief, the requesting spouse is not eligible for relief for the penalties and interest on that portion. However, the proposed rules would also adopt the current IRS practice (found in Internal Revenue Manual §25.15.3.8.1(5)) that relief from penalties and interest may be appropriate in situations where there was an underpayment of tax on the return but subsequent payments have paid all the tax, leaving only penalties and/or interest unpaid or partially unpaid.

The proposed rules incorporate an administrative rule that the attribution of an erroneous item follows the attribution of the underlying item that caused the increase to adjusted gross income. The rules also contain a tax benefit rule, whereby the amount of an erroneous item allocated to a requesting spouse may be increased or decreased depending upon the tax benefit to each spouse.

Finally, the rules governing the prohibition on collection and suspension of the collection statute are revised to reflect the amendments to the law permitting the Tax Court to review innocent spouse cases where the IRS has not determined a deficiency and suspending the limitation period when equitable relief is requested under Sec. 6015(f).

The proposed rules will apply when they are published as final in the Federal Register.

In Scott,⁵² the Tax Court granted partial relief from joint liabilities to a wife from her husband’s separate business activities. The court denied relief from adjustments made to the wife’s Schedule C activities, citing the fact that even though she did not prepare the returns under review and her husband admitted to the errors, she had reason to know or should have known that her income was understated. Noting her degree in accounting and her level of involvement with the financial affairs in question, the court relied on the inquiry used in Butler⁵³and stated, “Mrs. Scott has a responsibility to check the amounts reported for her business” and that she is “not relieved of this obligation simply because she is not involved in other financial aspects of the household.”

Sec. 6654: Failure by Individual to Pay Estimated Tax

The Tax Court sided with the IRS in ruling that a taxpayer was not mentally impaired by his autism spectrum disorder (ASD) and therefore was not relieved from the failure to pay an estimated tax penalty in accordance with Sec. 6654 for his 2007 return.⁵⁴ The taxpayer attempted to claim a waiver under Sec. 6654(e)(3) (which excuses a taxpayer from the penalty if during the tax year the taxpayer became disabled or was 62 or older and retired during the year), but the court held that his condition existed prior to the years in question and he was not prevented from making payments due to casualty, disaster, or other unusual circumstances. Further, the court held that the taxpayer’s ASD did not prevent him from managing his day-to-day business of financial trading.  

Footnotes

¹Hardy v. Fink, No. 14-1181 (8th Cir. 6/2/15).

²Cutler,T.C. Memo. 2015-73.

³REG-135524-14.

⁴Dunnigan,T.C. Memo. 2015-190.

⁵DeBough,142 T.C. No. 17 (2014).

⁶DeBough,799 F.3d 1210 (8th Cir. 2015).

⁷Taylor, T.C. Summ. 2015-51.

⁸Espaillat, T.C. Memo. 2015-202.

⁹Voss, 796 F.3d 1051 (9th Cir. 2015), rev’g Sophy, 138 T.C. 204 (2012).

¹⁰Chief Counsel Advice 201531016.

¹¹Chief Counsel Advice 201529008.

¹²Haff, T.C. Memo. 2015-138.

¹³Greenberger, No. 1:14-CV-01041 (N.D. Ohio. 6/19/15).

¹⁴Wideman, T.C. Summ. 2015-61.

¹⁵Espaillat, T.C. Memo. 2015-202.

¹⁶Espaillat, T.C. Memo. 2015-202.

¹⁷Wesley, T.C. Memo. 2015-200.

¹⁸Estate of Cape, No. 11-C-0357 (E.D. Wis. 10/2/15).

¹⁹WSK & Sons, Inc., T.C. Memo. 2015-204.

²⁰Thayer v. Commissioner of Revenue, No. C308533 (Mass. App. Tax Bd. 12/17/14).

²¹Robinson, T.C. Memo. 2014-120.

²²Redisch, T.C. Memo. 2015-95.

²³Porter, T.C. Memo. 2015-122.

²⁴Flying Hawk,T.C. Memo. 2015-139.

²⁵Boneparte, T.C. Memo. 2015-128.

²⁶In re Trojanowski, No. 14-06078-5-DMW (Bankr. E.D.N.C. 9/18/15).

²⁷Iglicki, T.C. Memo. 2015-80.

²⁸Muniz, T.C. Memo. 2015-125.

²⁹Chen, T.C. Memo. 2015-167.

³⁰Id.

³¹WSK & Sons, Inc., T.C. Memo. 2015-204.

³²Chen, T.C. Memo. 2015-167.

³³Flying Hawk,T.C. Memo. 2015-139.

³⁴Okonkwo, T.C. Memo. 2015-181.

³⁵Beck, T.C. Memo. 2015-149.

³⁶Sec. 469(h)(1).

³⁷Kline, T.C. Memo. 2015-144.

³⁸Simmons-Brown,T.C. Summ. 2015-62.

³⁹Youngquist, No. 13-35829 (9th Cir. 7/16/15).

⁴⁰Hughes, No. 4:12-cv-40025-TSH (D. Mass 10/5/15).

⁴¹Hughes, citing Youngquist, No. 3:11-cv-06113-PK (D. Or. 4/17/13).

⁴²Hughes, T.C. Memo. 2015-89.

⁴³DeBough, No. 14-3036 (8th Cir. 8/28/15).

⁴⁴Mehriary, T.C. Memo. 2015-126.

⁴⁵Patrick,No.14-2190 (7th Cir. 8/26/15).

⁴⁶Methvin, T.C. Memo. 2015-81.

⁴⁷Cokes,91 T.C. 222, 230—31 (1988).

⁴⁸Burlington Northern R.R. Co., 82 T.C. 143 (1984).

⁴⁹Morehouse,769 F.3d 616 (8th Cir.).

⁵⁰AOD 2015-002 (9/23/15).

⁵¹REG-134219-08.

⁵²Scott, T.C. Memo. 2015-180.

⁵³Butler, 114 T.C. 276 (2000).

⁵⁴Poppe, T.C. Memo. 2015-205.