Individual taxation report

By David R. Baldwin, CPA; Robert Caplan, CPA; Valrie Chambers, CPA, Ph.D.; Edward A. Gershman, CPA; Jennifer S. Korten, CPA; Darren Neuschwander, CPA; Jeffrey A. Porter II, CPA; Kenneth L. Rubin, CPA; David E. Taylor, CPA; and Donald J. Zidik Jr., CPA

 PHOTO BY NNEHRING/ISTOCK
PHOTO BY NNEHRING/ISTOCK
 

EXECUTIVE
SUMMARY

 
  • The IRS issued proposed regulations that update the definition of dependent to be consistent with Sec. 152 and reverse the IRS's previous position regarding when a taxpayer is considered childless for earned income tax credit purposes.
  • The Tax Court held that the IRS was not required to provide regulations allowing donee reporting as a substitute for the Sec. 170(f)(8) contemporaneous written acknowledgment requirement for charitable contributions, and, because the Service had not issued those regulations, a taxpayer could not take a charitable deduction without a contemporaneous written acknowledgment even though the donee had reported the information for the taxpayer's contribution on a Form 990.
  • As in prior years, the Tax Court decided in a number of cases whether taxpayers qualified as real estate professionals for purposes of the passive activity loss rules.
  • In two cases, the Tax Court addressed whether, based on the types of activities they performed for an LLC, the LLCs' members should be considered limited partners in the LLCs and their income from them should be excluded from the members' self-employment income.
  • The IRS identified a new hardship exemption from the individual shared-responsibility payment under Sec. 5000A.

This article is a semiannual review of recent developments in the area of individual taxation, including several cases involving taxpayers who claimed to be materially participating in their real estate activities, one case where a taxpayer with significant income from other sources was denied loss deductions for her horse-breeding business, several cases on education expense deductions, and many other topics. The items are arranged in Code section order.

Sec. 24: Child tax credit

In Polsky,1 a federal court of appeals upheld a district court's dismissal of a taxpayer's claim for a child tax credit for a permanently disabled daughter over the age of 17, saying that the age limit applied to all children eligible to be claimed for the credit and does not make an exception for disability, unlike the dependency exemption, which excepts from the age limitation individuals who are permanently and totally disabled.

Sec. 32: Earned income

Definition of "childless": The IRS reversed its position on what is considered "childless" for earned income tax credit (EITC) purposes. In IRS Publication 596, Earned Income Credit (EIC), the IRS took the position that if an individual meets the definition of a qualifying child for Taxpayer A and Taxpayer B, and Taxpayer A was awarded the tax break under the tiebreaker rules found in Sec. 152(c)(4), then Taxpayer B was not considered "childless" for EITC purposes. Under the new interpretation in Prop. Regs. Sec. 1.32-2(c)(3)(ii), Taxpayer B could claim the childless EITC provided the taxpayer met the other requirements of that section. The proposed regulation will be effective with tax years beginning after it becomes final, but pending the issuance of the final regulation, it may be applied to any open tax year.

Inmate in a penal institution: In Skaggs,2 the Tax Court concluded that a prisoner who was transferred to a state mental health care institution while incarcerated remained an inmate in a penal institution for purposes of Sec. 32(c)(2)(B)(iv), which bars income earned while an inmate at a penal institution from earned income for EITC purposes. Therefore, income he earned while he was at the state mental health care institution was not earned income.

Sec. 61: Gross income defined

The IRS issued a notice of deficiency to an individual taxpayer who, it claimed, had unreported income on her individual income tax return. Because the taxpayer, most of whose income came from her tax preparation business, did not keep adequate records, the Tax Court held that the IRS was justified in using the bank deposits method to reconstruct her income.3 This case is also discussed under Secs. 162, 170, 212, and 274.

Sec. 63: Taxable income defined

The IRS released proposed regulations (REG-137604-07) on Jan. 19, 2017, that apply changes made by the Working Families Tax Relief Act of 20044 to the uniform definition of dependent and other recent changes to the definition of dependency exemption. In addition, the proposed regulations also provide for changes made to the Code regarding filing status, the tax tables for individuals, the child and dependent care credit, the EITC, the additional standard deduction for the aged and blind, and taxpayer identification numbers for adopted children.

Before Sec. 63 was amended by the Tax Reform Act of 1986,5 a taxpayer received an additional personal exemption under Sec. 151 if the taxpayer or the taxpayer's spouse was either age 65 or older or blind as of year end. The proposed regulations remove the additional exemptions for age and blindness and add an additional standard deduction for age or blindness. This proposed change to the regulations reflects the current law.

Sec. 71: Alimony and separate maintenance payments

IRS Letter Ruling 201648001 is in response to a taxpayer's request that certain payments the taxpayer's ex-spouse made to the taxpayer not be considered alimony payments under Sec. 71(b). The payments related to the ex-spouse's being ordered to maintain a life insurance policy in an amount sufficient to cover his maintenance and child support obligations. The letter ruling concluded that the court-ordered spousal maintenance payments met only three of the four requirements to be considered alimony payments under Sec. 71(b)(1). Since the payments did not terminate at the payee spouse's death, the payments were not considered alimony payments. In addition, the payments did not end within six months before or after the date on which the former spouses' child would turn 18 and therefore were assumed not to be child support.

Sec. 83: Property transferred in connection with performance of services

A corporation was denied a deduction for stock given to an employee that it claimed was given as compensation for services rendered.6 The court of appeals concluded that the stock that the individual subscribed to in an earlier year was an investment and was not issued in connection with his employment. It further concluded that the only circumstances under which the individual would be required to return the stock to the company for less than fair market value (FMV) either did not constitute a substantial risk of forfeiture under Regs. Sec. 1.83-3(c)(2) or were so unlikely as to not constitute a substantial risk. A petition for writ of certiorari for this case was filed with the U.S. Supreme Court on April 4, 2017.7

Sec. 104: Compensation for injuries or sickness

IRS Letter Ruling 201643003 was issued in response to a taxpayer's request for guidance on the treatment of disability benefits paid to a police officer after the officer was injured and permanently disabled while performing official duties. The ruling states that certain benefits paid to the police officer by the locally administered plan were excludable from gross income under Sec. 104(a)(1) as compensation for personal injuries or sickness.

The city for which the police officer worked had a statute that provided for pension and disability benefits to be paid to police and firefighters from the state defined benefit plan. Localities could withdraw from the state pension fund if they maintained a locally financed and administered alternative pension plan. The city for which the police officer worked provided this benefit from a locally administered and financed alternative pension plan.

The letter ruling concluded that the statute, which provides that if a participant of a statewide defined benefit plan becomes totally disabled as a result of injuries incurred while performing official work duties, is in fact a statute in the nature of a workers' compensation act. As such, benefits paid to the taxpayer are excluded from the taxpayer's income under Sec. 104(a)(1).

Sec. 152: Dependent defined

Custodial parent: In Lowe,8 the Tax Court denied a dependency exemption for the primary custodial parent whose child did not live with her for more than half of the year at issue. The court order awarding primary custody was silent as to the tax treatment for the child. Further, the custodial parent did not have the proper written declaration required under Sec. 152(e), Form 8332, Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent.

Children placed for adoption: Proposed regulations update the definition of a "dependent" to be consistent with the Fostering Connections to Success and Increasing Adoptions Act of 2008 and the Working Families Tax Relief Act of 2004, which amended Sec. 152 to provide that a child lawfully placed with a taxpayer for adoption can qualify as a dependent.9 The definition of a dependent now includes an "adopted child" and an "eligible foster child." This proposed regulation also defines an authorized placement agency as an organization authorized by a state, the District of Columbia, a U.S. possession, a foreign country, or an Indian Tribal Government, or by a subdivision of any of those bodies.

Definition of AGI: Prop. Regs. Sec. 1.152-2 changes the interpretation in IRS Publication 501, Exemptions, Standard Deduction, and Filing Information, providing that in applying the tiebreaker rules, the adjusted gross income (AGI) of a taxpayer who files a joint tax return is the total AGI shown on the return. Prop. Regs. Sec. 1.152-4 clarifies the support rules and provides that medical insurance premiums paid and the unreimbursed portion of the expenses for the individual's medical care are treated as support.

Sec. 162: Trade or business expenses

Rental expense: In Kauffman,10 the taxpayer was denied a rental expense deduction on his single-member limited liability company (LLC) Schedule C, Profit or Loss From Business, for his cinematography business for a payment to his 100%-owned C corporation. The rental expense of $266,000 was for a camera that the C corporation owned. The court denied the deduction because the taxpayer failed to establish that the rental expense was "reasonable in amount." Since the taxpayer did not show that a similar rental charge would be assessed to a third party, the court denied the expense because it was not a reasonable and necessary business expense.

Employee expenses: The case of Beckey11 once again highlights the importance of following procedures. The taxpayer was denied a deduction for expenses reported on Form 2106, Employee Business Expenses, as unreimbursed employee expenses because the taxpayer failed to prove that the employer would not have reimbursed the expenses. The court stated: "When an employee has a right to reimbursement for expenditures related to his status as an employee but fails to claim reimbursement, the expenses are not necessary and are not deductible." Additionally, the court provided that "[a]n employee cannot fail to seek reimbursement and convert the employer's expenses into the employee's."

Education expenses: Creigh12 is a recent case on the deductibility of education expenses as ordinary and necessary expenses under Sec. 162. Under Regs. Secs. 1.162-5(a)(1) and (2), education expenses are deductible "if the education maintains or improves skills required by the individual in his or her employment or other trade or business or meets the express requirements of the taxpayer's employer." In the case at hand, the taxpayer filed a Schedule C for her new consulting business after she left her W-2 employment as software engineer/project manager. Given the lack of revenue from her consulting activities, the taxpayer obtained an Executive Master of Business Administration (EMBA) degree. She deducted the cost of the tuition and associated fees on her Schedule C for her consulting business.

Using a "commonsense approach," the court concluded that the EMBA degree qualified the taxpayer for a new trade or business and denied the Schedule C deductions. The court compared "the tasks and activities she was qualified to perform before she acquired the education at issue with those she was qualified to perform afterwards." From this comparison, it determined that the taxpayer's skills from her prior employment "did not include skills related to any of the studied business fields" associated with obtaining the EMBA degree.

In Long,13 another recent case on deducting education expenses, the Tax Court allowed the taxpayer to deduct his MBA education expenses as unreimbursed employee expenses. The taxpayer worked six years within the product marketing department of a semiconductor company. During his six years of employment, he was directly involved with financial analysis, managing teams, and evaluating potential mergers. Before leaving his job where he was an employee in 2011, the taxpayer enrolled in an MBA program that was finance and management related in May 2010. The taxpayer started in a new job as an employee in January 2012 as a senior research analyst. Additionally, he received his MBA degree in April 2012.

One of the "preferred" requirements of his new employment was an MBA degree. Even though the IRS contended that the MBA qualified the taxpayer for a "new trade or business and that it enabled him to acquire the position" with this new employer, the court concluded that the taxpayer "was qualified in the same trade or business before enrolling in the MBA program and remained in this trade or business when he became a senior analyst" with his new employer. The court stated that the taxpayer "was qualified in financial analysis through his studies and personal investment experience before enrolling in the MBA program."

Personal expenses: An individual taxpayer who had a tax preparation business was denied numerous unsubstantiated business deductions on her individual income tax return.14 Although she proved that she paid for internet service, the service was at her house and she did not establish a breakdown between personal and business use. Other expenses for supplies seemed to be more in the nature of personal expenses, such as for a DVD player, earphones, and batteries. This case is also discussed under Secs. 61, 170, 212, and 274.

Sec. 166: Bad debts

The taxpayer was denied a "business bad debt" deduction in Scheurer.15 The taxpayer, who worked full time as a financial adviser, loaned money to a business venture that a close personal friend started. After this venture failed, the taxpayer reported a loss of $122,856 on Form 4797, Sales of Business Property, as a business bad debt for the funds he allegedly advanced to the friend. The Tax Court denied the deduction under Sec. 166 because it found that the taxpayer was not in the business of lending money in connection with his activity as a financial adviser as "there is no evidence that he ever lent money to anyone else."16

Sec. 170: Charitable, etc., contributions and gifts

Several cases, for large and small amounts, highlight the importance of proper substantiation of charitable contributions.

Noncash donations: In Carmody,17 the Tax court disallowed an individual's claimed $500 noncash charitable contribution to Goodwill because the taxpayer's receipt did not describe the items donated, and, in fact, was completely blank aside from the date of the contribution.

Contemporaneous written ­acknowledgment: In Izen,18 the Tax Court denied an individual's charitable contribution deduction for a donation of a 50% interest in an aircraft because he did not obtain an adequate contemporaneous written acknowledgment from the donee organization. An aircraft donation is subject to the more stringent substantiation requirements that apply to used vehicles. In this case, the donee organization did not timely file Form 1098-C, Contributions of Motor Vehicles, Boats, and Airplanes, with the IRS, and the written acknowledgment was not addressed to Izen, but was instead addressed to the aircraft's other 50% owner.

Conservation easement: In 15 West 17th Street LLC,19 the Tax Court denied apartnership and its partners a $64.5 million charitable deduction for the contribution of a conservation easement on a certified historic structure. The contemporaneous written acknowledgment the partnership obtained failed to meet the technical requirements of Secs. 170(f)(8)(A) and (B). Sec. 170(f)(8)(D) provides an alternative to the contemporaneous written acknowledgment requirement if "the donee organization files a return, on such form and in accordance with such regulations as the Secretary may prescribe, which includes the information described in subparagraph (b) with respect to the contribution" (emphasis added).

Late in 2015, the IRS issued proposed regulations implementing that provision, including a form specifically designed for charities to report donations,20 but the IRS withdrew the rules after receiving overwhelmingly negative comments.21 As a result, the IRS has decided not to address the alternative documentation provision. Nonetheless, the donee organization filed an amended Form 990, Return of Organization Exempt From Income Tax, providing the information that would normally be included under Sec. 170(f)(8)(B) (i.e., that no goods or services were received by the donor).

A divided Tax Court concluded that the word "may" allows, but does not require, the IRS to issue guidance under Sec. 170(f)(8)(D), and that the alternative reporting provision will not operate until the IRS issues the guidance authorized by Congress. Five judges dissented from the majority concluding the IRS should not have the ability to negate a provision provided by Congress simply by refusing to issue guidance on the provision.

Church trip: Finally, in Barnes, a taxpayer who ran her own tax preparation firm also volunteered for her church with which she went on a trip to Africa.22 During the trip, the taxpayer went on a safari but also visited orphanages and schools. The IRS allowed a deduction for a portion of the trip's expenses but disallowed much of them. The Tax Court found that the letter from the taxpayer's church did not meet the contemporaneous written acknowledgment requirement because it did not state which goods or services the church or the taxpayer received. It also denied her deductions for other charitable contributions because they did not meet the contemporaneous written acknowledgment requirement. This case is also discussed under Secs. 61, 162, 212, and 274.

Sec. 183: Activities not engaged in for profit

In Hylton,23 the taxpayer failed to prove that she engaged in her consistently unprofitable horse-breeding activity for a profit. From 1998 to 2014, the taxpayer had a large amount of income from her family's real estate business, which she offset with large losses from her horse-breeding activity. During this 17-year period, her Schedule F, Profit or Loss From Farming, activity never showed a profit.

Applying the nine factors in Regs. Sec. 1.183-2(b), despite the significant amount of time that the taxpayer devoted to the activity, the court found that given "a record of large losses over many years and the unlikelihood of achieving profitability are persuasive evidence" that the taxpayer did not have a profit intent for the activity. Additionally, the court found that even though the taxpayer engaged the services of a CPA, the horse-breeding activity was not undertaken in a businesslike manner because its financial records were summarized by the CPA during tax return preparation using a check register and third-party receipts. The court stated that the financial statements the CPA prepared were only provided to the taxpayer when her annual income tax returns were filed and "were not used by petitioner or anyone else to analyze" the horse-breeding activity's "profitability or expenses."

The taxpayer did not have a business plan for the activity until the CPA prepared one in response to an IRS exam, and she testified that "she kept a business plan only in . . . [her] head." Further, there was also evidence that she derived a substantial amount of personal pleasure from the horse-breeding activity, had substantial income from other sources to absorb her losses, and did not consult experts to attempt to make a profit from the activity. Weighing all those factors, the court denied the losses.

Sec. 212: Expenses for production of income

Connection to trade or businessIn Rangen, an individual taxpayer, who was employed for the tax year as a substitute teacher, claimed over $46,000 in unreimbursed employee business expenses on his 2010 tax return.24 When the IRS denied these deductions, the taxpayer challenged the IRS's determination in Tax Court, claiming that the unreimbursed expenses were related to his teaching job, but when the case went to trial, the taxpayer claimed that they were from his trade or business as a cartoonist. The court disallowed the deductions, finding that they were not ordinary and necessary business deductions because the taxpayer failed to connect the expense items to either of his trades or businesses, and in addition, for the vehicle expenses, the taxpayer did not provide the proper documentation to deduct them.

Rental property: The Tax Court denied an individual taxpayer numerous unsubstantiated business deductions on her individual income tax return.25 In this case, the taxpayer, who had a tax preparation business, was denied expenses for property that she rented to her cousin at less than FMV. Although she claimed that she reduced the rent because the property had been damaged, she provided no evidence of this and also did not prove that she did not live there. The only expense the court permitted for the house was the property taxes that the taxpayer supported with documentation.

Sec. 213: Medical, dental, etc., expenses

In vitro fertilization: An individual taxpayer was denied a deduction for medical expenses incurred in pursuit of conceiving a child through in vitro fertilization.26 The taxpayer, who was male and unable to conceive a child with his male life partner, sought to use in vitro fertilization, which required an egg donor and surrogate mother to carry the child until birth. The taxpayer claimed a deduction for costs incurred in this process.

The court rejected the taxpayer's deduction for two reasons. First, Sec. 213(a) clearly states that deductible medical expenses are related to costs incurred for medical care of the taxpayer, the taxpayer's spouse, or the taxpayer's dependent and because the medical costs were for a third party, the court found that they did not meet the requirements under Sec. 213(a). In addition, Sec. 213(d)(1) defines the term medical care, which includes expenses paid "for the diagnosis, cure, mitigation, treatment or prevention of disease, or for the purpose of affecting any structure or function of the body." The taxpayer argued that he was effectively infertile as a result of his sexual orientation, so the in vitro fertilization process affected his body's reproductive function. The court, however, concluded that the only bodily function affected by the in vitro fertilization process was that of the third-party surrogate and the egg donor, neither of whom qualified as the taxpayer's dependent, so the expenses were not for medical care.

The taxpayer also claimed that the IRS had violated his constitutional rights because it had disallowed his deductions based on his sexual orientation. The court disagreed, finding that Sec. 213 would not allow an individual, regardless of sex, sexual orientation, or gender, to deduct the kinds of in vitro fertilization expenses claimed by the taxpayer.

Substantiation: An individual taxpayer who did not file a return for 2010 received a deficiency notice from the IRS and filed a petition with the Tax Court.27 Sec. 213 allows taxpayers to deduct medical expenses that in aggregate exceed an AGI threshold, 7.5% in this case. However, the court found that all the expenses were either for nondeductible over-the-counter medications or had not been properly substantiated.

Health insurance: A group of unrelated nonresident aliens participated in the U.S. State Department's Summer Work Travel Program (SWTP) during 2012, submitting nonresident individual income tax returns for their time spent in the United States.28 All of the individuals claimed a deduction for unreimbursed employee expenses under Sec. 162. The IRS challenged the deductibility of these expenses on the premise that their "tax home" was their principal place of business and not their primary residence in their home country because all of the taxpayers either had no business connection to their principal residence abroad or severed any previous connection upon starting their employment in the United States.

The court ruled in the IRS's favor, disallowing the taxpayers' deductions for the expenses related to their participation in the SWTP except for their health insurance costs because they were not away from home as required by Sec. 162. For the health insurance expenses, the court found that the expenses were personal and subject to Sec. 213 so the taxpayers could deduct them only if they exceeded the 10%-of-AGI threshold for medical expenses.

Long-term-care premiums: The 2017 inflation-adjusted limitations under Sec. 213(d)(10) were released on Oct. 26, 2016.29 Long-term-care premiums includible in the term "medical care" are as followings:

  • $410: Ages 40 and below;
  • $770: Ages 41-50;
  • $1,530: Ages 51-60;
  • $4,090: Ages 61-70;
  • $5,110: Over age 70.
Sec. 215: Alimony, etc., payments

Property settlement agreement: An individual taxpayer improperly claimed alimony deductions for payments to his former spouse for numerous tax years.30 The taxpayer and his former spouse's separation was completed through a separation and property settlement agreement, which was established to resolve all matters between the couple, including payments to the former spouse. The court held that, regardless of the couple's intent with respect to the payments, under the terms of the agreement, which the couple had hastily and significantly altered shortly before signing, the payments did not qualify as alimony.

Lump-sum payment: In Letter Ruling 201706006, the IRS denied a taxpayer an alimony deduction for the amount of lump-sum payments the taxpayer was required to make to a former spouse under a court order. Sec. 215 allows a taxpayer to deduct alimony or separation payments made during the tax year as long as the recipient includes those payments in income under Sec. 71. Sec. 71(a) requires alimony or separate maintenance payments received by a taxpayer to be included in the computation of gross income.

Sec. 71(b) lays out four requirements that must be satisfied for payments to qualify as an alimony or separate maintenance payment. One of these is that the divorce or separation instrument does not designate the payment as a payment that is not includible in gross income under Sec. 71 and not allowable as a deduction under Sec. 215. In this case, there was an express designation in the court judgment that the lump-sum payments were not includible in the taxpayer's ex-spouse's income. Therefore, the IRS ruled that the lump-sum payments were not alimony.

Sec. 217: Moving expenses

Married taxpayers were denied moving expenses incurred when moving from Pennsylvania to California.31 The taxpayers elected to move after the husband was laid off from his previous employer and felt he had connections in California that he could use to find a new opportunity. When the couple arrived in California on March 7, 2012, the husband was still searching for a job. On June 7, the husband agreed to a job offer, which began on July 16, 2012, with a one-year term. The taxpayer agreed to complete several tasks for his new employer before July 16, but the company did not pay him.

The IRS disallowed the taxpayers' deduction for qualified moving expenses because the taxpayers did not satisfy all of the requirements under Sec. 217(c). The taxpayers fulfilled Sec. 217(c)(1)(A), which required the move be greater than 50 miles from the taxpayer's former principal place of residence. However, Sec. 217(c)(2)(A) requires that the taxpayer be a full-time employee at his new place of employment for at least 39 weeks during a one-year period commencing on March 7, 2012. Because the taxpayer did not start his new job until July 16, he did not meet the 39-week requirement.

The taxpayers attempted to persuade the court that the husband's employment began on the date that the contract was signed because he could no longer seek work after the signing date, but the court found nothing in the agreement that prevented the taxpayer from seeking other employment after that date. The taxpayer in the alternative argued that the unpaid tasks he performed for the company after the signing date constituted employment, but the court concluded that under its normal definition, work without pay is not employment, so the taxpayer did not commence his employment with the company until July 16.

Sec. 274: Disallowance of certain entertainment, etc., expenses

A taxpayer who ran her own tax preparation firm was denied various business expense deductions for failing to substantiate them.32 The taxpayer was also denied deductions for business vehicle expenses in excess of an amount the IRS permitted because the taxpayer failed the strict substantiation guidelines (i.e., mileage logs) required to claim those deductions. This case is also discussed under Secs. 61, 162, 170, and 212.

Sec. 469: Passive activity losses and credits limited

Regrouping authority of the IRS: In Hardy,33 the court upheld the taxpayer's position that two activities were not properly grouped together as one "appropriate economic unit" under the passive activity regulations at Regs. Secs. 1.469-4(c)(1) and (2). Upon audit, the IRS disallowed passive loss deductions taken by the taxpayer in 2008, arguing that the activity, a surgical center, was in fact grouped with the taxpayer's medical practice. The surgical center was held in an LLC, filing as a partnership; the taxpayer did not manage the center. His 2008 tax returns reported the activity as passive, although the 2006 and 2007 returns had treated the activity as nonpassive because the Schedules K-1, Partner's Share of Income, Deductions, Credits, etc., reported ordinary business income in box 1 and self-employment earnings in box 14.

If a taxpayer's grouping of activities is inappropriate, Regs. Sec. 1.469-4(f)(1) gives the IRS the authority to require a regrouping into an appropriate economic unit. In Hardy, the IRS made two arguments for its position. First, the IRS argued that the taxpayer had in fact grouped the activities in his 2006 and 2007 returns by reporting the LLC's income as nonpassive. Second, the IRS argued that the facts in this case closely resemble an example in the regulations that illustrate a proper economic grouping (Regs. Sec. 1.469-4(f)(2)).

With regard to the first argument, the court found that the evidence in the case did not indicate that the taxpayer had grouped the activities by reporting the income from the surgical center as nonpassive. Thus, the taxpayer had not impermissibly regrouped the activities when he later began reporting the income from the surgical center as passive.

With regard to the second argument, after the trial, the IRS issued a technical advice memorandum (TAM 201634022, see Baldwin, et al., "Current Developments in Taxation of Individuals," 48 The Tax Adviser 198 (March 2017)) that argued against its own position in this case. This TAM presents an example quite similar to Hardy but concludes that more than one grouping may be available and that either can be chosen if they are reasonable and do not have as a principal purpose the circumvention of the Sec. 469 regulations. In Hardy, the taxpayer was able to demonstrate his decision to invest in the surgical center was for sound business reasons, and not simply to evade the passive loss rules. Thus, the court found that the IRS could not regroup the taxpayer's activities.

Material participation requirements for real estate professionals: Three Tax Court cases of note have been recently published, all involving whether a taxpayer with another full-time job can qualify for real estate professional status. In Penley,34 the court upheld the IRS's findings that the taxpayer did not meet requirements under Sec. 469(c)(7)(B) to qualify as a real estate professional—namely more than 750 hours of service in a real estate trade or business that account for more than 50% of personal services provided during the year. In Penley, the taxpayer had full-time jobs during 2012 in which he spent 2,194 hours, and a calendar showing he spent 2,520 hours on his real estate properties. The taxpayer was a licensed real estate broker in Colorado, where he had three rental properties. The court noted that the calendar was not sufficiently specific to be credible—he reported an unreasonably large number of hours worked, all entries were rounded to the hour or half-hour and did not specify a start or stop time, and no time was included for meals or other breaks, and found that he had not adequately substantiated his hours.

In Zarrinnegar,35 the court upheld the taxpayer's claim he qualified as a real estate professional for the years 2010-2012, despite working as a dentist for a practice he and his wife, who was also a dentist, owned. They owned a real estate brokerage business and had four rental properties, although the spouse did not work in the real estate business. The taxpayer produced records substantiating that he worked in the practice only during afternoons four days per week, totaling 728 hours, and worked on his real estate for more than 1,000 hours. In court, the taxpayer husband was able to answer detailed questions about the calendar entries and brought in other witnesses to testify supporting his assertions.

In Windham,36 the court also held that the taxpayer qualified as a real estate professional for the year 2010, even though she also worked as a stockbroker. The taxpayer owned 12 rental properties in Florida, for which she claimed over 900 hours of time spent during the year. She also spent 600 hours per year working as a stockbroker. The court found her records and testimony credible and that they adequately substantiated her claims for all of her properties except for one, a vacant lot.

However, the taxpayer had not elected to treat all her real estate activities as one activity under Sec. 469(c)(7)(A), so each property had to qualify separately. The taxpayer's records showed hours of participation ranging from 54 to 107 during 2010. The court applied each of the seven tests in Temp. Regs. Sec. 1.469-5T(a) and concluded that all of the properties met the requirements either under Temp. Regs. Sec. 1.469-5T(a)(2)—the taxpayer's participation "constitutes substantially all of the participation" or Temp. Regs. Sec. 1.469-5T(a)(7)—"based on all the facts and circumstances." Therefore, the court allowed all of the taxpayer's passive losses, except for the vacant lot.

In another case, the court found that the taxpayer did not qualify as a real estate professional and therefore could not deduct his passive activity losses on his individual income tax return.37 The taxpayer, a lawyer by trade, also owned a property he intended to rent out to a tenant. The taxpayer deducted numerous expenses associated with the piece of real estate, while claiming no rental income. The taxpayer was unable to produce sufficient records proving the extent of his participation. However, he did qualify for relief under Sec. 469(i) for one of the two years at issue, which allowed a $25,000 deduction for that year when his income was low enough.

Sec. 1011: Adjusted basis for determining gain or loss

Deed in lieu of foreclosureThe Tax Court in Bobo38ruled that a payment received for a deed-in-lieu-of-foreclosure agreement (cash-for-keys incentive) was not ordinary income, as the taxpayers had reported on their tax return. The taxpayers signed the deed over to the mortgage company in exchange for loan forgiveness on the balance of the note. The court ruled that the deed in lieu of foreclosure and the cash-for-keys incentive are the results of a single transaction. The court noted that the petitioner husband did not work for the mortgage company; therefore, the Form 1099-MISC, Miscellaneous Income, was issued for the cash-for-keys incentive payment. In addition, the mortgage company also paid the incentive payment to avoid a lengthy and expensive legal process of foreclosure.

Tax shelter transaction: The Tax Court in Putanec39 held that a taxpayer could not deduct a $112 million paper loss from the redemption of a note in a CARDS (custom adjustable rate debt structure) tax shelter transaction. In the transaction, an LLC took out a loan that was collateralized 85% by a certificate of deposit (CD) and 15% by a promissory note. The taxpayer assumed the entire liability for the loan in exchange for the promissory note and claimed that his basis in the note was the entire amount of the loan. The court found that he could not include the portion of the loan collateralized by the CD in his basis for the note because that portion of the loan was a contingent liability.

Sec. 1211: Limitation on capital losses

The Tax Court in Reynoso40 ruled that a taxpayer, a chiropractor who did not file tax returns from 1997 through 2004 and had pleaded guilty to tax evasion for 2001, was unable to treat his losses from stock sales as ordinary losses because he did not make a mark-to-market election under Sec. 475(f). Although the taxpayer insisted he was in the trade or business of trading securities and that he made the mark-to-market election, the taxpayer was unable to provide any substantiation for making the election besides claiming that the IRS had lost it when it searched his office under a search warrant "at gunpoint." In addition, the taxpayer's records did not reflect any matching for any particular stock's sale or year-end price with its purchase. Therefore, the taxpayer's stock losses were limited to the $3,000 limitation on capital losses under Sec. 1211(b).

Sec. 1402: Self-employment

Minority interest in surgery center: The court allowed the taxpayer to exclude income under Sec. 1402(a)(13) earned through his minority interest in a surgery center where he performed operations.41 (This case is also discussed under Sec. 469.)

In 2006, Hardy, a plastic surgeon, purchased a minority interest in MBJ LLC, a surgery facility that he used for a portion of his patient procedures. Acting on his CPA's advice, Hardy began reporting his income from MBJ as passive in 2008 after having reported the income as nonpassive in prior years. This allowed Hardy to offset his MBJ income with unrelated passive losses carried forward from prior years. The IRS disagreed with this treatment and argued that his performing surgeries at the center precluded his being considered a limited partner.

The court cited Renkemeyer42 as clarifying the definition of "limited partner" and ruled that Hardy was purely an investor in MBJ LLC, unlike the attorneys in Renkemeyer. Hardy took no part in the surgery center's business operations. Further, Hardy and MBJ billed patients separately for procedures—Hardy for the operation and MBJ for the use of the facilities. Because the distributions Hardy received from MBJ were based on the fees that patients paid for use of the facilities in proportion to his ownership percentage, he would still be entitled to a distribution even if he performed no operations. The court found that Hardy owned his interest in MBJ as an investor, and therefore he was not subject to self-employment tax on his income from MBJ.

PLLC member compensation: Castigliola, Banahan, and Mullen were attorneys in Mississippi during 2008-2010.43 All three were member-managers of a professional LLC through which they practiced law. The firm was originally organized as a general partnership but reorganized as a PLLC in 2001. The PLLC has never had a written operating agreement.

During the period in question, the compensation agreement required that each member receive guaranteed payments as determined by a survey of legal salaries in the area. Any net profits that exceeded the amounts paid out as guaranteed payments were then distributed to the members in accordance with the members' agreement. This arrangement was established on the advice of a CPA who was the longtime adviser for the firm and its members and had nearly 40 years of experience. Based on this advice, the members reported their guaranteed payments as self-employment income and remitted the necessary taxes on these payments. However, they did not include the excess payments they received as self-employment income. The IRS determined that these excess payments were also subject to self-employment tax and issued a notice of deficiency.

The petitioners argued that the exclusion from self-employment income established under Sec. 1402(a)(13) for limited partners applied to the payments they received in excess of their guaranteed payments. The IRS contended that the members were not limited partners, rendering the exclusion inapplicable.

The court cited Renkemeyer, Campbell & Weaver, LLP in noting that no statutory or regulatory authority defines "limited partner" for the purposes of Sec. 1402(a)(13). The court noted that Renkemeyer indicated that the meaning of "limited partner" is not necessarily confined solely to the limited partnership context. The court's decision therefore focused on whether a member of a PLLC is functionally equivalent to a limited partner in a limited partnership.

The court applied the version of the Revised Uniform Limited Partnership Act (1985) that was adopted by Mississippi in 1987 to the facts. It states in relevant part that a "limited partner" would lose limited liability protection if "in addition to the exercise of his rights and powers as a limited partner, he participates in the control of the business."44

The PLLC in question was member-managed; therefore, management power over the business was vested in each member during the period in question. All three members participated in hiring and firing employees, determining compensation, and borrowing money. Further, no written operating agreement was in place that limited their power as members. All three members also testified that there was no general partner and that management participation was split equally among the members. As a result, the court sided with the IRS in determining that the members were not limited partners under Sec. 1402(a)(13) and disallowed any exclusion.

Sec. 5000A: Requirement to maintain minimum coverage

In Notice 2017-14 the IRS identified a new hardship exemption from the individual shared-responsibility payment (individual mandate) under Sec. 5000A. The new exemption applies to an individual who was not enrolled in qualifying health coverage between July and December 2016 but would have been eligible for this coverage if enrolled. The Notice applies to tax years ending after June 30, 2016.

Sec. 6015: Relief from joint and several liability on a joint return

In Taft, the court sided with the taxpayer and granted her innocent spouse relief under Sec. 6015(b), allowing her to receive a refund that was disallowed under the IRS's previous determination that she qualified for relief under Sec. 6015(c), which does not allow refunds of tax.45

Mrs. Taft, a registered nurse by trade, filed a joint return with her husband for tax year 2010. Shortly after losing his job in 2009, Mr. Taft began an extramarital affair that he funded during 2010 by secretly liquidating stock benefits he had previously earned and cashing out pensions and annuities. Mr. Taft directed their longtime accountant to electronically file their 2010 return without Mrs. Taft's review or approval. The return failed to report $4,874 in taxable dividends Mr. Taft received, which caused the IRS to assess additional taxes on the unreported income, also without Mrs. Taft's knowledge.

Upon discovering the affair, Mrs. Taft promptly filed for a divorce that was finalized in early 2013, prior to her filing of her 2012 return. When Mrs. Taft filed her 2012 return, it showed that she was due a refund of $5,261. The IRS did not issue the full refund requested, instead crediting $1,570 to the joint 2010 liability for the unreported dividends. Mrs. Taft filed Form 8857, Request for Innocent Spouse Relief, and was granted relief under Sec. 6015(c) but was not entitled to a refund because Sec. 6015(g)(3) prohibits refunds when relief is granted under Sec. 6015(c).

The court decided that Mrs. Taft was instead entitled to relief under Sec. 6015(b) and a full refund. The IRS contended that Mrs. Taft did not meet the requirements of Secs. 6015(b)(1)(C) and (D) because she had reason to know of the understatement and because it would not be inequitable to hold her liable for the deficiency. The court recognized that as a nurse, she possessed no formal accounting or business background. Further, she and her ex-husband maintained separate accounts throughout their marriage, and he purposely hid his misdeeds from her. She was not a beneficiary of Mr. Taft's draining the family savings, and therefore the court decided it would be inequitable to hold her accountable for Mr. Taft's actions.

Sec. 6038: Information reporting with respect to certain foreign corporations and partnerships

The court held that a taxpayer was liable for penalties for his failure to declare his ownership interests in two controlled foreign corporations.46

Edward Flume owned a 50% interest in FFM for all of 2001 and reduced his interest to 9% on Feb. 8, 2002, through the sale of a portion of his interest to a Mexican citizen. During April 2001, Flume and his wife incorporated Wilshire-Belize, a Belizean international business company, and issued one bearer share to each of Flume and his wife. At a later unknown date, the original articles of association for Wilshire-Belize were amended to eliminate the original bearer shares and change the ownership structure. After amendment, Flume and his wife purportedly owned only a 9% interest in the company, and the Mexican citizen owned the remaining 73%.

In accordance with Secs. 6038 and 6046, each of Flume's ownership interests and the sale of his interest in FFM required him to file Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, for the years in question. However, Flume did not file Forms 5471 for 2001 and 2002 until January 2013. He argued that his late-filed forms should be retroactive, thereby eliminating his penalties. Flume also contested his need to file Form 5471 for his ownership of Wilshire-Belize, asserting that the amended articles reducing his ownership percentage relieved him of his reporting obligation. The court disagreed with both of these arguments.

For FFM's Forms 5471, the court rejected Flume's retroactivity argument out of hand and then considered whether Flume had reasonable cause for failing to file the forms because he relied on his accountant's advice. The court found that Flume failed to meet the three-pronged test for reasonable cause based on a tax adviser's advice from Neonatology Assocs., P.A.47Flume contended that his accountant did not make him aware of his filing requirement, but he testified that he was unaware of his accountant's credentials and that he also did not inform her of his interests in FFM and Wilshire-Belize. The court decided that this barred him from reasonably relying on her advice.

In regard to Wilshire-Belize, the court found the amended articles of association to be unavailing. While the articles were backdated to April 2001, Flume could not prove when the articles were amended or if the amendments had actually been made. Flume's argument was also undercut because the UBS bank account that was opened in 2005 was used solely by him and his wife. The bank was never provided with the amended articles of association, and the account activity from 2006 to 2009 was directed entirely by Flume. The court held that Flume was required to file Forms 5471 for years 2001 to 2009 and that the penalties were accurate.  

Footnotes

1Polsky, 844 F.3d 170 (3d Cir. 2016).

2Skaggs, 148 T.C. No. 15 (2017).

3Barnes, T.C. Memo. 2016-212.

4Working Families Tax Relief Act of 2004, P.L. 108-311.

5Tax Reform Act of 1986, P.L. 99-514.

6QinetiQ U.S. Holdings, Inc., No. 15-2192 (4th Cir. 1/6/17), aff'g T.C. Memo. 2015-123.

7QinetiQ U.S. Holdings, Inc.,No.16-1197 (U.S. 4/4/17) (petition for writ of certiorari).

8Lowe, T.C. Memo. 2016-206.

9Fostering Connections to Success and Increasing Adoptions Act of 2008, P.L. 110-351; Working Families Tax Relief Act of 2004, P.L. 108-311.

10Kauffman, T.C. Memo. 2017-38.

11Beckey, T.C. Summ. 2017-13.

12Creigh, T.C. Summ. 2017-26.

13Long, T.C. Summ. 2016-88.

14Barnes, T.C. Memo. 2016-212.

15Scheurer, T.C. Memo. 2017-36.

16Id.at *228-229.

17Carmody, T.C. Memo. 2016-225.

18Izen,148 T.C. No. 5 (2017).

1915 West 17th Street LLC, 147 T.C. No. 19 (2016).

20REG-138344-13.

21REG-138344-13, withdrawn, 81 Fed. Reg. 882 (Jan. 8, 2016). See also, 15 West 17th Street LLC, 147 T.C. No. 19 at *19-23 (2016).

22Barnes, T.C. Memo. 2016-212.

23Hylton, T.C. Memo. 2016-234.

24Rangen, T.C. Memo. 2016-195.

25Barnes, T.C. Memo. 2016-212.

26Morrissey, No. 8:15-cv-2736-T-26AEP (M.D. Fla. 12/22/16).

27Alexander, T.C. Memo. 2016-214.

28Liljeberg, 148 T.C. No. 6 (2017).

29Rev. Proc. 2016-55.

30Quintal, T.C. Summ. 2017-3.

31Anderson, T.C. Summ. 2017-17.

32Barnes, T.C. Memo. 2016-212.

33Hardy, T.C. Memo. 2017-16.

34Penley, T.C. Memo. 2017-65.

35Zarrinnegar, T.C. Memo. 2017-34.

36Windham, T.C. Memo. 2017-68.

37Ekeh, T.C. Summ. 2016-80.

38Bobo, T.C. Summ. 2016-74.

39Putanec, T.C. Memo. 2016-221.

40Reynoso, T.C. Memo. 2016-185.

41Hardy, T.C. Memo. 2017-16.

42Renkemeyer, Campbell & Weaver, LLP, 136 T.C. 137 (2011).

43Castigliola, T.C. Memo. 2017-62.

44Miss. Code §79-14-303.

45Taft, T.C. Memo. 2017-66.

46Flume, T.C. Memo. 2017-21.

47Neonatology Assocs., P.A., 115 T.C. 43 (2000).

 

Contributors

David Baldwin is a partner with ­Baldwin & Baldwin PLLC in Phoenix. Robert Caplan is a CPA at Robert M. Caplan CPA in Foster City, Calif. Valrie Chambers is an associate professor of accounting at Stetson University in DeLand, Fla. Edward A. Gershman is a managing director with Deloitte Tax LLP in Chicago. Jennifer S. Korten is a partner at Kubo Korten PLLC in Seattle. Darren Neuschwander is a managing member with Green, Neuschwander & Manning, a virtual CPA firm with members all across the country. ­Jeffrey A. Porter II is a CPA with Porter & Associates CPAs in Huntington, W.Va. Kenneth L. Rubin is a partner with RubinBrown LLP in St. Louis. David E. Taylor is a partner at Anton Collins Mitchell in Denver. ­Donald J. Zidik Jr. is a director with Marcum LLP in Boston and an adjunct professor of taxation at Suffolk University in Boston. Mr. Zidik is the chair, Mr. Rubin is the immediate past chair, and the other authors are current members of the AICPA Individual & Self-Employed Tax ­Technical Resource Panel (TRP). For more information about this article, contact thetaxadviser@aicpa.org.

 

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