Individual tax report

This article is a semiannual review of recent developments in the area of individual federal taxation. It covers cases, rulings, and guidance issued to explain the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, among many other topics. The items are arranged in Code section order.

Sec. 24: Child tax credit

In IR-2018-217, the IRS reminded taxpayers of the changes to the child tax credit in the TCJA. The income limitation has increased to $400,000 for married couples and $200,000 for single taxpayers, and the amount of the credit has increased to $2,000 per child with up to $1,400 refundable. There is also a new $500 credit for other dependents such as children over 17 and other qualifying relatives.

Sec. 31: Tax withheld on wages

In Program Manager Technical Advice (PMTA) 2018-015, the IRS determined that an employer’s payment of taxes that should have been withheld in a prior year did not create wages to the employee in that prior year. In the examination in which this issue arose, an employer was determined to have provided an employee $10,000 of taxable fringe benefits that had not been reported. The employer was assessed $4,030 in income tax withholding and the employer and employee shares of Federal Insurance Contributions Act (FICA) taxes. The employer was required to issue a Form W-2c, Corrected Wage and Tax Statement, to the employee reporting the fringe benefit income of $10,000.

The employee was not given credit for income tax that was required to be withheld, was not withheld, and was paid by the employer, as this was the employer’s liability, not the employee’s. The taxes are not included in the employee’s income, but the employee is given credit for the employee FICA taxes paid, which are reported on the Form W-2c in box 4, “Social Security tax withheld,” and box 6, “Medicare tax withheld.”

Sec. 36B: Premium tax credit

In Notice 2018-84, the IRS provided interim guidance clarifying how the suspension of the personal exemption applies to certain rules under Sec. 36B. Under the TCJA, the personal exemption for the taxpayer, spouse, and dependents is reduced to zero for years 2018-2025.

The premium tax credit rules under Sec. 36B apply whether or not a taxpayer claims or claimed a personal exemption deduction under Sec. 151 for an individual.

Notice 2018-84 states that for purposes of the regulations under Secs. 36B and 5000A, taxpayers are considered to have claimed a personal exemption for themselves if they file a tax return for the year and do not qualify as another taxpayer’s dependent. Further, a taxpayer is considered to have claimed a personal exemption for an individual if the individual’s name and Social Security number are listed on page 1 of Form 1040, U.S. Individual Income Tax Return.

In Rev. Proc. 2018-34, the IRS provided indexing amounts for certain provisions of the Patient Protection and Affordable Care Act, P.L. 111-148, under the premium tax credit.

In Rev. Proc. 2018-43, the IRS provided the 2018 monthly national average premiums for health plans that have a bronze level of coverage.

Sec. 61: Gross income defined

Donations to pastor: In Felton,¹ the taxpayer was the founder and pastor of Holy Christian Church in St. Paul, Minn. (with a congregation of about 600 families), and Holy Christian Church International, which set up churches in Rwanda, Liberia, Jamaica, Florida, Louisiana, and another one in Minnesota. The taxpayer’s wife also played an important role as the pastor of women’s affairs and by helping run the church.

Contributions from the church congregation were managed with a system of colored envelopes: gold for special projects and retreats and white for contributions to sustain the church. However, these envelopes also included a “pastoral” line that delineated contributions intended specifically for the taxpayer. White envelopes were available at the church’s entrance and passed out by ushers during services. Both white and gold envelope contributions were tracked and included in the members’ annual contribution statements. Blue envelopes, which were used to contribute directly to the taxpayer, were handed over to him unopened and were not tracked by the church. Church members were informed that those contributions were not tax-deductible. The taxpayer preached about tithing and making offerings in white envelopes, but he did not preach about personal donations in blue envelopes.

Although the church’s executive board authorized a salary for him in 2008 and 2009, the taxpayer did not take it. He received, in both 2008 and 2009, $40,000 of personal donations from some members of the congregation in white envelopes, which he reported as wages. The church also gave him a parsonage allowance of almost $80,000 per year. In addition, in both 2008 and 2009, the taxpayer received over $230,000 in blue-envelope cash and personal checks from his congregants in addition to their regular church offerings.

Among other issues, the Tax Court was tasked with determining whether these blue-envelope transfers were nontaxable gifts, as the taxpayer contended, or taxable income payments. After analyzing the following factors found in case law on donations to clergy, the court determined that the payments were taxable income:

• Whether the donations were objectively provided in exchange for services;
• Whether the cleric (or other church authorities) requested the personal donations;
• Whether the donations were part of a routinized, highly structured program and given by individual church members or the congregation as a whole; and
• Whether the cleric received a separate salary from the church, and the amount of that salary compared with the personal donations.

Lawsuit settlement: In IRS Letter Ruling 201831011, the taxpayer, a bankruptcy estate, was created in response to an unfavorable judgment against the insured, who fatally injured a person with his automobile. The professional negligence of the law firm representing the insured resulted in a significant judgment against the insured. As a fiduciary for the creditors of the bankruptcy estate, comprising almost exclusively the victim’s family, the taxpayer expected to distribute the proceeds of the settlement payment to the victim’s family. As such, the ruling concluded that the subsequent settlement payment stemming from the resulting malpractice lawsuit is a return of capital to compensate for a loss or destruction of the capital of the insured. No economic gain benefited the insured personally. Therefore, the payments were excludable from gross income, as they were deemed a return of capital to compensate for a loss or destruction of capital.

State grants: Another letter ruling, IRS Letter Ruling 201816004, involved a state-run home improvement program that offers grants to or on behalf of in-state homeowners of owner-occupied residences whose houses meet requirements demonstrating a need for certain building-code-based structural reinforcements (e.g., the location of the home, the home’s age and physical characteristics, and the grant recipient having an insurance policy with the taxpayer). The taxpayer is the state entity establishing the program. The potential for significant harm reduction, in terms of avoiding both property damage and ensuring the safety of occupants, motivated the taxpayer to pursue the program. However, the structural and substantial home improvements are not incidental to the program’s benefits, as the homeowners obtain the tangible benefits of a safer and more desirable home that is better able to withstand certain disasters. Thus, grants that the taxpayer provides to or on behalf of homeowners under the program are accessions to wealth that are includible in the recipients’ taxable income under Sec. 61. The Sec. 139(g) general welfare exclusion does not apply, as the grants the taxpayer provided are not based on individual or family need. Moreover, the grants are paid to eligible homeowners regardless of income to mitigate the effects of future disasters, not to alleviate suffering and damage resulting from a disaster.

Sec. 104: Compensation for injuries or sickness

Veterans’ disability payments: The IRS announced that any veteran who received disability severance payments after Jan. 17, 1991, and included that payment as income should file Form 1040X, Amended U.S. Individual Income Tax Return, to claim a credit or refund of the overpayment attributable to the disability severance payment.² Veterans can either submit a claim based on the actual amount of their disability severance payment by completing Form 1040X or claim a standard refund amount based on the calendar year (an individual’s tax year) in which they received the severance payment. Claiming a standard refund avoids the need to access the original tax return from the year of the lump-sum disability severance payment. The Department of Defense will issue letters to veterans who received a one-time lump-sum disability severance payment when they separated from their military service with instructions on how to claim the refunds to which they are entitled. These refunds must be claimed within one year from the date of the Department of Defense letter.

Police benefits: In IRS Letter Ruling 201819004, the taxpayer, a state entity, implemented a benefits plan for police officers who either died or suffered injury in the line of duty. A police officer or a surviving spouse of a police officer receiving these benefits will be allowed to exclude the benefits from gross income as benefits under a statute in the nature of a workers’ compensation act under Sec. 104(a)(1) to the extent they do not exceed 50% of the police officer’s final average compensation. Benefits that exceed the 50% threshold will be classified as gross income. However, if the disability benefits and line-of-duty death benefits are paid under the plan to former spouses of police officers under eligible domestic relations orders, those benefits are not excludable from the former spouses’ taxable income.

Sec. 108: Income from discharge of indebtedness

Rev. Proc. 2018-39 provides relief to taxpayers who took out private student loans to finance attendance at a school owned by Corinthian College Inc. (CCI) or American Career Institutes Inc. (ACI). The revenue procedure provides that the IRS will not assert that a taxpayer within its scope must (1) recognize gross income as a result of the discharge of a private student loan taken out to finance attendance at a school owned by CCI or ACI, or (2) increase his or her taxes owed in the year of a discharge, or in a prior year, if he or she received an education credit under Sec. 25A attributable to payments made with proceeds of the discharged loans, claimed a deduction for the payment of interest under Sec. 221 attributable to interest paid on a discharged loan, or claimed a deduction for the payment of qualified tuition and related expenses under Sec. 222 attributable to payments made with proceeds of the discharged loan. The revenue procedure amplifies Rev. Proc. 2015-57 and Rev. Proc. 2017-24.

Sec. 165: Losses

In Forlizzo,³ the Tax Court held that the taxpayer was not entitled to a loss deduction for worthlessness of partnership interests. Prior to 2008, the taxpayer had invested in real estate partnerships that built and sold commercial property. Due to the economic downturn in 2008, some of the projects no longer appeared to be financially viable, but none of the properties had gone through foreclosure or been liquidated. Additionally, the taxpayer was a guarantor on some of the related loans.

The Tax Court explained that a loss on a partnership investment must be evidenced by closed and completed transactions fixed by identifiable events (e.g., sale, foreclosure, liquidation, bankruptcy).⁴ It also stated that courts have held that a mere decline in value is not evidence of a closed or completed transaction and that attempts to obtain additional capital or minimize losses establish that property subject to recourse debt retains enough value to avoid being worthless.

The court found that there was value remaining in the partnerships relating to the underlying properties, which the taxpayer recognized would be lost if certain projects were not completed and properties were immediately foreclosed upon, and in addition, in 2011, the construction loans had been renegotiated to add value to the partners by minimizing losses. Therefore, the Tax Court held that the taxpayer had failed to prove the partnership interests were worthless at the end of 2008.

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

In the last six months of 2018, the IRS issued two significant regulation projects on charitable contributions. In addition, several cases highlighted the importance of accurate recordkeeping in claiming deductions for charitable contributions, and other cases highlighted the importance of meeting exact statutory and regulatory requirements related to conservation easements.

Substantiation regulations: With T.D. 9836, the Service issued final regulations on the substantiation of charitable contributions. (For a description of the final regulations, see “News Notes: IRS Issues Final Rules on Adequate Substantiation of Charitable Contributions,” The Tax Adviser (October 2018).)

State tax credits: The IRS also issued Prop. Regs. Sec. 1.170A-1, Prop. Regs. Sec. 1.170A-13, and Prop. Regs. Sec. 1.642(c)-3, under which amounts otherwise deductible as a charitable contribution would generally be reduced by the amount of any state or local tax (SALT) credit received or expected to be received by the contributing taxpayer. For example, if an individual makes a contribution of $1,000, which is expected to yield a $350 state tax credit, the individual’s charitable deduction must be reduced by the expected $350 state credit so that the net charitable contribution would be $650. The proposed regulations provide a de minimis exception exempting contributions that produce an expected state tax credit of 15% or less of the amount contributed.

The regulations also allow a full charitable deduction for any contributions that produce a state tax deduction instead of a state tax credit as long as the deduction does not exceed or is not expected to exceed the amount of the contribution. If the taxpayer receives or expects to receive a state or local tax deduction that exceeds the amount of the contribution, the taxpayer’s charitable contribution deduction must be reduced. The regulation preamble (REG-112176-18) requested comments on how to determine the reduction. The workaround regulations are proposed to apply to any contributions after Aug. 27, 2018.

Substantiation: In Archer,⁵an individual was denied cash contributions of $5,650 and noncash charitable deductions of $3,749. The taxpayer failed to produce canceled checks or receipts for the cash contributions as required by Sec. 170(f)(8) and produced only receipts that he filled out himself for the noncash contributions. He estimated values but did not adequately describe any donated property other than as “bags/boxes” and “large household item(s).”

Value of donated property: In Grainger,⁶ a taxpayer who was fond of shopping sought to combine her love of shopping with a desire for a tax cut. In 2010, the taxpayer developed what she described at trial as her “personal tax shelter.” Having learned that a taxpayer may generally claim a charitable contribution deduction in an amount equal to the fair market value (FMV) of donated property, she assumed that the FMV of a retail item is the dollar amount shown on the price tag when the retailer first offers the item for sale. Thus, the taxpayer saw an opportunity to buy low and donate high. She bought items that had been heavily discounted and then immediately donated those items to charity, claiming a deduction of the price the item had originally been offered for sale.

For 2012, the year at issue, the taxpayer claimed a noncash charitable deduction of $34,401. She acquired these items by making an outlay of $2,520 in cash and using $3,527 in loyalty points. She attached six Forms 8283, Noncash Charitable Contributions, to her tax returns, describing most donations as clothing or some variation. The Tax Court disallowed her deduction in excess of the amount the IRS allowed (her $2,520 cash outlay plus loyalty points used⁷), finding that she failed to use a reasonable valuation method. The court further noted that the taxpayer would have failed the qualified appraisal requirements of Sec. 170(f)(11) because items of a similar nature must be grouped together to determine whether the items exceed the $5,000 threshold.

In addition, the court determined that even if she had properly substantiated the deduction, it would still be disallowed because she did not use a legitimate valuation method for the donated clothing. Finally, the court observed that the donated goods would have been treated as short-term capital gain property if they had been sold, since the taxpayer donated all of her goods to charity immediately after purchase. As a result, even if she established a value in excess of her out-of-pocket costs for the donated goods, Sec. 170(e)(1)(A) would cause her deduction to be reduced by the amount of gain she would have realized if she had sold them.

Land improvements: In Presley,⁸ taxpayers were denied a 2010 charitable deduction of over $107,000 paid to make land improvements to property that a charitable organization owned. The land improvements were made over several years prior to 2010 and paid for by an LLC owned by the taxpayers, but no charitable deductions were claimed in the years incurred. The court cited a number of reasons why the taxpayers could not take the deduction.

First, the taxpayers could not have contributed the land improvements to the charity because they had conceded that they did not own them. Second, the deduction was not allowable in 2010 because the land improvements were paid for in years before 2010. Third, even if the expenses had been paid in 2010, the expenses that the LLC paid were not directly connected with or solely attributable to the rendering of services by the LLC to the charitable organization as required by Regs. Sec. 1.170A-1(g). Finally, the deduction would not be allowable because the taxpayers had failed to meet the substantiation requirements for the contribution of the land improvements.

Further, the court found that the taxpayers failed to include a Form 8283 and the appraisal required under Sec. 170(f)(11) when reporting a charitable deduction in excess of $5,000, so any charitable contribution deduction the taxpayers might have been allowed was rendered moot by their failure to meet those requirements.

Conservation easement: In Champions Retreat Golf Founders, LLC,⁹ the taxpayer was denied a charitable deduction of $10.4 million related to a conservation easement on a golf course. A conservation easement qualifies for a charitable deduction if, among other things, it is made exclusively for conservation purposes.¹⁰ A contribution is treated as made exclusively for conservation purposes if it either:

1. Protects a relatively natural habitat of fish, wildlife, or plants, or a similar ecosystem;¹¹ or
2. Preserves open space (including farmland and forest land) where such preservation is for the scenic enjoyment of the general public, or pursuant to a clearly delineated federal, state, or local governmental conservation policy, and will yield a significant public benefit.¹²

The Tax Court determined that Champions Retreat did not satisfy the conservation purpose requirement of Sec. 170(h) and therefore was not entitled to a qualified conservation contribution deduction. It found that the first requirement of a relatively natural habitat requirement was not met for the easement because Champions Retreat presented evidence of only one rare, endangered, or threatened species with a habitat on the easement area — denseflower knotweed — and it inhabited just a small 26-acre portion of the easement area (only 7.5% of the overall easement). Further, the court noted that part of the golf course was designed to drain into the 26-acre swath, introducing chemicals including herbicides into its habitat. Based on the evidence, the court further concluded that the preservation of open space by the easement was not for the enjoyment of the general public nor pursuant to a clearly delineated governmental conservation policy.

Sec. 183: Activities not engaged in for profit

Horse–breeding hobby: In Householder,¹³in applying the nine factors provided by Regs. Sec. 1.183-2(b), the Tax Court found that the taxpayers’ business activity listed on Schedule F, Profit or Loss From Farming, was not engaged in for profit. The taxpayers entered into a horse-breeding agreement with ClassicStar starting in 2002. As part of this agreement, the taxpayers leased breed horses from ClassicStar and paid for the horses’ board and breeding costs. The foals that resulted from the breeding were assets the taxpayers retained or sold. Taxpayers participated in this activity through ClassicStar from 2002 to 2005. During this time frame, the taxpayers only received income of $180,000 from the sale of the one and only foal born from 2002 to 2005, which was sold in 2005. However, the taxpayers deducted expenses of $1.3 million, primarily incurred from 2002 to 2003. These expenses reported on Schedule F were used to reduce the taxpayers’ income from other sources — either other sources of business income or brokerage-related income. The Schedule F activity decreased their taxable income in 2002 and 2003 to almost zero, additionally creating net operating losses (NOLs) that were carried back to prior open years.

Factors weighing against the taxpayers included:

1. Lack of signed and completed agreements;
2. Lack of expertise in horse breeding (one spouse owned a 40-office financial advisory firm, and the other spouse was a licensed psychologist);
3. Inconclusive evidence to support the taxpayers’ collective time and effort in the horse-breeding activity;
4. Lack of success in activities similar to horse breeding; and
5. Lack of occasional profits.

The $180,000 profit from the sale of one foal was approximately 10% of the expenses incurred and was the single transaction that generated any revenue for the Schedule F activity. Additionally, it was determined that the taxpayers were more motivated to enter the horse-breeding activity for its ability to generate NOLs.

Personal pleasure was determined to be another reason for engaging in this activity, as the taxpayers took various trips sponsored by ClassicStar, including to the Breeders’ Cup, the Kentucky Derby, Yellowstone, and the U.S. Virgin Islands.

Ranch business: In another case, the taxpayers were successful in escaping hobby loss characterization, only to fail under the passive loss rules. In Robison,¹⁴ the IRS contended that the losses from the taxpayers’ ranch operation were hobby losses, but the court held that the ranch operation was a trade or business. This case has an excellent analysis of the factors to be considered related to hobby loss determinations in general, finding it to be a close case with the factors favoring the taxpayers just slightly outweighing those favoring the IRS. This case is also discussed under Sec. 212 and Sec. 469.

Sec. 199A: Qualified business income

In January, the IRS finalized proposed regulations on the Sec. 199A qualified business income (QBI) deduction. Sec. 199A allows owners of sole proprietorships, partnerships, trusts, and S corporations to deduct 20% of their QBI beginning in 2018.¹⁵

The deduction is generally available to taxpayers whose 2018 taxable incomes fall below $315,000 for joint returns ($321,400 for 2019) and $157,500 for other taxpayers ($160,700 for single and head of household and $160,725 for married filing separately for 2019). The deduction is generally equal to the lesser of 20% of the taxpayer’s QBI plus 20% of the taxpayer’s qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income, or 20% of taxable income minus net capital gains. Deductions for taxpayers above the thresholds may be limited; the application of those limits is described in the regulations.

The final regulations address a variety of subjects.

Regs. Sec. 1.199A-1 contains the operational rules, including how to determine the deduction for taxpayers with incomes at or below the threshold amounts and for those with incomes above the thresholds. It also contains definitions of many terms, including trade or business, net capital gain, QBI, relevant passthrough entity (RPE), specified service trade or business (SSTB), threshold amount, total QBI amount, unadjusted basis immediately after acquisition (UBIA) of qualified property, and W-2 wages.

For Sec. 199A purposes, the IRS decided to apply the definition of “trade or business” contained in Sec. 162(a) because that definition is derived from a large amount of case law and administrative guidance interpreting the term in the context of a broad range of industries. The IRS believes this will provide for administrable rules that are appropriate for the purposes of Sec. 199A and that taxpayers have experience applying, and that it will reduce compliance costs, burden, and administrative complexity.

Regs. Sec. 1.199A-2 contains rules for determining W-2 wages and the UBIA of qualified property, both of which are components in calculating limitations on the deduction. The rules for determining W-2 wages are based on the rules under the repealed Sec. 199 deduction for qualified domestic production activities, except, unlike Sec. 199, the Sec. 199A W-2 wages are determined separately for each trade or business.

Regs. Sec. 1.199A-3 provides additional guidance on the determination of QBI, qualified REIT dividends, and qualified PTP income.

Regs. Sec. 1.199A-4 contains aggregation rules allowing separate trades or businesses to be grouped when applying the Sec. 199A rules. The IRS rejected comments suggesting the application of the grouping rules under Sec. 469 (the passive loss provision) and instead adopted a flexible method that looks into common ownership, shared services, and other commonality, but specifically excludes SSTBs from being aggregated. The regulations impose a duty of consistency that requires that once multiple trades or businesses are aggregated into a single aggregated trade or business under Sec. 199A, taxpayers must consistently report the aggregated group in subsequent tax years unless there is a change in facts and circumstances. Aggregation must be elected on an original return, except for 2018, when taxpayers may elect aggregation on an amended return. Aggregation allows for ease of administration and was one of the AICPA’s recommendations in a letter it sent to the IRS in February 2018.

Regs. Sec. 1.199A-5 defines SSTBs and the trade or business of performing services as an employee. The regulations include an anti-abuse rule designed to prevent taxpayers from separating out parts of what otherwise would be an integrated SSTB, such as the administrative functions, in an attempt to qualify those separated parts for the Sec. 199A deduction. They also include a presumption that an individual who was previously treated as an employee and is subsequently treated as an independent contractor while performing substantially the same services for the same employer or a related person will be presumed to still be in the trade or business of performing services as an employee for purposes of Sec. 199A.

Regs. Sec. 1.199A-6 contains special rules for RPEs, PTPs, trusts, and estates that these entities may need to follow for purposes of computing the entities’ or their owners’ Sec. 199A deductions.

Regs. Sec. 1.643(f)-1 addresses concerns about the abusive use of multiple trusts by confirming the applicability of Sec. 643(f), which permits the IRS to issue regulations to prevent taxpayers from establishing multiple trusts or contributing additional capital to multiple existing trusts to avoid federal income tax.

Rev. Proc. 2019-11, issued contemporaneously with the final regulations, contains three methods for calculating W-2 wages (1) for purposes of the limitation based on W-2 wages to the amount of the deduction for QBI under Sec. 199A; and (2) for purposes of the reduction to the Sec. 199A deduction based on W-2 wages for certain specified agricultural and horticultural cooperative patrons.

Also released simultaneously with the final regulations were new proposed regulations¹⁶ on how to treat previously suspended losses and how to determine the deduction for taxpayers that hold interests in regulated investment companies (RICs), charitable remainder trusts (CRTs), and split-interest trusts, and Notice 2019-07, which provides a safe-harbor rule for rental real estate businesses.

Sec. 212: Expenses for production of income

The Tax Court ruled in Robison¹⁷ that the taxpayers were entitled to deduct the expenses from their ranching activity from 2000-2015. The taxpayers presented qualified documentation of hours spent and employees hired for their ranching activity, therefore engaging in it for profit, which should be deductible under Sec. 162 as trade or business expenses (and Sec. 212 as expenses for production of income) and not be limited as an activity not engaged in for profit. The court ruled that the ranching activities for the years in issue were engaged in with the requisite profit objective and therefore could not be classified as a hobby. Therefore, they were deductible, except to the extent they were limited by the passive loss rules. This case is also discussed under Sec. 183 and Sec. 469.

Sec 213: Medical, dental, etc., expenses

Transportation: The Tax Court held in Sutherland¹⁸ that the taxpayers were not entitled to deduct under Sec. 213(d)(1)(B) the $3,198 they claimed they spent on transportation for medical care in 2014, because they did not adequately substantiate the expenses. The court found that the taxpayers provided no mileage logs or other proof to substantiate the claimed mileage but only provided a total mileage amount for each medical expense without substantiating where the trip originated, what vehicle was used, or any other evidence to substantiate the reported expense. Therefore, they were not entitled to deduct the $3,198 of disputed medical expenses.

Weight loss: The Tax Court held in Fiedziuszko¹⁹ that the taxpayer was not entitled to a deduction for a medically supervised weight loss program and a root canal in 2012. The taxpayer argued that because she was diagnosed with morbid obesity and entered into the weight loss program as a treatment of the disease, the cost should be deductible under Sec. 213(d)(1)(A). The court ruled that although the IRS considers obesity a disease and treatment is deductible under Sec. 213, the taxpayer failed to substantiate the cost of her treatments. The statement of expenses prepared for trial and the taxpayer’s sworn testimony were not sufficient substitutes for a proper itemized statement of verified medical expenses.

Sec 215: Alimony payments

The Tax Court held in Vanderhal ²⁰ that the taxpayer was entitled to an alimony deduction for the payments made toward student loans incurred by his former spouse in 2013. The court explained that the divorce decree did not address or specifically denote the division of debts as tax-free transfers of property made under Sec. 1041. Furthermore, the court found that the payments did not clearly state they were nonalimony payments as required in the text of Sec. 71 and Sec. 215. This case is also discussed under Sec. 1041.

Sec 217: Moving expenses

The Tax Court held in Benjamin²¹ that the taxpayer was not entitled to the moving expense deduction for tax years 2012—2014, in which he claimed that he incurred costs in moving his work gear and equipment from his residence in California to job sites in other states. The court determined these expenses were not deductible moving expenses because although he provided numerous receipts and showed payments for hotels, meals, and car rentals, he did not classify which, if any, were moving expenses. Additionally, he continued to maintain his principal residence in California while incurring the expenses. Furthermore, the court found the deduction was not allowable because the taxpayer did not provide evidence that he stayed in the new location for over 39 weeks as is required to be eligible to deduct moving expenses under Sec. 217(c).

Sec. 469: Passive activity losses and credits limited

Two cases of note provide examples of what hours a taxpayer spends on an activity count toward participation when an outside manager is used.

Real estate professional: In Antonyshyn,²² the court upheld the IRS’s findings that the taxpayers had losses in the years 2009-2010 that were passive losses and not deductible against other income. The taxpayers owned six residential rental properties located in five different states — none in their home state of California. They hired management companies for four of the properties, which were located in Georgia, Missouri, and North Carolina, to handle daily operations, including collecting rents, interacting with tenants, and arranging for maintenance as needed. The other two properties were not leased out during the years under audit. The court found that most of the taxpayers’ time spent on the activities was not for daily operations but was for activities related to being investors, which is generally not counted as participation. Therefore, the wife did not qualify as a real estate professional under Sec. 469(c)(7). In addition, the court noted the taxpayers kept poor records, which were not credible in many instances.

Ranch business: In Robison,²³ the taxpayers claimed losses totaling $2.8 million on their Schedule E, Supplemental Income or Loss, passed through from the Schedule F from the Form 1065, U.S. Return of Partnership Income, for the limited liability company Robison Ranch, which owned their ranch in southern Utah for the years 2010-2014. During those same years, the husband reported wage and salary income of $21 million from his position as an executive in Silicon Valley. During all years, the taxpayers had employed a full-time manager to oversee the ranch’s daily activities.

The IRS disallowed the ranch losses under the passive activity rules of Sec. 469 because the taxpayers did not materially participate in the activities. The taxpayers did not keep contemporaneous records for the years under audit and created records in response to the audit. The court found these records were generated based on how much the taxpayers estimated the activities should require and were generally not specific enough, i.e., they did not include any detail of work actually done, and therefore the time spent on the work could not be counted toward the 500-hour test for material participation under Temp. Regs. Sec. 1.469-5T. Furthermore, under Temp. Regs. Secs. 1.469-5T(b)(2)(ii)(A) and (B), the presence of a full-time paid manager at the ranch for all of the years at issue disqualified the time spent working on management services for the ranch from counting toward their participation for purposes of the facts-and-circumstances test for material participation.²⁴

Contemporaneous records: CPAs who also claim real estate professional status on their Form 1040 should take note of Ballard.²⁵ The taxpayer husband was a CPA in California with a master’s degree in taxation and was working in private industry during the years 2008-2010 when he and his wife deducted real estate losses of $311,000 on their Form 1040. The taxpayer wife was a homemaker caring for their three young children at the time. They owned six rental properties, five of which were located in Georgia, and added a seventh in 2010 that was located in California. During the years under audit, the taxpayers did not visit any properties in Georgia, and they used outside vendors to repair and otherwise maintain the rental units.

Similar to the above Sec. 469 cases, the taxpayers did not keep contemporaneous records but recreated them after reviewing emails, phone records, and receipts — several years after the events occurred. The court found that these logs were not credible and did not establish the taxpayers’ time spent in the rentals’ daily operations. The IRS assessed accuracy-related penalties under Sec. 6662(a) for the years 2008 and 2010. The court upheld these, citing that the taxpayers did not rely upon outside professionals. Further, based on his “experience, knowledge, and education,” the taxpayer had no reason for not understanding the law or for not properly documenting the activities contemporaneously.

Sec. 1001: Determination of amount of and recognition of gain or loss

The Tax Court ruled in Azam²⁶ that a Form 1099-B, Proceeds From Broker and Barter Exchanges, was sufficient to provide the cost bases for all but two of the taxpayers’ investments. The court also found that the taxpayers could not produce evidence to show that unreported long-term capital gain was not taxable. The taxpayers were also not able to substantiate the $3,000 capital loss carryover deduction on their return.

Secs. 1001 and 1259: Constructive sales treatment for appreciated financial positions

The Second Circuit in Estate of McKelvey²⁷reversed a Tax Court ruling in which variable prepaid forward contracts (VPFCs) entered into by a decedent taxpayer were ruled by the Tax Court to not be a taxable exchange under Secs. 1001 and 1259. The Second Circuit ruled that the amended contracts were constructive sales and remanded the case to the Tax Court to determine if the termination of the obligations generated short-term capital gains when the new contracts were executed. The case was also remanded to the Tax Court to calculate any long-term capital gains from the constructive sale of the collaterized shares.

The facts from the Tax Court case were that the decedent entered into various VPFCs with two investment banks for which the investment banks provided prepaid cash payments to the taxpayer, who later died. The taxpayer (decedent) was then required to deliver variable quantities of stock on specified future settlement dates in 2008. The execution of the original VPFCs was treated as open transactions under Rev. Rul. 2003-7, and therefore there was no reportable gain or loss. Before the original settlement dates, the decedent paid to extend the settlement dates to 2010. No gain or loss was reported as the transactions were treated as being open. The IRS argued that the extension of the VPFCs constituted a sale or exchange of property under Sec. 1001. The Tax Court ruled that the open transaction treatment (under Rev. Rul. 2003-7) continues until transactions are closed by future delivery of stock.

Sec. 1033: Involuntary conversions

The IRS issued Notice 2018-79, which provides guidance about an extension of the replacement period under Sec. 1033(e) for livestock sold on account of drought in specified counties, for the purpose of nonrecognition of gain on the involuntary conversion. The replacement period will be extended for one year for droughts reported during the 12-month period ending on Aug. 31, 2018. The Appendix to Notice 2018-79 contains the lists of counties for which exceptional, extreme, or severe drought was reported during the 12-month period ending on Aug. 31, 2018.

Sec. 1041: Transfers of property incident to divorce

The Tax Court held in Vanderhal ²⁸that payments the taxpayer made toward student loans incurred by his former spouse qualified for the alimony deduction. The IRS argued that the payments were a division of property and therefore not entitled to the alimony deduction. The court looked to the “Tax Free Transfers” section of the divorce decree and found that property and debt were clearly distinguished. Therefore, the court found that there was nothing in the divorce decree that clearly expressed that the student loan payments were nonalimony payments. The court also could find no prior authority to suggest that the terms “property” and “debt” were interchangeable. This case is also discussed under Sec. 215.

Secs. 1400Z-1 and -2: Qualified opportunity zone fund investment

Treasury and the IRS issued guidance to clarify the procedural requirements that are required to defer gain recognition by investing in a qualified opportunity fund (QOF).²⁹ The guidance also clarifies that only capital gains may be deferred (not ordinary income) — and only gains that would be recognized if it were not for the Sec. 1400Z-2 deferral. That is, gains deferred under Sec. 1031 do not qualify. Other requirements for the QOF, entities involved, and specifics on the properties or businesses involved are discussed in the guidance.

Secs. 1401-1403: Self-employment tax

The Sec. 199A regulations further clarify that the 20% QBI deduction does not reduce net earnings from self-employment under Sec. 1402.³⁰

Termination of compensation agreement: In a Tax Court case, the court held that the payment received for the termination of a compensation agreement for a salesman was subject to self-employment tax and was not a sale of goodwill.³¹ The taxpayer received a payout for the termination of a compensation agreement after the company he held the agreement with, Green Country, was bought out by a competitor in an asset purchase. The taxpayer’s wholly owned S corporation was also part of the asset purchase agreement, but neither he nor his S corporation received compensation for the assets sold. After the asset sale, Green Country paid the taxpayer according to the terms of the compensation agreement. The taxpayer, on his accountant’s advice, reported this transaction as a sale of goodwill and not subject to self-employment tax. His S corporation continued to do unrelated business beyond the asset sale in question.

Termination payment: In deciding that the termination payment was subject to self-employment tax, the court found that no sale of goodwill had taken place. Citing Schelble,³² the court highlighted that to qualify as a sale of goodwill, the taxpayer must demonstrate that the underlying business to which the goodwill attaches was sold. According to the court, the taxpayer did not sell his business; in fact, he did not even sell his assets, because he received no compensation in the asset purchase. Further, he and his S corporation had only one client, Green Country, so selling his customer contacts was not an option because they were Green Country’s customers. Accordingly, the payment was treated as a right to service Green Country’s customers and was ordinary income.

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

The taxpayer was denied relief under Sec. 6015(f) rules for a tax return filed jointly with his spouse even though she went to prison for fraud.³³

In August 2012, Dannielle Welch-Benson was charged with fraud for overbilling through her S corporation. She was convicted and later served prison time. Her husband, Brian Benson, was not aware of her misdeeds until she was charged with fraud. In October 2012, the couple filed their 2011 tax return, showing a balance due of $69,513. Owing a large balance at the time of filing was not a new occurrence, as the Bensons also owed substantial balances for 2009 and 2010 — both of which were paid off through installment agreements arranged by Welch-Benson. Benson requested innocent spouse relief for 2011 and was initially granted relief in late 2015, but the relief was denied some six months later after Welch-Benson filed Form 12509, Statement of Disagreement, objecting to his relief as an intervenor.

There are three avenues for relief under Sec. 6015: Secs. 6015(b) (innocent spouse relief), (c) (separate liability relief), and (f) (equitable relief). Because there was no understatement or deficiency on the 2011 return, neither (b) nor (c) applied, and the court was left to review the case for equitable relief under Sec. 6015(f). The court first applied the streamlined relief procedures from Rev. Proc. 2013-34, Section 4.01. After determining that he satisfied both the marital status test and the economic hardship test, the court examined whether Benson had “no knowledge or reason to know when the return was filed that the nonrequesting spouse would not or could not pay the tax liability reported on the joint tax return.” Looking at the situation, the court held that Benson did not satisfy this requirement. He testified that he knew that, in prior years, Welch-Benson had paid the outstanding tax due by using her funds from her business. Due to the fraud conviction and loss of business, the court held that Benson had reason to know that Welch-Benson would not have access to these funds to pay the liability in question.

After determining that Benson failed to satisfy the conditions for streamlined relief, the court then applied seven factors outlined in Rev. Proc. 2013-34, Section 4.03. Of those factors, only marital status favored relief due to the couple being separated at the time the relief was denied. Two factors — the reason to know factor and the tax compliance factor — weighed against granting relief. Benson had failed to timely pay his income tax liabilities for both 2013 and 2014 and, according to the court, had made no attempt to do so. All of the other factors were determined to be neutral. Given that he would face no economic hardship and had good reason to know that Welch-Benson would not be able to pay the 2011 l­iability, the court did not grant relief to Benson.  

Footnotes

¹Felton, T.C. Memo. 2018-168.

²IRS News Release IR-2018-148.

³Forlizzo, T.C. Memo. 2018-137.

⁴Regs. Sec. 1.165-1(b).

⁵Archer,T.C. Memo. 2018-111.

⁶Grainger, T.C. Memo. 2018-117.

⁷The IRS initially conceded the taxpayer’s charitable deduction included the value of the loyalty points used in obtaining the goods, and the IRS later attempted to amend its pleading to disallow the deduction related to the loyalty points, but the court felt that such an amendment would prejudice the taxpayer.

⁸Presley, T.C. Memo. 2018-171.

⁹Champions Retreat Golf Founders, LLC, T.C. Memo. 2018-146.

¹⁰Sec. 170(h)(1).

¹¹Sec. 170(h)(4)(A)(ii).

¹²Sec. 170(h)(4)(A)(iii).

¹³Householder, T.C. Memo. 2018-136.

¹⁴Robison,T.C. Memo. 2018-88.

¹⁵Proposed regulations REG-107892-18; final regulations T.D. 9847.

¹⁶REG-134652-18.

¹⁷Robison, T.C. Memo. 2018-88.

¹⁸Sutherland, T.C. Memo. 2018-186.

¹⁹Fiedziuszko, T.C. Memo. 2018-75.

²⁰Vanderhal,T.C. Summ. 2018-41.

²¹Benjamin, T.C. Memo. 2018-70.

²²Antonyshyn,T.C. Memo. 2018-169.

²³Robison,T.C. Memo. 2018-88.

²⁴Temp. Regs. Secs. 1.469-5T(b)(2)(ii)(A) and (B).

²⁵Ballard,T.C. Summ. 2018-53.

²⁶Azam, T.C. Memo. 2018-72.

²⁷Estate of McKelvey, No. 17-2554 (2d Cir. 9/26/18), rev’g 148 T.C. 312 (2017).

²⁸Vanderhal, T.C. Summ. 2018-41.

²⁹Rev. Rul. 2018-29; IR-2018-206; REG-115420-18.

³⁰Regs. Sec. 1.199A-1(e)(3).

³¹Potter, T.C. Memo. 2018-153.

³²Schelble, 130 F.3d 1388 (10th Cir. 1997), aff’g T.C. Memo. 1996-269.

³³Benson, T.C. Memo. 2018-157.