Recent developments in individual taxation

By David R. Baldwin, CPA; Robert Caplan, CPA; Shannon Hudson, CPA; David H. Kirk, CPA/PFS; Jennifer S. Korten, CPA; Frank Lin, CPA; Dana McCartney, CPA; Darren Neuschwander, CPA; Jeffrey A. Porter II, CPA; and Donald J. Zidik Jr., CPA

IMAGE BY VIEWAPART/ISTOCK
IMAGE BY VIEWAPART/ISTOCK
 

EXECUTIVE
SUMMARY

 
  • Among other notable developments in individual taxation in the six months ending October 2019, the D.C. Circuit held that a taxpayer was ineligible for a charitable deduction because of failure to list the donated asset's tax basis on Form 8283, Noncash Charitable Contributions.
  • A U.S. district court dismissed a lawsuit that New York and three other states brought against the federal government challenging the state and local tax (SALT) deduction limitation of $10,000.
  • The IRS announced that it had begun to send letters to taxpayers identified as possibly failing to report income from virtual ­currency transactions.
  • The Tax Court found in two cases that taxpayers did not engage in horse-raising-related activities for a profit.
  • The Tax Court denied a popular author's attempt to classify payments she received for the use of her name and likeness (or her "brand") as not subject to self-employment tax.
  • In a private letter ruling, the IRS found that Sec. 121 applied to the disposition of vacant land on which a fire-destroyed principal residence was once located.
  • The Tax Court held that a part-time professional poker player was ineligible to deduct his gambling-related expenses on Schedule C, Profit or Loss From Business, noting that he earned his livelihood from a different ­occupation and gambled only about 75 days per year.

This article is a semiannual review of recent developments in the area of individual federal taxation. It covers cases, rulings, and guidance on a variety of topics from May through October 2019. The items are arranged in Code section order.

Sec. 36B: Premium tax credit

Indexing adjustmentsIn Rev. Proc. 2019-29, the IRS announced the 2020 Affordable Care Act premium credit indexing adjustments. In years prior to 2020 the rate of premium growth was based on per-enrollee spending for employer-sponsored insurance as published by the National Health Expenditure Account.

Starting in 2020 the measure of indexing adjustments is provided by the Department of Health and Human ­Services (HHS) and is based on increases in individual market premiums in addition to increases in employer-sponsored insurance premiums.

Sec. 61: Gross income defined

CryptocurrencyIn July 2019,1 the IRS announced that it had begun to send letters to taxpayers identified as potentially failing to report income from virtual currency transactions. The IRS estimated that more than 10,000 taxpayers would receive these educational letters (Letter 6173, Letter 6174, or Letter 6174-A). All three versions have the same purpose: to help taxpayers understand their filing obligations as well as how to correct any past errors.

In October 2019, the IRS issued Rev. Rul. 2019-24 to provide guidance on two specific issues:

  1. Does a taxpayer have gross income under Sec. 61 as a result of a "hard fork" of a cryptocurrency if units of a new cryptocurrency are not received?
  2. Does a taxpayer have gross income under Sec. 61 as a result of an "airdrop" of a new cryptocurrency following a hard fork if new cryptocurrency is received?

The revenue ruling stresses the ability to exercise dominion and control. If the address to which the cryptocurrency is airdropped is contained within a wallet managed through an exchange that does not support the newly created cryptocurrency, that would not give the taxpayer the ability to exercise dominion and control over the currency and therefore would not result in income.

The revenue ruling concludes that:

  1. A taxpayer does not have gross income under Sec. 61 as a result of a hard fork if the taxpayer does not receive units of a new cryptocurrency.
  2. A taxpayer has gross income, ordinary in character, under Sec. 61 as a result of an airdrop following a hard fork if the taxpayer receives units of new cryptocurrency.

Income and frivolous returns penalties: The Tax Court in Wells2 assessed married tax protesters a $10,000 frivolous claims penalty for omitting their W-2 wage income, as they were previously warned against making baseless arguments. Although both worked for large corporations, they indicated on their joint 2014 income tax return that they had no income and sought a full refund of all withholding. Along with Forms W-2 received from their employers, they submitted Forms 4852, Substitute for Form W-2, Wage and Tax Statement, indicating zero wages. They attached a statement that made tax protester arguments. The Tax Court granted summary judgment against them and also assessed each a penalty of $5,000.

Sec. 104: Compensation for injuries or sickness

In McMillan,3the Tax Court held that a taxpayer was not entitled to exclude $70,000 in purported pain-and-suffering damages she received upon settling her lawsuit against her homeowner's association. Sec. 104(a)(2) excludes from gross income damages that are received by suit or agreement "on account of personal physical injuries or physical sickness." The settlement document did not indicate that the money was an award for pain and suffering. In addition, the taxpayer admitted that her sickness could have been the result of stress, which would make it a symptom of emotional distress and mean that the settlement proceeds would still be includible in her income.

The taxpayer also argued that the $70,000 was not taxable because it was used to pay her attorneys, but when settlement proceeds are income, so too is the portion that goes to attorneys' fees, as held in Banks.4

Sec. 108: Income from discharge of indebtedness

Partner's deferred COD income: The IRS National Office stated in a Technical Advice Memorandum that deferred cancellation-of-debt (COD) income under Sec. 108(i) is not included in calculating a transferee partner's share of adjusted basis to the partnership of partnership property for purposes of Regs. Sec. 1.743-1(d)(1) because that amount is not "tax gain" within the meaning of Regs. Sec. 1.743-1(d)(1)(iii).5 The IRS reasoned that this income is not taxable gain that would arise upon the disposition of partnership assets within the meaning of Regs. Sec. 1.743-1(d)(1)(iii) because it does not arise as a result of a disposition of partnership assets or property at fair market value (FMV) for cash. The hypothetical transaction described in Regs. Sec. 1.743-1(d)(2) is only concerned with determining the amount of partnership tax gain or loss that would result from the disposition of partnership assets at FMV for cash, for purposes of determining an inside basis adjustment to partnership property. Deferred COD income is not and does not relate to partnership assets or property for purposes of the hypothetical transaction described in Regs. Sec. 1.743-1(d)(2) but is simply an item of deferred income that does not have or attract basis, is not transferrable or marketable, and has no FMV.

Qualified principal residence debtThe taxpayer in Bui6 sought to exclude $355,488 of discharged indebtedness from her gross income as qualified principal residence indebtedness. The Tax Court held that she may properly exclude $48,151 but must include the remaining $307,337 in gross income. Although the loans giving rise to COD income were secured by the taxpayer's residence, she was unable to offer adequate proof that, with the limited exception of $5,299, the funds were used to acquire, construct, or substantially improve the property. As a result, the court was unable to conclude that the COD income was excludable from gross income as qualified principal residence indebtedness, except for $5,299. Of the remaining COD income, the IRS and the taxpayer agreed that she was eligible to exclude $42,852 due to insolvency.

Sec. 115: Income of states, municipalities, etc.

The IRS concluded in a private letter ruling that a qualified settlement fund trust, set up to resolve claims arising from violations of certain federal and state laws, was exercising an essential governmental function with income accruing to a state or U.S. possession government. Therefore, its income was excludable from gross income under Sec. 115.7

Sec. 121: Exclusion of gain from sale of principal residence

In a private letter ruling, the IRS found that Sec. 121 applied to the disposition of vacant land on which a fire-destroyed principal residence was once located and that Secs. 121 and 1031 may be applied to the same transfer of property.8

A taxpayer purchased property as a principal residence and, after getting married, the couple used the property as their principal residence. Following their move to a new residence, the taxpayers rented the property to full-time tenants and/or as a short-term rental until the home was destroyed in a fire.

As a result of the destruction of the dwelling unit, the taxpayers received insurance proceeds in the year of the fire. The taxpayers sold the land on which the dwelling unit was located and acquired a new property.

Although the taxpayers' sale of land was not a sale of vacant land as described in Regs. Sec. 1.121-1(b)(3), the IRS found that it was reasonable to apply those same requirements to a sale of vacant land on which the dwelling unit was once located. While considering Regs. Sec. 1.121-1(b)(3)(ii)(A), which provides that gain on the sale of the land is then excluded only to the extent of the maximum limitation amount applicable to the taxpayer, minus the gain excluded on the sale of the dwelling unit, the IRS concluded that the gain excluded under Sec. 121 on the sale of the land is the difference between the maximum limitation amount applicable to taxpayers and the gain excluded under Sec. 121 from the sale of the dwelling unit. Finally, citing Rev. Proc. 2005-14, the IRS ruled that the fact that the taxpayers excluded gain under Sec. 121 on the sale or exchange of property did not preclude them from deferring all or a portion of the remainder of the gain, if any, under Sec. 1031.

Sec. 162: Trade or business expenses

The taxpayer in Zalesiak9 argued unsuccessfully that he was a professional gambler entitled to deduct his gambling-related expenses on Schedule C, Profit or Loss From Business. A taxpayer does not qualify as a professional gambler by election. In order to be a professional gambler, the taxpayer must engage in gambling activities with the intent of making a profit. Whether this standard is met is based on facts and circumstances, including (1) the frequency of the gambling activities during the year; (2) the extent to which a taxpayer pursues the activity to produce income for a livelihood; and (3) the amount of time the taxpayer devotes to the activity. Here, the taxpayer's only gambling activity was playing poker, both online and in person (both private games and at casinos).

During 2015, the year in question, the taxpayer also worked an average of 30 hours per week as a construction manager, "which constituted 98.1% of his total reported income." Due to his construction manager job, he was unable to engage in any poker-related activity between May and September of 2015. As a result of accruing paid leave time from the manager job, the taxpayer was able to gamble in December 2015. The taxpayer alleged that he "spent about 271 days gambling, reviewing . . . [his] results, and studying relevant poker literature." However, of these 271 days, he only spent "approximately 75 days playing poker."

As a result of his reliance on his managerial job for his overall livelihood and the limited number of days during the year that he actually played poker, the Tax Court concluded that the taxpayer was not engaged in a trade or business as a professional gambler. Thus, the taxpayer was only allowed to deduct gambling losses to the extent of gambling winnings and the costs of some books related to gambling on Schedule A, Itemized Deductions. The court further held that his vehicle and travel-related expenses were not deductible either because they were personal expenses or were not substantiated.

Sec. 163: Interest

In Milkovich,10 a U.S. district court addressed whether taxpayers were entitled to a mortgage interest deduction in a short-sale situation. As part of their joint Chapter 7 bankruptcy filing in 2010, the married taxpayers were discharged of their mortgage debt on their personal residence, which was sold in a short sale in 2011. Because the mortgage was "nonrecourse," the taxpayers were not personally liable for the outstanding mortgage of $744,993. The holder of the mortgage, Citibank, received $522,015 from the short sale. Unpaid interest associated with the mortgage amounted to $114,688. Within its own accounting records, Citibank allocated a portion of the short-sale proceeds against the outstanding interest amount and, in turn, issued a 2011 Form 1098, Mortgage Interest Statement, to the taxpayer, showing mortgage interest paid of $114,688.

The taxpayers reported and deducted this Form 1098 amount on Schedule A of their 2011 Form 1040, U.S. Individual Income Tax Return. The taxpayers claimed that because a Form 1098 was issued by Citibank, they were entitled to the mortgage interest deduction. However, no case law was presented to support that the IRS was "bound by a third party's Form 1098." The court ruled that since the outstanding mortgage debt exceeded the FMV of the property, no interest deduction is allowed due to the lack of "economic substance," citing ­Estate of Franklin, 544 F.2d 1045 (9th Cir. 1976), as there was "no bona fide debt obligation."

Sec. 164: Taxes

A U.S. district court dismissed a suit against the federal government by the states of Connecticut, Maryland, New Jersey, and New York challenging the state and local tax (SALT) deduction limitation of $10,000.11 Recognizing that the SALT deduction limitation, adopted by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, could be described as a "legislative novelty," the district court concluded that the states "failed to persuade the court that this novelty alone establishes that the SALT cap exceeds Congress's broad tax power under Article 1, section 8 and the Sixteenth Amendment."

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

Effect of state or local tax credit: The IRS published final regulations on June 11, 2019, governing the availability of a charitable contribution deduction when a taxpayer receives or expects to receive a corresponding state or local tax credit for the charitable contribution (T.D. 9864, amending Regs. Secs. 1.170A-1, 1.170A-13, and 1.642(c)-3). The final regulations retain the quid pro quo rule: a charitable contribution to an entity in expectation of a credit for state or local taxes results in a reduction of the charitable contribution for federal income tax purposes by the amount of the benefit of the state or local tax credit. The regulations take the position that something of value has been received in exchange for the charitable donation and, thus, the donation must be reduced by the value received. This position is the reversal of the IRS Chief Counsel determination in CCA 201105010.

The final regulations treat a deduction differently for this purpose than a credit. If the contribution only results in a deduction in determining the taxable income for state or local income taxes, a reduction in the charitable contribution is not required (unless the state tax deduction is in excess of the amount donated by the taxpayer).

The final regulations also allow a de minimis exception to the reduction of the charitable donation by the state or local tax credit benefit. The credit can be ignored if the state or local tax credit is 15% or less of the amount donated. This exception is permitted as an equivalency to the previously mentioned provision that says a deduction for the contribution on the state or local tax return does not reduce the charitable contribution.

Simultaneously on June 11, 2019, Notice 2019-12 was issued. This notice permits the disallowed charitable deduction to be deducted as a state or local tax deduction to the extent that it is applied on the taxpayer's state or local income tax return against a tax liability. The credit treated as an income tax expense is subject to the new $10,000 SALT deduction limitation of Sec. 164(b)(6).

The above rules also apply to payments made by a trust or a decedent's estate.

Reporting tax basis: In Blau,12 a taxpayer was denied a charitable deduction for failing to report the tax basis of a donated asset on Form 8283, Noncash Charitable Contributions. The taxpayer left the line for reporting the tax basis blank on the Form 8283 reporting the donation. The omission of this information allowed the courts to deny the deduction without addressing whether the $33 million valuation was overstated. The D.C. Circuit agreed with the Tax Court that the IRS needs the basis of the property or an explanation of why the basis is not available to evaluate the contribution amount, as intended by Congress, thus the omission of the basis resulted in no tax deduction for the donated property. This case is another reminder that Sec. 170 deductions are subject to strict statutory reporting requirements and that taxpayers and practitioners must exercise extreme care to comply with all reporting and substantiation requirements to ensure the charitable deduction will be allowed.

Sec. 183: Activities not engaged in for profit

'Virtual farm' horse activityThe Tax Court found that married taxpayers in Donoghue13 did not race and breed thoroughbred horses for profit, as indicated by the nine factors listed in Regs. Sec. 1.183-2(b). In their approximately 30 years of horse-related activity, they reported a net loss every year. They operated a "virtual farm," paying other farms to keep and train their horses. They had a separate business bank account, maintained accounting records within Quicken, and had a written business plan that was "reproduced" annually. From 1988 through 2006, the business plan projected that the activity would generate a net loss. They had income from other sources totaling $100,000 annually, which was reduced by the virtual-farm activity reported on Part II of Schedule E, Supplemental Income and Loss, of their Form 1040.

The court found that the horse-related activity was "well beyond the startup phase," stating that "in 2010, the first year at issue, [the taxpayers] were already in their 25th year of their horse activity (all without a profit)." The taxpayers attributed the lack of profit to the Great Recession, to which the court responded that while "operations may have been harmed by the recession, [the] history of losses long predates that recession and thus the recession cannot entirely account for the losses."

More horse-related activityIn Sapoznik,14 a married couple failed to prove that they engaged in their consistently unprofitable horse-related activity for a profit. From 2010 to 2015, the taxpayers failed to report a net profit from the activities. For the specific years in question of 2014 and 2015, the taxpayers reported net Schedule C losses of $57,114 and $49,343, respectively. Applying the relevant factors from Regs. Sec. 1.183-2(b), the court found that the taxpayers did not have a written business plan, nor did they maintain complete books and records. They failed to show that they sought the expertise needed for their horse-related activity. Although the husband was retired, instead of spending most of his time on horses, he started a new business similar to the one that he retired from. With respect to their financial status, the taxpayers stated that they "are not taxpayers who could just frivolously put $50,000 into a horse business because it was a hobby." Unconvinced, the court found that the taxpayers had "comfortable gross income" outside of the horse-related activity, noting that they purchased a new horse in 2016 for $48,000 that the husband testified he "rides as a hobby."

Architecture activity: The Tax Court held in Sarkin15 that a professional architect did not engage in architecture activities for profit, where his only project was to remodel his mother-in-law's home. Although he had once co-founded a South African architecture firm, he gave up the architecture profession when he immigrated to the United States in 2004. He moved back to South Africa in 2011 to resume his former architecture activity, but during 2012 and 2013 had only one architectural project, a renovation for his mother-in-law, ­before he returned to New York.

During 2012 and 2013, the taxpayer filed a Schedule C associated with the architecture activity, reporting net losses of $24,749 and $14,132, respectively. In applying the nine factors listed in Regs. Sec. 1.183-2(b), the court found that the taxpayer's Schedule C business activity was not a for-profit venture due to the following:

  • Lack of a formal business plan, a business bank account, and separate financial books and records;
  • Lack of support to show how much time was spent on the architecture activity while in South Africa;
  • Lack of expected appreciation in assets used within the activity (a previously owned apartment used as an office was the only asset associated with the activity);
  • Lack of success in carrying out similar activities that have displayed a profit motive, along with a consistent history of losses associated with the activity — even though the taxpayer had a similar business in South Africa from 1997 to 2003, no records were presented to show that this prior business activity was successful; and
  • Lastly, because the taxpayer's spouse had "significant income," the taxpayer was unable to prove a lack of substantial income from other sources.

Sec. 195: Startup expenditures

At issue in Smith16 was whether a taxpayer who started a vegan food export business had improperly deducted expenses on Schedule C that were Sec. 195 startup expenditures. The Tax Court explained that, in determining whether an activity has become an active trade or business, it relies on cases addressing whether a taxpayer is engaged in a trade or business under Sec. 162. Here, the taxpayer had completed his business plan in the previous tax year and had obtained suppliers of vegan products and entered into a license agreement for distribution exclusivity with one supplier. The taxpayer was actively marketing these products in various foreign countries. The court ruled that the taxpayer's activities were not mere research into a potential business and were not subject to Sec. 195 limitations.

Sec. 212: Expenses for production of income

Personal expenses: The Tax Court held in Rogers17 that a tax attorney failed to substantiate various business expenses, including meals and entertainment, travel expenses, and legal and professional fees. He argued that these items were directly related to operating his law firm and should be deductible under Sec. 162 (trade or business expenses) and Sec. 212 (expenses for the production of income). The court ruled, however, that the disallowed portions of the expenses were personal in nature and not deductible under Sec. 262(a) and/or that the business purpose was not sufficiently substantiated.

Personal residence: In Rose,18 the Tax Court held that the married taxpayers' deductions for expenses for an Idaho property they owned and rented out were not limited by Sec. 280A because the taxpayers did not use the property for more than 14 days during the years in question. However, the court further held that losses from the property were passive losses that were not deductible until the year the property was disposed of because the wife, who managed the property, could not prove to the court's satisfaction that she was a real estate professional.

Sec 217: Moving expenses

Unemployment after move: The Tax Court held in Haskins19 that the taxpayers were not entitled to deduct $1,610 ($1,460 of lodging and half of $300 for meals) as moving expenses after it was disallowed as an unreimbursed employee business expense. The taxpayers argued that the expenses incurred were qualified moving expenses after they moved to Florida from Arizona for work in 2012. The court ruled that the employment period for 39 weeks of the 12-month period following Mr. Haskins's arrival in Florida was not satisfied because he was unemployed from his arrival time in August 2012 until 2013 and there was no evidence of Ms. Haskins working in Florida after she moved there (Sec. 217(c)(2)). Furthermore, there was no documentary evidence supporting the moving expenses and, therefore, the substantiation requirements were not met.

Post-moving expensesThe Tax Court held in Sarkin 20 (also discussed above under Sec. 183) that the taxpayers were not entitled to deduct moving expenses of $10,850 in 2012 and $8,746 in 2013. The taxpayers argued that even though they moved to South Africa in 2011, the move was over a two-year period and they incurred storage, shipping, and travel costs in 2012 and 2013. The court ruled that no receipts or other documentation showed the expenses were incurred in 2012 and/or 2013 (Sec. 217(a)). Furthermore, there was no record that the husband stayed and worked in the new location for the requisite 39 weeks in the first 12-month period (Sec. 217(c)(2)).

Multiple locations: In Krishnan ,21 the Tax Court held that the taxpayer was not entitled to deduct moving expenses of $1,500 for 2014 and $1,000 for 2015. The taxpayer argued that he moved between multiple locations more than 50 miles apart and provided a rental car confirmation from Budget car rental totaling $482. The court ruled that the taxpayer did not meet his burden of showing he satisfied the conditions for the allowance of a deduction for moving expenses under Sec. 217(c). The taxpayer failed to meet the condition of Sec. 217(c)(2) because he did not work 39 weeks in the first 12 months after the move.

Sec. 267: Losses, expenses, and interest with respect to transactions between related taxpayers

In Petersen,22 an ERISA trust, which was an employee stock ownership plan (ESOP), held stock of an S corporation. The issue was whether the employees participating in the ESOP were related to the corporation. If they were related, then, under Sec. 267, the employees' payroll expenses were only deductible in the tax year in which the amounts were includible in the payees' gross income.

The S corporation had deducted accrued payroll expenses for employees who participated in the ESOP, but a portion of those expenses remained unpaid at the end of each year. The S corporation's majority shareholders claimed deductions for these accrued but unpaid payroll expenses.

The Tenth Circuit held, affirming the Tax Court, that these accrued payroll expenses could not be deducted until the year they were paid because the employees and the corporation were related. It found they were related because the ESOP was a trust, the employees participating in it were beneficiaries of the ESOP, and therefore the employees were owners of the stock of the corporation. As such, the employees were related to the corporation under Sec. 267(c)(1).

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

The Tax Court in Breland23determined that the amount realized from the sale of properties at foreclosure was the highest bid price and did not include the amount of liabilities from which the taxpayer was relieved, as the debt was recourse. The court found that the balance of the recourse loan survived the foreclosure sale. The court also noted there was no evidence the bank forgave the balance of the mortgage loan as part of the foreclosure sale and it did not issue a Form 1099-C, Cancellation of Debt.

Sec. 1012: Basis of property — cost

The Tax Court in Worsham24disagreed with the taxpayer's claim that he was entitled to take his "basis in labor" into account and include the value or cost of his labor as basis to be applied against income from his law practice.

Sec. 1031: Like-kind exchanges

The IRS concluded in a private letter ruling (also discussed above under Sec. 121) that the fact that taxpayers excluded gain on a principal residence under Sec. 121 did not preclude them from deferring all or a portion of the remainder of the gain, if any, under Sec. 1031.25 The ruling permitted the Sec. 121 exclusion, as the destruction of the dwelling unit in a fire and the taxpayers' subsequent receipt of insurance proceeds in the year before the land sale qualified as a sale or exchange of the dwelling unit within two years of the land sale. The taxpayers represented that they held the property as investment property between certain dates. The ruling mentioned Rev. Proc. 2005-14, where a transfer of property qualifying for the Sec. 121 exclusion may also qualify for nonrecognition under Sec. 1031, provided that all requirements of Sec. 1031 are met with respect to the transfer.

Sec. 1033: Involuntary conversions

The IRS provided guidance in Notice 2019-54 that farmers and ranchers who were forced to sell livestock due to drought may have an additional year to replace the livestock and defer tax on any gains from forced sales. The farmer or rancher must be in an applicable region, being a county designated as eligible for federal assistance plus counties contiguous to that county. The sales must be solely due to drought, flooding, or other severe weather causing the region to be designated as eligible for federal assistance. Therefore, farmers or ranchers in the applicable regions specified in the notice whose drought-sale replacement period was scheduled to expire after Dec. 31, 2019, now have until the end of their next tax year in most cases.

Sec. 1231: Property used in the trade or business and involuntary conversions

The Tax Court in Ashkouri26found that the sale of a condominium unit was mischaracterized as Sec. 1231 trade or business gain because the condo was not "property used in the trade or business." Nor was the condo a capital asset under Sec. 1221. The court agreed with the IRS that the taxpayer held the property primarily for sale to customers in the ordinary course of business and that the gain was ordinary income.

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

On April 17, 2019, the IRS issued a second set of proposed regulations on the qualified opportunity zone tax incentives enacted as part of the TCJA.27 The IRS subsequently issued final regulations on Dec. 19, 2019.28 Treasury has posted FAQs (available at www.journalofaccountancy.com that highlight differences between the proposed and final regulations.

Secs. 1401-1403: Self-employment tax

In Slaughter,29 the Tax Court denied a popular author's attempt to classify part of her earnings as not subject to self-employment tax. Her longtime tax preparer came to believe that the author's earned income was solely the amount she was paid for writing and that any income from use of her name and likeness (or her "brand," which provided prestige to the publishing house) was "investment income." After finding no definitive authority regarding a so-called brand author, the preparer decided to report on Schedule E all the advances and royalties the author received and subtract the portion relating to the trade or business of writing and report that portion on Schedule C. The preparer did not have a copy of the taxpayer's contracts and instead used a calendar-based approach to split the income, relying on the taxpayer's estimate of how many months it generally took her to write a manuscript.

At trial, the taxpayer cited Rev. Rul. 68-499 to support her position that payments for her brand are separate and distinct from payments for her writing. Rev. Rul. 68-499 discusses a company paying royalties to certain individuals who are also employed by the company. Because the licensing contracts and the employment contracts are separate and distinct, the revenue ruling states that the royalties are not payments for employment and are therefore not subject to payroll tax. The taxpayer also relied on testimony from an expert in the publishing industry that the writing of a manuscript is a small percentage of what a publisher seeks from an author, even though the manuscript and the author's brand appeal are often valued together. The taxpayer analogized that her writing a manuscript is akin to providing services to the publishing house, and those earnings are subject to self-employment tax; however, payments beyond the writing of the manuscript are payments for something other than a service, and (citing Jones30) the separate and distinct payments for her brand are not subject to self-employment tax.

The court disagreed with this argument. Stating that the taxpayer's reliance on Rev. Rul. 68-499 was misplaced, the court emphasized that self-employment tax is due on net earnings from any trade or business. Also citing Jones, the court concluded that the taxpayer's brand is part of her trade or business because she was engaged in developing it with regularity and continuity with the primary purpose of income and profit. Due to her reliance on her preparer, though, the court ruled that she was not liable for negligence penalties.

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

In Sleeth,31 a taxpayer wasdenied innocent-spouse relief because her knowledge or reason to know outweighed the multiple factors that counted in her favor. The taxpayer and her ex-spouse in early 2011 filed joint returns for the period 2008-2010 showing unpaid tax, penalties, and interest totaling $446,024, and none of the returns showed payments of tax through withholding or estimates. The taxpayer signed the returns and made no inquiry of her then-husband as to whether the tax would be paid because she "assumed" it would be. At the time of trial in 2019, the taxes for 2008-2010 were still unpaid. The taxpayers divorced in 2018 and as part of the divorce, her ex-husband stated that he would intervene on the petitioner's behalf (which he did) and claim responsibility for the outstanding tax liabilities.

In deciding if it would be inequitable to hold the taxpayer liable for any unpaid tax, the court applied the list of factors provided by Rev. Proc. 2013-34. Finding that marital status, lack of significant benefit, and subsequent compliance with income tax laws weighed in her favor, and that most other factors were neutral, the Tax Court denied innocent-spouse relief based on the "knowledge or reason to know" factor.

The court explained that the taxpayer's ex-husband had been trying for several years to sell their condominium, which was encumbered by a large mortgage. Shortly after filing the returns in 2011, he left his full-time employment and began working short-term positions. The couple previously had tax issues in 2005 and had been unable to pay the tax due, as the petitioner was aware. Examining all this evidence, the court found that the taxpayer's assumption that her ex-husband could pay the outstanding taxes was unreasonable and not credible.  

Footnotes

1IRS News Release IR-2019-132.

2Wells, T.C. Memo. 2019-134.

3McMillan, T.C. Memo. 2019-108.

4Banks, 543 U.S. 426 (2005).

5IRS Technical Advice Memorandum 201929019.

6Bui, T.C. Memo. 2019-54.

7IRS Letter Ruling 201930004.

8IRS Letter Ruling 201944006.

9Zalesiak, T.C. Summ. 2019-16.

10Milkovich, No. 2:18-cv-01658-BJR (W.D. Wash. 5/17/19).

11State of New York v. Mnuchin, No. 18-cv-6427 (S.D.N.Y. 9/30/19).

12Blau, Tax Matters Partner of RERI Holdings I, LLC, 924 F.3d 1261 (D.C. Cir. 2019), aff'g 149 T.C. No. 1.

13Donoghue, T.C. Memo. 2019-71.

14Sapoznik, T.C. Memo. 2019-77.

15Sarkin, T.C. Memo. 2019-131.

16Smith, T.C. Summ. 2019-12.

17Rogers, T.C. Memo. 2019-90.

18Rose, T.C. Memo. 2019-73.

19Haskins, T.C. Memo. 2019-87.

20Sarkin, T.C. Memo. 2019-131.

21Krishnan, T.C. Summ. 2019-14.

22Petersen, 924 F.3d 1111 (10th Cir. 2019).

23Breland, T.C. Memo. 2019-59.

24Worsham, T.C. Memo. 2019-132.

25IRS Letter Ruling 201944006.

26Ashkouri, T.C. Memo. 2019-95.

27REG-120186-18.

28T.D. 9889.

29Slaughter, T.C. Memo. 2019-65.

30Jones, T.C. Memo. 1998-354.

31Sleeth, T.C. Memo. 2019-138.

 

Contributors

David R. Baldwin, CPA, is a partner with Baldwin & Baldwin PLLC in ­Phoenix. Robert Caplan is a CPA at Caplan & Wong CPAs LLC in San Mateo, Calif. Shannon Hudson, CPA, MST, is a founding partner of Altair Group PLLC in Bedford, N.H. David H. Kirk, CPA/PFS, is a partner with Ernst & Young in Washington, D.C. Jennifer S. Korten, CPA, is a partner at Kubo Korten PLLC in Seattle. Frank Lin is a CPA with Jet Tax Service Inc., a privately owned accounting firm in Queens, N.Y. Dana McCartney, CPA, is a partner with Maxwell Locke & Ritter LLP in Austin, Texas. Darren Neuschwander, CPA, 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. Donald J. Zidik Jr. is a CPA with ­Waldron H. Rand & Company in Dedham, Mass., and an adjunct professor of taxation at Suffolk University in Boston. Mr. Baldwin is the chair, Mr. Zidik is the immediate past chair, and the other authors are current members of the AICPA Individual & Self-Employed Tax Technical Resource Panel. For more information about this article, contact thetaxadviser@aicpa.org.

 

Newsletter Articles

50th ANNIVERSARY

50 years of The Tax Adviser

The January 2020 issue marks the 50th anniversary of The Tax Adviser, which was first published in January 1970. Over the coming year, we will be looking back at early issues of the magazine, highlighting interesting tidbits.

PRACTICE MANAGEMENT

2019 tax software survey

This annual survey shows how CPAs rate the tax preparation software they used during last tax season and how it handled the recent tax law changes.