Current developments in taxation of individuals: Part 1

This semiannual update surveys recent federal tax developments involving individuals. It summarizes notable cases, rulings, and guidance on a variety of topics issued during the six months ending October 2024. The update was written by members of the AICPA Individual and Self–Employed Tax Technical Resource Panel. The items are arranged in Code section order.

Sec. 25C: Energy-efficient home improvement credit; Sec. 25D: Residential clean-energy credit

The Inflation Reduction Act of 2022, P.L. 117–169, extended and revised the energy–efficient home improvement credit under Sec. 25C, which allows individuals a tax credit equal to 30% of qualified energy–efficient improvements and property installed during the year. This credit can cover items such as exterior windows, exterior doors, certain insulation materials or systems, and heating and cooling equipment. There are annual credit caps depending on property type, which replace a previous $500 lifetime limitation.

Beginning in 2025, specified property placed in service must be produced by a qualified manufacturer, and individuals must include a product identification number (PIN) on a tax return claiming the credit. Rev. Proc. 2024–31 and proposed regulations¹ provide guidance on how manufacturers can comply and assign PINs to their products for individuals to report. A separate but similar credit is available under Sec. 25D, the residential clean–energy credit, for alternative energy property, such as certain solar panels, solar water heaters, geothermal heat pumps, and battery storage technologies. Differences exist between the credits, but both are claimed on Form 5695, Residential Energy Credits.²

Sec. 25E: Previously owned clean vehicles

The Inflation Reduction Act extended and revised the Sec. 30D new clean vehicle credit and created a tax credit opportunity for used vehicles as well under Sec. 25E. For both credits, eligibility restrictions were imposed with respect to the vehicle manufacturer’s suggested retail price, manufacturer requirements, and taxpayer modified adjusted gross income (MAGI). In addition, beginning in 2024, a vehicle will not qualify for the credit if components in the battery of the vehicle are manufactured or assembled by a foreign entity of concern (FEOC). Beginning in 2025, a vehicle will not qualify for the credit if an FEOC extracts, processes, or recycles critical minerals used in the battery of the vehicle. As such, selection of vehicles for the credits may be reduced. In May 2024, final regulations were issued for manufacturers to comply with the new FEOC rules.³

Sec. 36B: Refundable credit for coverage under a qualified health plan

With respect to the premium tax credit, proposed regulations issued in September 2024 would amend Regs. Secs. 1.36B–2 and 1.36B–3 to modify the existing rules related to the definition of “coverage month” and some of the rules related to the computation of an individual’s credit.⁴ These amendments were proposed due to an inconsistency in the reporting of the enrollment premiums during the first–month grace period by different exchanges when the taxpayer has not paid the full amount of the premium prior to the unextended due date for the taxpayer’s income tax return. Some exchanges report the full premium amount, since it is paid by the advance premium tax credit, and some report $0. This results in different premium tax credits for similarly situated taxpayers. Thus, the proposed amendments would treat the first month of a grace period as a coverage month for the premium tax credit if the other coverage–month requirements in Regs. Sec. 1.36B–3(c) are satisfied. The proposed regulations also contain a conforming change to the calculation of the premium tax credit to ensure that the credit does not exceed the amount of premiums paid by the taxpayer.

Sec. 72: Annuities; certain proceeds of endowment and life insurance contracts

A recent Tax Court case, Kohl, ruled that a taxpayer did not qualify for a hardship exception to the 10% additional tax on early withdrawals from retirement accounts before age 59½.⁵ In this case, Caren Kohl withdrew funds to pay past–due rent so that her landlord would not evict her but was still subject to the penalty because the withdrawal did not meet any applicable exceptions under Sec. 72(t). Notably, Kohl’s argument referenced Sec. 72(t)(2)(l), allowing early withdrawals for certain emergency personal expenses, which the court noted applies only to distributions made after Dec. 31, 2023, rendering it irrelevant to her situation in 2018.

Recently, the IRS issued Notice 2024–55 with guidance on exceptions to the 10% additional tax on early distributions from qualified retirement plans including under Sec. 72(t)(2)(I). This guidance was issued as a result of the SECURE 2.0 Act,⁶ which amended Sec. 72(t) to add exceptions for emergency personal expense distributions and domestic abuse victim distributions to the 10% additional tax on early retirement distributions.

An emergency personal expense distribution is any distribution made from an applicable eligible retirement plan to an individual for purposes of meeting unforeseeable or immediate financial needs relating to necessary personal or family emergency expenses.⁷ A domestic abuse victim distribution is any distribution from an applicable eligible retirement plan to a domestic abuse victim if made during the one–year period beginning on any date on which the individual is a victim of domestic abuse by a spouse or domestic partner. Domestic abuse is defined as “physical, psychological, sexual, emotional, or economic abuse, including efforts to control, isolate, humiliate, or intimidate the victim, or to undermine the victim’s ability to reason independently, including by means of abuse of the victim’s child or another family member living in the household.”⁸

Going forward, because of these additional exceptions, there will be more opportunities for retirement plan distributions that will not be subject to the 10% additional tax. However, it is important to note that these additional exceptions apply only to distributions made after Dec. 31, 2023.

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

In Strom,⁹ the Tax Court denied the taxpayer, Mark Strom, innocent–spouse relief from a joint tax liability, holding that he clearly knew or had reason to know of a large understatement on the couple’s 2000 tax return. Strom was a surgeon, and his wife, Bernee Strom, was president and COO of an information technology company, InfoSpace.com Inc., during the dot–com boom of the late 1990s. As part of her employment agreement, Bernee Strom was granted incentive and nonstatutory stock options, and Mark Strom signed a “consent of spouse” form indicating he had read and understood the agreement.

Bernee Strom wrote checks totaling $15,794,804 during 2000 to exercise the InfoSpace options and pay the withholding tax. In order to pay the exercise and withholding tax, she borrowed $10 million from InfoSpace, and the taxpayers jointly borrowed $10 million from Bank of America.

The value of the shares subsequently decreased dramatically during 2000. Bernee Strom’s 2000 Form W–2, Wage and Tax Statement, included the market value at the time of the exercise, resulting in total compensation of $106,526,884. She felt the market value was overstated, and the couple participated in discussions with attorneys and tax consultants to develop a strategy to defer the income related to the stock option exercises until 2001, when the market value of the stock was lower, resulting in $100 million less income reported on their 2000 tax return.

The taxpayers took the position based on discussions with their advisers that, under Sec. 83(c)(3), the calculation and recognition of the income attributable to the option exercises was deferred until June 30, 2000, because a sale of Bernee Strom’s shares prior to that time could have subjected her to a lawsuit under Section 16(b) of the Securities Exchange Act of 1934, P.L. 73–291. They also took the position that, under Regs. Sec. 1.83–3(k), calculation and recognition of income attributable to the option exercises was postponed until Jan. 29, 2001, because the shares in question were subject to restriction on transfer under the “pooling–of–interests accounting” rules.

KPMG tax consultants warned the taxpayers that they believed these positions could not be upheld upon audit. They subsequently determined the positions had “reasonable basis” and that disclosure of the positions must be included in the return. Both Stroms were part of these discussions and approved the disclosure statement. Their 2000 joint return reported a $17,033,879 overpayment, of which $15,033,879 was claimed as a refund and $2 million was applied to their 2001 estimated tax.

The couple were subsequently audited for the 2000 tax year and assessed $39,812,187 in income tax related to the unreported Form W–2 income. After receiving this notice, they executed a property status agreement effectively allocating joint assets to Mark Strom.

Mark Strom then requested innocent–spouse relief by filing Form 8857, Request for Innocent Spouse Relief, on which he did not report his business education, the couple’s financial difficulties, or his participation in handling the household finances. He indicated that he did not participate in decisions regarding stock option exercises or the reporting of the income related to the stock option exercises. Bernee Strom also indicated on Form 12508, Questionnaire for Non–Requesting Spouse, that her spouse was not involved in household finances. Mark Strom requested innocent–spouse relief a second time, this time indicating that he did in fact hold an MBA degree but that he had a present mental or physical problem.

The Stroms filed an amended return for 1999 to treat the options Bernee Strom received in that year consistently with the tax treatment on their 2000 tax return, claiming a refund for that year. The IRS did not act on the amended return, and the Stroms filed a refund suit in district court. The district court held that Bernee Strom was entitled under Sec. 83(c)(3) to defer the calculation and recognition of income from the sale of her stock options in 1999 and 2000 until Dec. 23, 2000. It further held that the couple were entitled to a refund of taxes paid on amounts erroneously included in her income for 1999 and a partial refund for 2000.¹⁰ However, on appeal by the government, the Ninth Circuit reversed the district court’s holding that the income from the option exercises in 1999 and 2000 was deferred under Sec. 83(c)(3).¹¹

The Tax Court, where a petition had been stayed pending the resolution of the district court case and appeal, held that Mark Strom did not qualify for innocent–spouse relief. The court held that he did not satisfy the requirements of Sec. 6015(b) because he clearly knew or had reason to know of the understatement on the 2000 tax return, finding that he had participated in discussions, phone calls, and emails regarding the issue and had signed consent agreements related to the stock option exercises. In addition, the court found that he had received significant benefit from the understatement, so it was not inequitable to hold him liable for the deficiency attributable to the understatement.

Sec. 117: Qualified scholarships

The IRS issued several private letter rulings¹² indicating that employer–related scholarships awarded by private foundations to employees’ children were not taxable income to the recipients if used for qualified tuition and related expenses. The IRS determined that the procedures used by the private foundations to award the scholarships met the requirements of Sec. 4945(g)(10), including awarding the grant on an objective and nondiscriminatory basis, receiving advance IRS approval of the process, subjecting the grant to the requirements of Sec. 117(a), and requiring the grant to be used for study at a qualified educational institution.

Sec. 135: Income from US savings bonds used to pay higher education tuition and fees

The IRS released inflation–adjusted items for tax years beginning in 2025,¹³ including the exclusion under Sec. 135 of income from U.S. savings bonds for taxpayers who pay qualified higher education expenses. The phaseout begins at MAGI above $149,250 for joint returns and $99,500 for all other returns. The exclusion is completely phased out at MAGI of $179,250 or more for joint returns and $114,500 or more for all other returns.

Sec. 162: Trade or business expenses

Omaha engineering firm not entitled to deduct New York penthouse used personally: In the Tax Court case Schnackel,¹⁴ during 2012 through 2014 (the years at issue), Gregory Schnackel was the sole owner of Schnackel Engineers Inc. (SEI). While headquartered in Nebraska at the time, SEI also had offices in California and New York City. Schnackel’s then–wife, with whom he filed a joint income tax return, provided limited bookkeeping for SEI.

In the early 2000s, SEI entered the New York market, with Schnackel frequently staying in hotels while building the business. Despite only having small projects there, by 2006 Schnackel spent at least a third of his time in New York City, so he purchased a local 2,900–square–foot penthouse condo for $3,250,000. The condo was in his name only, and as part of the purchase agreement, he agreed to use it as his second home.

The condo was subsequently leased to SEI for use by any of its employees for $28,000 per month, a slightly above–market rate at the time. Schnackel used his company credit card to furnish the penthouse, including with a baby grand piano. These expenses totaled over $326,000 over the years, for which SEI took depreciation deductions. The expenses were necessary, Schnackel argued, for SEI to appear successful in the New York market and lodge SEI employees traveling there for business.

Regardless of the arrangement, SEI’s business was not the sole use of the condo, as the Schnackels and their family stayed there while visiting New York City on vacations, and their daughter lived there for one semester while attending New York University in 2013. Despite this activity, neither personal nor business use was tracked beyond credit card receipts and dates circled on calendars. The business could not substantiate any instances of an SEI employee staying at the condo for business use.

Sec. 162 allows a deduction for ordinary and necessary business expenses, with an ordinary expense being one that commonly or frequently occurs in the taxpayer’s business, and a necessary expense being one that is appropriate and helpful in carrying on the business. Sec. 167(a) allows a depreciation deduction for trade or business property. Sec. 179 permits an election for full expensing for the year an asset is placed into service; however, no deduction is allowed where less than 50% of the property’s use is for business purposes.¹⁵ Additionally, heightened substantiation requirements under Sec. 274(d) need to be satisfied when traveling away from home for work.

The Tax Court noted: “Where an expense is primarily associated with profit–motivated purposes and personal benefit can be said to be distinctly secondary and incidental, it may be deducted under [Sec.] 162(a).”¹⁶ The IRS contended that the lack of substantiation and multiple personal reasons for visiting New York City proved the penthouse was not intended or used for business purposes at all and denied SEI’s related deductions. The Tax Court agreed with the IRS, denying rental expenses and depreciation deductions related to the New York City penthouse.

The Tax Court also granted equitable innocent–spouse relief under Sec. 6015(f) to Schnackel’s ex–wife regarding the understatement attributable to the expenses related to the penthouse, finding that she did not have reason to know of the items giving rise to the understatement and did not significantly benefit from the penthouse.

Deductions for fines and penalties did not meet exception requirements: In Chief Counsel Advice memorandum 202439015, the IRS Office of Chief Counsel advised that Sec. 162(f)(1) disallowed a taxpayer’s deduction for amounts paid to a governmental agency pursuant to a court order in relation to a violation of the law where, pursuant to the order, the agency was allowed to use the money for consumer redress and pay any amount left over to the U.S. Treasury. It also advised that Sec. 162(f)(1) disallowed a deduction by the taxpayer’s wholly owned S corporation for the forgiveness of debt issued to the taxpayer’s customers. The Chief Counsel’s Office found that the exception to disallowance provided under Sec. 162(f)(2) did not apply because the order did not identify the payments as restitution or amounts paid to come into compliance with the law, and the taxpayer failed to establish that either the payments or forgiven debt constituted restitution.

Sec. 165: Losses

In Wright,¹⁷ the taxpayers, Terry and Cheryl Wright, were denied a capital loss deduction associated with what the Tax Court found to be an abusive, tax–motivated foreign currency option transaction under Sec. 1256 because no profit motive was proven.

Deductible losses by individuals are limited under Sec. 165(c) to those related to (1) a trade or business, (2) investment, or (3) casualty/theft. As neither a business nor a casualty or theft was in play regarding the Wrights’ transaction, the Tax Court focused on whether the loss was incurred in a transaction entered into for profit under Sec. 165(c)(2).

In determining whether a taxpayer has entered into a transaction primarily for profit, the court applies the following guidelines:¹⁸

• The ultimate issue is profit motive and not profit potential. However, profit potential is a relevant factor to be considered in determining profit motive.
• Profit motive refers to economic profit independent of tax savings.
• The deductibility or nondeductibility of a loss is determined by the overall scheme, not merely by the losing legs of a position.
• If there are two or more motives, it must be determined which is primary, or of first importance. The determination is essentially factual, and greater weight is to be given to objective facts than to self-serving statements characterizing intent.
• Because the statute speaks of motive in entering a transaction, the main focus must be at the time the transactions were initiated. However, all circumstances surrounding the transactions are material to the question of intent.

While an incidental profit motive is generally insufficient, profit need not be the sole motive.¹⁹

The Wrights argued that because Sec. 1211(b) allows the deduction of capital losses to a specified extent, it allows a capital loss deduction on a stand–alone basis, unmoored from other provisions limiting loss deductibility. However, the Tax Court found that its own precedent provides otherwise. For example, the court determined in Wilson that “[a] capital loss deduction is allowed to an individual only if the loss was incurred in a trade or business or in a transaction entered into for profit.”²⁰ Accordingly, the Tax Court applied Sec. 165(c) to disallow artificial capital loss deductions by individuals. Ultimately, the court found the transactions in question to be tax–motivated rather than entered into for profit, in that the “paper losses enormously exceeded the amounts actually at risk,”²¹ so the Wrights could not deduct the losses from them under Sec. 165(c)(2).

Sec. 170: Charitable contributions

IRS issues final conservation contributions regulations: On June 24, 2024, the IRS published final regulations²² addressing the disallowance of the income tax deduction for certain qualified conservation contributions made by a partnership or an S corporation. Enacted as part of SECURE 2.0 and effective for contributions of qualified conservation contributions made after Dec. 29, 2022, Sec. 170(h)(7) and related regulations provide that an income tax deduction for a qualified conservation contribution by a partnership or S corporation will be disallowed if the amount of the contribution exceeds 2.5 times the sum of each partnership partner’s or S corporation shareholder’s relevant basis in the property contributed. This is commonly known as the “disallowance rule.”

The final regulations provide additional guidance on the disallowance rule, including definitions, the appropriate methods to calculate the basis of a partner or S corporation shareholder, the application of the rule to tiered ownership structures, and reporting requirements. The final regulations also address three statutory exceptions to the disallowance rule, which include exceptions for certain contributions made outside a three–year holding period, contributions made by family passthrough entities, and contributions to preserve certified historic structures.

The final regulations also impose stricter reporting and substantiation requirements for all noncash charitable contributions of more than $500 (not just qualified conservation contributions). These new rules include a requirement that taxpayers input numerical entries on Form 8283, Noncash Charitable Contributions, in lieu of “nonresponsive responses” (such as “available upon request”). Further, there are additional disclosure and reporting requirements for partners and shareholders who receive an allocation of a noncash charitable contribution from a partnership or S corporation. In such cases, the final regulations provide that partners or shareholders must not only complete their own Form 8283 to report the contribution, but they must also attach a copy of the partnership’s or S corporation’s completed Form 8283 to the return on which the deduction is claimed.

Notably, the preamble to the final regulations also addresses whether compliance with Sec. 170’s substantiation, reporting, and disclosure requirements must be “strict” or merely “substantial.” Both the IRS and the courts have consistently emphasized that Sec. 170 requires strict compliance with these rules for taxpayers to claim a charitable contribution deduction. In response to the proposed regulations originally issued in November 2023,²³ the IRS received a comment urging it to include a substantial–compliance standard in the final regulations. The commenter argued that a taxpayer’s deduction should not be disallowed for a good–faith mistake, such as miscalculating a partner’s basis, when analyzing the potential impact of the disallowance rule. The IRS explicitly rejected this request, noting that certain Sec. 170 reporting and disclosure requirements, including the requirement to obtain a qualified appraisal and attach an appraisal summary to the return, are statutorily imposed and cannot be satisfied through substantial compliance. Therefore, strict compliance with the Sec. 170 reporting and disclosure requirements continues to be necessary for taxpayers to claim a charitable contribution deduction.

Conservation easement regulation on perpetuity requirement declared invalid: In Valley Park Ranch,²⁴ the Tax Court held that a conservation easement regulation (not one of those discussed above) was invalid because the IRS had failed to follow proper notice–and–comment procedures. The taxpayer, Valley Park Ranch LLC, granted a conservation easement to Compatible Lands Foundation (CLF), a qualified organization. The deed of gift accompanying the donation included the conservation purpose of the easement, which was to be protected in perpetuity. The deed also contemplated various situations in which the conservation purpose of the easement could become obsolete, impossible to accomplish, or extinguished through eminent domain. In such cases, the deed stipulated that CLF (the charitable donee) would be entitled to compensation from the condemnation of the easement property as determined by a court or by a qualified appraisal.

On its 2016 tax return, Valley Park Ranch claimed a $14.8 million charitable income tax deduction under Sec. 170(h) in connection with the easement. The return included Form 8283, which indicated that the property had been acquired in January 1998 with a cost basis of $91,610. Upon examination, the IRS disallowed the deduction because the conservation purpose of the easement was not “protected in perpetuity.” In this context, the IRS argued that the easement did not satisfy the requirements of Regs. Sec. 1.170A–14(g)(6)(ii), which provides guidance on how sales proceeds must be allocated between a donor and a donee if a perpetual conservation easement is subsequently extinguished through a sale, exchange, or involuntary conversion of the underlying property. In response, Valley Park Ranch not only argued that the easement satisfied the perpetuity requirement but also maintained that Regs. Sec. 1.170A–14(g)(6)(ii) was procedurally invalid under the Administrative Procedure Act (APA).

A “qualified conservation contribution” must meet several statutory requirements to qualify as a deduction under Sec. 170(h). Among those requirements, the restriction placed on the qualified real property interest subject to the easement must not only be granted in perpetuity under Sec. 170(h)(2)(C), but it must also be protected in perpetuity under Sec. 170(h)(5)(A). Regs. Sec. 1.170A–14(g)(6) addresses the protected–in–perpetuity requirement in situations where a sudden, unexpected change in circumstances makes the continued use of the property for conservation purposes either impossible or impractical. In such cases, if the restrictions placed on the easement property are ultimately extinguished by a judicial proceeding, then the donee must receive proceeds from the sale or extinguishment at least equal to the proportionate value of the perpetual conservation restriction, including post–donation improvements. If the donee uses those proceeds in a manner consistent with the conservation purpose of the original contribution, then the protected–in–perpetuity requirement will be met.

As discussed in the March and September 2023 Tax Adviser update articles on developments in individual taxation,²⁵ the validity of Regs. Sec. 1.170A–14(g)(6)(ii) was previously addressed by decisions in Oakbrook and Hewitt, resulting in a split between two circuits. In Oakbrook, the Sixth Circuit upheld the validity of the regulation’s method for allocating post–extinguishment proceeds,²⁶ while in Hewitt, the Eleventh Circuit held that the regulation was invalid under the APA’s procedural requirements.²⁷ In Valley Park Ranch, the Tax Court was not required to follow the decision of either the Sixth Circuit (Oakbrook) or the Eleventh Circuit (Hewitt) because any subsequent appeal would be made to the Tenth Circuit, which had not yet ruled on the issue.

Holding for the taxpayer, the Tax Court explained that the APA generally requires federal agencies to follow a three–step process prior to issuing final regulations. First, an agency must issue a general notice of proposed rulemaking. Second, the agency must not only give interested persons an opportunity to participate in the rulemaking process but also must respond to any significant comments received. Third, once the rule has been established, the agency must include a summary of the final rule’s basis and purpose. Further, the agency must respond to comments “that can be thought to challenge a fundamental premise” of the agency’s decision. With this process in mind, and consistent with the Eleventh Circuit’s decision in Hewitt, the court concluded that Regs. Sec. 1.170A–14(g)(6)(ii) was procedurally invalid because the IRS failed to respond to significant comments regarding the extinguishment provision during the initial rulemaking process — in violation of the APA’s notice–and–comment procedures. For this reason, the court upheld Valley Park Ranch’s $14.8 million deduction after determining that the deed of gift accompanying the easement satisfied both the granted–in–perpetuity and protected–in–perpetuity requirements.

Property held to be ordinary–income with zero basis: In Oconee Landing Property,²⁸ the Tax Court considered whether Oconee Landing Property LLC was entitled to a $20.67 million charitable contribution deduction in connection with a conservation easement. The court concluded that Oconee’s deduction should be limited to zero, not only because it failed to obtain a qualified appraisal but also because the entity could not establish that its basis in the donated property was greater than zero. However, it declined to consider the IRS’s argument that the deduction should be disallowed on its face due to a perceived lack of donative intent.

In 2003, James M. Reynolds III acquired a 1,130–acre plot of land located in Greene County, Ga. A fixture within the Greene County community for decades, Reynolds and his family had developed a reputation as successful real estate developers and landowners. From 2011 through 2015, the Reynoldses unsuccessfully marketed the land for sale to prospective buyers at prices ranging from $6.7 million to $7.9 million, at which point the family began to investigate a conservation easement. With this new strategy in mind, they divided the 1,130–acre tract into several parcels, including one of 355 acres that was transferred to Oconee.

Upon receipt of the land, Oconee donated a conservation easement on the property to the Georgia–Alabama Land Trust (GALT), a qualified organization. On its timely filed 2015 partnership tax return, Oconee claimed a charitable contribution deduction of $20.67 million in connection with the easement. The return included Form 8283, which indicated that Oconee’s basis in the property was $3,348,498, along with an appraisal report that valued the 355–acre tract at $21,200,000 before the easement was granted and $530,000 afterward.

The IRS selected Oconee’s return for audit and disallowed the entire easement deduction. Holding for the IRS, the Tax Court agreed that Oconee was not entitled to a charitable contribution deduction because it failed to secure a “qualified appraisal” as required by Sec. 170(f)(11) and could not substantiate its basis in the donated property. Although Oconee did in fact obtain an appraisal of the donated property, it was not a qualified appraisal because it was not conducted by a qualified appraiser as required by Sec. 170(f)(11)(E)(i).

Under Regs. Sec. 1.170A–13(c)(5)(ii), an appraiser will not be a qualified appraiser if the donor “had knowledge of facts that would cause a reasonable person to expect the appraiser falsely to overstate the value of the donated property.” This will be true if, for example, “the donor and the appraiser make an agreement concerning the amount at which the property will be valued and the donor knows that such amount exceeds the fair market value of the property.”²⁹

According to the court, the Reynoldses knew that the 355–acre plot was worth less than $10 million after unsuccessfully attempting to sell the entire 1,130–acre tract for years at prices ranging from $6.7 million to $7.9 million. The court also found that the Reynoldses, acting through their intermediaries, had agreed with the appraisers what the appraisal value of the Oconee property would be. Thus, under Regs. Sec. 1.170A–13(c)(5)(ii), the appraisers were not qualified appraisers, and, consequently, the appraisal was not a qualified appraisal.

Separately, the court concluded that Oconee’s deduction should be limited to its basis, due to the operation of Sec. 170(e)(1) and Sec. 724(b). Under Sec. 170(e)(1)(A), an otherwise allowable charitable contribution deduction must be reduced by the amount of gain that would not be long–term capital gain if the property had been sold for its fair market value at the time of contribution. Therefore, if the property is ordinary–income property, which would give rise to ordinary gain upon its sale, the charitable contribution deduction for a contribution of the property is limited to the property’s basis.

Because the Reynolds family originally acquired the property as part of their real estate development business, the 355–acre tract was inventory in their hands and should be characterized as ordinary–income property. Once the land was contributed to Oconee, under Sec. 724(b), any subsequent sale within the five–year period after the contribution would have generated ordinary income to the partnership. For these reasons, Oconee’s charitable contribution deduction would be limited to its basis in the land.

However, neither Oconee nor the Reynolds family could substantiate the purchase price of the 1,130–acre tract originally acquired in 2003, nor could they demonstrate how that basis was allocated to the 355 acres transferred to Oconee on which the easement was granted. As a result, the court determined that Oconee had failed to prove that the basis in the property on which the easement was granted was greater than zero, and thus Oconee’s charitable contribution deduction was limited to zero.

The IRS also argued in the alternative that Oconee’s deduction should be disallowed because the easement donation was a quid pro quo exchange with GALT. According to the IRS, because the overstated tax deductions Oconee’s investors would receive were the only purpose for the donation, Oconee lacked the donative intent requisite for a charitable contribution.

The Tax Court concluded that, without disputing the intended purpose of the easement donation claimed by the IRS, the facts, without more, were insufficient to disallow the charitable contribution deduction. GALT was a qualified Sec. 501(c)(3) organization, and it did not provide any consideration to Oconee in exchange for the easement, which was transferred pursuant to a valid deed of gift. Further, in a typical quid pro quo case, the donor receives goods or services from a party to the transaction (i.e., the donee). In this case, any benefits received by Oconee in connection with the easement would have been supplied indirectly by Treasury, not GALT. Moreover, the court noted that it had found no case in which the tax benefits associated with a charitable contribution deduction have been deemed a quid pro quo that negated donative intent.

The Tax Court has rejected similar arguments from the IRS in other conservation easement cases, including Mill Road 36 Henry,³⁰ Buckelew Farm, LLC,³¹and the consolidated cases of Murphy Hollow and Hales Gap.³²

Sec. 183: Activities not engaged in for profit

Under Sec. 162, taxpayers are generally allowed deductions for business–related expenses. Sec. 183 limits deductions that can be claimed when an activity is not engaged in for profit. When an activity is classified as a hobby instead of a business, losses from the activity are not permitted to be used to offset other income, and allowable deductions cannot exceed gross receipts from the activity. Two recent cases highlight the importance of demonstrating a genuine profit motive when claiming business deductions as well as the complexities associated with distinguishing personal hobbies from business activities under Sec. 183.

In Mazotti,³³ married taxpayers filed a Schedule C, Profit or Loss From Business (Sole Proprietorship), for the wife’s, Debra Lea Jones–Mazotti’s, “writer researcher” activities for the tax years in question (2018—2020). Upon examination, the IRS determined that the writer–researcher activities were not engaged in with the intent to make a profit and that the taxpayers were not entitled to deductions for her alleged business expenses.

Regs. Sec. 1.183–2(b) provides a nonexhaustive list of nine factors that should be considered when assessing whether a taxpayer’s activity is engaged in with the intent to make a profit. The Tax Court evaluated these, including the manner in which Jones–Mazotti conducted the activity, her expertise and time devoted to the activity, her success in conducting similar activities, her history of income or losses from the activity, and elements of personal pleasure derived from the activity. The court determined that Jones–Mazotti did not conduct her writing activities in a businesslike manner, as evidenced by her admission that she had no business plan and no profit–and–loss statements and did not keep accurate books and records. She was unable to produce supporting evidence for most of the reported expenditures associated with the writing activities. There was no evidence that she engaged in extensive study of how to conduct a writing business, nor did she provide evidence of precisely how much time she spent on the activity during the tax years in question.

An activity may experience a series of losses during its startup phase and still be engaged in for profit. However, Jones–Mazotti’s writer–researcher activity sustained a 30–year period of losses before making a profit in 2022 and had substantial losses in the tax years at issue. For example, for 2018, she had a loss in excess of $60,000 on gross income of $30. This suggested to the Tax Court that Jones–Mazotti did not engage in her activity with the intent to make a profit.

Finally, the personal and recreational elements associated with Jones–Mazotti’s writer–researcher activities were evident to the court, as she said her work was “very much a passion” and she went on “research trips” to Hawaii, California, and Florida that the court said were “extensive vacations” with her family. Thus, it was apparent to the Tax Court that the recreational and personal elements of her activities outweighed her desire for a profit.

The court held that Jones–Mazotti had failed to substantiate her writing and research business activities and, based on the nine–factor analysis, had not engaged in these activities with the principal intent to make a profit. Thus, it sustained the IRS’s disallowance of her claimed business expense deductions associated with these activities.

In Schwarz,³⁴ the taxpayer, Gary Schwarz, a dentist and oral surgeon, and his wife owned over 15,000 acres of ranch land in Zapata County, Texas, on which they conducted real estate, farming, and ecotourism activities. The couple had a history of successful real estate activities in Texas involving the purchase, development, and sale of land at a profit. In addition, they conducted farming and ecotourism activities through their partnership, Tecomate Industries LLC (TI). The partnership reported large losses on Schedule F, Profit or Loss From Farming, which flowed through to the Schwarzes’ individual income tax return. The IRS examined tax years 2015—2017 and found that the partnership’s Schedule F activity was not engaged in for profit, disallowing deductions and assessing a 20% accuracy–related penalty.

The primary issue centered on whether the Schedule F farming operation was a for–profit activity. To decide whether an intent to make a profit existed, the Tax Court first had to ascertain the activity. The taxpayers argued that TI’s unprofitable farming activity and their profitable real estate activities should be considered together for purposes of Sec. 183. Where a taxpayer is engaged in multiple activities, these may be treated as one activity if they are sufficiently interconnected.³⁵

The Schwarzes failed to establish the necessary interconnectedness. The objective of their real estate activities was to increase the value of their properties and sell them at a profit. This they accomplished successfully. TI’s farming objectives were to develop and run its ecotourism operations and to complete custom farming jobs, neither of which was designed to maximize property values for prospective purchasers. Ecotourism operations were driven by Gary Schwarz’s longtime passion for growing big deer and bass fish and included sales of hunting, fishing, and event packages. Custom farming was mostly attributed to work in support of ecotourism and consisted of clearing land, plowing, planting, fencing, and building roads and lakes and the like.

The court determined that the taxpayers did not demonstrate that any significant percentage of the farming activity losses was related to the development of properties sold or intended to be sold, and they knew they would never profit from the partnership’s ecotourism or farming activity as a whole. Therefore, their effort to characterize unprofitable farming/ecotourism and the profitable real estate activities as a single activity was weak, artificial, and unreasonable. The court rejected the single–activity characterization.

With the farming activity ascertained, the court then deliberated the nine factors of Regs. Sec. 1.183–2(b) that should be considered when assessing whether a taxpayer’s activity is engaged in with the intent to make a profit. Five of the factors favored the IRS: the manner in which the Schwarzes carried on the activity; their history of losses with respect to the activity; their amount of occasional profits, if any; their financial status; and elements of personal pleasure or recreation. The court’s analysis determined that the Schwarzes did not run the farming activity in a businesslike manner. The activity’s books and records appeared to have survived an IRS audit with no deductions disallowed or unreported income found; however, the books did a poor job of explaining why TI’s farming activity lost money so that appropriate changes could be made. Year after year, TI’s farming activity continued to lose money, yet the taxpayers did not use the records to improve the operations or stem recurring and significant losses. Furthermore, problematic leases essentially guaranteed that TI’s ecotourism activity could not be profitable. In short, the manner in which the taxpayers carried out the activity was not businesslike.

Regarding the taxpayers’ history of income and losses associated with the farming activity, the court noted that from 2005 to 2020, TI’s farming activity had total expenses over two times larger than its gross income. In the court’s opinion, the Schwarzes had sufficient time to build out their operation and become profitable, but there was no sign that TI would ever do so.

The fact that a taxpayer does not have substantial income or capital from sources other than the activity may indicate that an activity is engaged in for profit.³⁶ Conversely, substantial income from sources other than the activity (particularly if the losses from the activity generate substantial tax benefits) may indicate that the activity is not engaged in for profit, especially if personal or recreational elements are involved. In the years at issue, Gary Schwarz made millions of dollars from his dental practice. The Schwarzes also made substantial profits from real estate activities over many years. They had the money to pursue Schwarz’s longtime passion for deer and ranch development independently of any desire to earn a profit. To the court, the farming activity appeared to be an attempt to offset Schwarz’s substantial earned income. TI’s work helped Schwarz continue his longtime hobbies and furthered his enjoyment of owning and operating ranches.

Considering all the facts and circumstances, the court found that the taxpayers did not have an actual and honest profit objective and found that TI’s farming activity was not engaged in with the intent to make a profit. Accordingly, the court upheld the IRS’s disallowance of TI’s Schedule F losses.

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

The IRS issued Notice 2024–71 on Oct. 17, 2024, which provided a safe harbor under Sec. 213 for amounts paid for condoms. Sec. 213 allows for the itemized deduction of expenses paid for medical care to diagnose, cure, mitigate, treat, or prevent disease or to affect any structure or function of the body. Since a facts–and–circumstances test determines whether expenses are incurred for the prevention of disease or medical care, whether amounts paid for condoms are a qualified medical expense under Sec. 213 was not clear. Notice 2024–71 establishes a safe harbor where Treasury and the IRS will treat amounts paid for condoms as amounts paid for medical care under Sec. 213(d), thus alleviating any need for a facts–and–circumstances determination.

Sec. 223: Health savings accounts

The IRS issued Notice 2024–75 on Oct. 17, 2024, which superseded Notice 2018–12, clarified Notice 2004–23, and clarified and expanded Notice 2019–45. In Notice 2024–75, the IRS expanded the list of preventive care benefits permitted to be provided by a high–deductible health plan (HDHP) without a deductible or with a deductible below the applicable minimum deductible for the HDHP. The expanded list of benefits includes over–the–counter oral and emergency contraceptives; male condoms; breast cancer screening, including imaging other than mammograms, such as MRIs, ultrasounds, and similar breast cancer screening services; and continuous glucose monitors, including those that both monitor and provide insulin but not those that have additional medical or nonmedical functions that are not preventive care, other than minor functions such as clock and date functions. Additionally, Notice 2024–75 allows an HDHP to provide insulin products described in Sec. 223(c)(2)(G) prior to the individual’s satisfying the HDHP’s minimum annual deductible.

Sec. 280A: Disallowance of certain expenses in connection with business use of home, rental of vacation homes, etc.

In Kalk,³⁷ many of the issues were negotiated and agreed by the taxpayer and the IRS related to unreported income, itemized deductions, and the removal of accuracy–related penalties. The remaining issues decided by the Tax Court related to the taxpayer’s income from her software installation and training consulting business and her gambling–related activities.

Although expenses relating to a taxpayer’s residence are generally not deductible, Sec. 280A(c)(1)(A) provides an exception for “any item to the extent such item is allocable to a portion of the dwelling unit which is exclusively used on a regular basis … as the principal place of business for any trade or business of the taxpayer.” Under Tax Court precedent, a taxpayer may have only one principal place of business, and to determine the principal place of business, the Tax Court must ascertain the “focal point” of a taxpayer’s business activities.

The taxpayer testified that she provided the bulk of her services to one company in Chicago and she was required to be at its office most of each week. Thus, the Tax Court found that, for purposes of her claimed home office deduction, the taxpayer was unable to verify that the focal point of her business was her home. In addition, the taxpayer failed to establish what (if any) portion of her home was used exclusively for business purposes. Thus, the Tax Court denied the taxpayer’s home office deductions.

The court also denied deductions the taxpayer took for rental expenses for storage facilities because the taxpayer had contracted for the storage facilities in her personal capacity rather than in the name of her business.

The taxpayer also claimed gambling losses on one of her two Schedules C, allegedly as research related to her intended development of a software app for gamblers to track their daily wagering. She conceded at trial that she did not in fact develop the app and she had no casino app trade or business during the years in question, so the Tax Court found that the expenses were not deductible business expenses. However, the court allowed her to deduct her substantiated gambling losses up to the amount of her winnings, as allowed by Sec. 165(d).

In Bachchan,³⁸ a taxpayer claimed unreimbursed employee expenses, including local travel and home office expenses, as miscellaneous itemized deductions on Schedule A, Itemized Deductions, of his 2015 income tax return. The taxpayer was an employee of a company that permitted him to work remotely to be closer to where his wife was working. He was not required to work remotely.

The Tax Court noted that an employee may not deduct expenses where the employee was entitled to reimbursement for the expenses from their employer but failed to claim it. The taxpayer in this case did not seek reimbursement for his local travel or home office expenses, but it was unclear to the court whether he was entitled to reimbursement and simply failed to request it. Thus, the court found the taxpayer had not met his burden of proof with respect to the expenses.

With respect to the home office expenses, even if the taxpayer had sought reimbursement, Sec. 280A provides that no deduction is allowed for an employee’s home office unless certain requirements are met, including that the office be kept for the convenience of the employer.³⁹ In this case, the Tax Court found that the taxpayer did not keep the home office for the convenience of the employer, so his home office expenses were not deductible.

Sec. 280E: Expenditures in connection with the illegal sale of drugs

The IRS reminded taxpayers in News Release IR–2024–177 that while marijuana federally remains a Schedule I controlled substance, Sec. 280E limitations on business deductions and credits still apply despite legalization in many states.

In May 2024, the Justice Department published a notice of proposed rulemaking to initiate a formal process to reschedule marijuana under the Controlled Substances Act.⁴⁰ As a result, several marijuana businesses began submitting amended tax returns as if Sec. 280E no longer applied. The IRS warned that until marijuana is formally rescheduled, Sec. 280E’s prohibition of deductions or credits for any trade or business that consists of trafficking in Schedule I or II controlled substances remains in force. However, Sec. 280E does not prohibit the deduction of properly calculated cost of goods from gross receipts.

In October 2024, in a challenge by a California medical cannabis dispensary, the Tax Court, citing its own precedent,⁴¹ held that Sec. 280E and the Controlled Substances Act are constitutional.⁴²

Footnotes

¹REG-118264-23.

²For more information about these credits, see Jemiolo and Farnsel, “New and Enhanced Energy Tax Credits for Individuals,” 238-5 Journal of Accountancy 34 (November 2024).

³T.D. 9995.

⁴REG-116787-23. The next update article will discuss final regulations issued in December 2024 (T.D. 10019).

⁵Kohl, T.C. Summ. 2024-4.

⁶SECURE 2.0 Act of 2022 (Division T of the Consolidated Appropriations Act, 2023, P.L. 117-328).

⁷Sec. 72(t)(2)(I)(iv).

⁸Sec. 72(t)(2)(K)(iii).

⁹Strom, T.C. Memo. 2024-58.

¹⁰Strom, 583 F. Supp. 2d 1264 (W.D. Wash. 2008).

¹¹Strom, 641 F.3d 1051 (9th Cir. 2011).

¹²IRS Letter Rulings 202446022, 202446023, 202446018, 202446017, 202446015, 202446021, 202446020, 202446019, 202443026, 202442011, 202442012, 202436020, 202436021, 202436019, 202436018, 202435017, 202434017, 202434016, 202434015, and 202432021.

¹³Rev. Proc. 2024-40.

¹⁴Schnackel, T.C. Memo. 2024-76.

¹⁵Regs. Sec. 1.179-1(d)(1).

¹⁶Citing International Artists, Ltd., 55 T.C. 94 (1970).

¹⁷Wright, T.C. Memo. 2024-100.

¹⁸Citing Ewing, 91 T.C. 396, 417—18 (1988).

¹⁹Citing Fox, 82 T.C. 1001, 1019 (1984).

²⁰Wilson, 49 T.C. 406 (1968), rev’d on other grounds, 412 F.2d 314 (6th Cir. 1969).

²¹Quoting Fox, 82 T.C. at 1025.

²²T.D. 9999.

²³REG-112916-23.

²⁴Valley Park Ranch, LLC, 162 T.C. No. 6 (2024).

²⁵Bowles et al., “Current Developments in Taxation of Individuals,” 54-3 The Tax Adviser 30 (March 2023), and Brennan et al., “Current Developments in Taxation of Individuals,” 54-9 The Tax Adviser 26 (September 2023).

²⁶Oakbrook Land Holdings, LLC, 28 F.4th 700 (6th Cir. 2022).

²⁷Hewitt, 21 F.4th 1336 (11th Cir. 2021).

²⁸Oconee Landing Property, LLC, T.C. Memo. 2024-25.

²⁹Regs. Sec. 1.170A-13(c)(5)(ii).

³⁰Mill Road 36 Henry, T.C. Memo. 2023-129.

³¹Buckelew Farm, LLC, T.C. Memo. 2024-52.

³²Murphy Hollow, LLC, Nos. 9620-21 and 13346-21 (T.C.) (order, 8/16/24).

³³Mazotti, T.C. Memo. 2024-75.

³⁴Schwarz, T.C. Memo. 2024-55.

³⁵Regs. Sec. 1.183-1(d).

³⁶Regs. Sec. 1.183-2(b)(8).

³⁷Kalk, T.C. Memo. 2024-82.

³⁸Bachchan, T.C. Summ. 2024-14.

³⁹Sec. 280A(c)(1), flush language.

⁴⁰89 Fed. Reg. 44597 (May 21, 2024).

⁴¹N. Cal. Small Bus. Assistants Inc., 153 T.C. 65 (2019).

⁴²Patients Mutual Assistance Collective Corp., Inc., T.C. Memo. 2024-98.

Contributors

Elizabeth Brennan, CPA, is a practitioner in New Orleans. Jodi Eckhout, CPA, is a shareholder with Woods & Durham, Chartered, in Holdrege, Neb. Mary Kay Foss, CPA, practices in Carlsbad, Calif. Karmen Hoxie, CPA, is a solo practitioner in the Minneapolis area. Amie Kuntz, CPA, is a partner in the national tax group of RubinBrown LLP. Jared Lowe, CPA, is a senior tax manager with Deloitte Tax LLP in Fresno, Calif. Stephen Mankowski, CPA, CGMA, is owner and founder of Mankowski Associates CPA, LLC, in Hatboro, Pa. Dana McCartney, CPA, is a partner with Maxwell Locke & Ritter LLP in Austin, Texas. Matthew Mullaney, CPA, is a director, Private National Tax, with PwC US Tax LLP in Florham Park, N.J. Patrick Sanford, CPA, is president of Probity Accounting PLLC in Van Buren, Ark. McCartney is the chair, and the other authors are members, of the AICPA Individual and Self-Employed Tax Technical Resource Panel. For more information about this article, contact thetaxadviser@aicpa.org.

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