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RECENT TAX DEVELOPMENTS
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Daniel Cullinane CPA
25 Plaza 5 25th fl Jersey City NJ phone 732-516-1648 fax 732-516-9778
This article is a semiannual review of recent developments in the area of individual federal taxation, including issues of deductible alimony, trade or business expenses, and recognition of loss. The items are arranged in Code section order.
This article is a semiannual review of recent developments in the area of individual federal taxation, including issues of deductible alimony, trade or business expenses, and recognition of loss. The items are arranged in Code section order.
Sec. 36B: Refundable credit for coverage under a qualified health plan
On July 24, 2017, the IRS issued final regulations relating to the Sec. 36B premium tax credit and the deduction for health insurance costs for self-employed individuals.1 The final regulations address issues including eligibility of victims of spousal abuse or abandonment to claim the credit, certain allocation issues that arise in reconciling advance credit payments with the actual credit amount, and the calculation of the Sec. 36B(f)(2)(B) repayment limitation for taxpayers claiming the self-employed medical insurance deduction.
The regulations provide for a certification process for a married victim of domestic abuse or abandonment to claim the Sec. 36B credit. They also provide guidelines for situations involving multiple families or divorced taxpayers covered under a single medical plan.
Sec. 61: Gross income defined
Payments received by a taxpayer because a bank engaged in improper home mortgage foreclosure practices were held to be taxable where the payments were made from a settlement fund for which the taxpayer did not have to show financial harm to be eligible.2
Sec. 71: Alimony and separate maintenance payments
Divorce or separation agreement: In 2006, while still married to his wife, the taxpayer in Mudrich3 earned a bonus for services he provided. The taxpayer filed for divorce in January 2007 and received the bonus he earned in 2006 during 2007. In June 2007, the taxpayer executed an agreement with his ex-wife under which she would receive half of the bonus, net of withholding taxes, and he would include the full amount of the bonus in gross income on his 2007 tax return. When the taxpayer filed his 2007 tax return, he included the full amount of the bonus and claimed a deduction for the bonus payment he made to his ex-wife as alimony. The Tax Court concluded that the bonus agreement was not a divorce or separation instrument, so the payment was not alimony because it was not mandated by a divorce or separation agreement as required under Sec. 71(b)(1)(A).
Oral modification: Another case addressed by the Tax Court involved whether a taxpayer was entitled to deduct as alimony more than the amount he was required to pay by the marital separation agreement.4 The taxpayer separated from his wife in 2009 and divorced her in 2010. The taxpayer's separation agreement required him to pay his ex-wife $2,000 per month in spousal support until their marital residence was sold, when the payments would increase to $8,000 per month. Given the troubled real estate market in 2009, the taxpayer was unable to sell the home, so the taxpayer and his ex-wifeagreed orally to modify the separation agreement. Under this modification, prior to the sale of the marital residence, the taxpayer paid his ex-wife $5,000 per month instead of the amount ordered by the court. The court found that the oral modification of the separation agreement did not meet the requirements of Sec. 71, and, therefore, the amounts the taxpayer paid to his ex-wife in excess of the $2,000 per month required by the separation agreement were not deductible as alimony on the taxpayer's return.
Sec. 83: Property transferred in connection with performance of services
In Austin,5 the Tax Court held that restricted stock was subject to a substantial risk of forfeiture when issued and not substantially vested, as the IRS contended. The court noted that neither of the taxpayers, two men who worked together in a company they founded, held a controlling position in the company, so neither of them could unilaterally remove the restrictions on the stock. Additionally, if either taxpayer failed to perform his duties or left the company before the restrictions ended, the other taxpayer had an incentive to insist on enforcement of the forfeiture provision, which provided that each would lose 50% of the value of his stock if he were to leave the company within five years, so it was likely the agreement would be enforced.
The IRS further contended that the fair market value (FMV) of the stock was taxable income to the taxpayers when the restrictions on the stock lapsed on Jan. 1, 2004. Prior to this date, the taxpayers reorganized their business. They claimed that in the reorganization they had "surrendered" their original shares and acquired replacement shares in exchange for a promissory note, and they reported the difference between the FMV of the replacement shares and the promissory note as compensation income.
The court concluded that the "surrender" and "repurchase" transactions lacked economic substance, and thus each taxpayer was required to report as compensation income an amount equal to the FMV of the stock on the day the restrictions lapsed, to the extent this amount exceeded the taxpayer's basis in those shares.
Also addressed was a "special dividend" received by the taxpayers. The court concluded that, due to the amounts included in income from the lapse of the stock restrictions, the taxpayers received an increase to their basis. Thus, the receipt of the special dividend was a nontaxable event, as each taxpayer had sufficient basis in his shares to absorb the special dividend.
Sec. 162: Trade or business expenses
Travel: In Barrett,6 the IRS denied the taxpayer a deduction for business-related travel expenses because it determined that the city the taxpayer traveled to was his tax home. The taxpayer and his spouse resided in Nevada, where the spouse had a job and the couple had several rental properties. The taxpayer had worked as a self-employed video producer since the mid-1980s. The company for which he primarily worked had video studios in Washington, D.C., and as part of his work agreement with the company, he was required to travel there to use its editing facilities.
The taxpayer testified that 75% of his work related to video production was performed outside Washington and conducted from his office in Nevada. When he was required to travel to Washington, he spent an average of two weeks there. The taxpayer deducted the travel-related expenses for trips to Washington on his Schedule C, Profit or Loss From Business. The IRS denied the deduction on the basis that his tax home was in Washington, and his work of over 21 years was permanent rather than temporary.
The court held in favor of the taxpayer. Because the taxpayer performed a substantial portion of his work in Nevada, plus the fact that he and his wife lived together in Nevada and had rental properties that the taxpayer assisted in maintaining, the taxpayer's travel to Washington only to complete the production process for just a few sporadic weeks did not support the position of the IRS that the taxpayer's tax home was in Washington. However, the court disallowed expenses claimed beyond those previously allowed by the IRS, for lack of substantiation.
Substantiation: Larkin involved a married couple residing in the United Kingdom during the years in question while the husband was employed by a multinational law firm.7
The IRS disallowed many of the deductions claimed by the taxpayers on their Schedule C. In the majority of the instances, the taxpayers failed to provide documentation to support their claims for deductions and credits associated with several of the husband's business endeavors. These claims included home office expenses, depreciation for a home computer, medical expenses, home mortgage interest, casualty losses, and charitable contributions. Of these, the husband provided limited documentation, and the court disallowed most of them. The court allowed the taxpayers to deduct a few expenses for which it found credible support, primarily items stated on the husband's Schedule K-1 from the law firm. The court found the husband's credibility lacking, relying on his testimony only when other evidence supplied additional support.
Business purpose: An individual taxpayer was denied deductions for numerous unreimbursed employee expenses, charitable deductions, and home office expenses claimed on his 2011 income tax return.8 At trial, the taxpayer failed to address a claim for a deduction of tax preparation and attorneys' fees, and it was disallowed. The taxpayer asserted that his unreimbursed employee expenses fell under his employer's unofficial policy rather than the employer's written reimbursement policy. Due to the taxpayer's failure to provide either the written policy or proof of this unofficial policy, the deduction for the unreimbursed employee expenses was disallowed. The taxpayer claimed deductions for unreimbursed meals and other travel expenses of donating his services to a charitable foundation, which were disallowed, and expenses of maintaining the foundation's website, which were allowed. The court sustained the IRS's denial of a home office deduction, both with respect to his claimed use of it as an employee, since he presented no evidence the employer required him to use the home office for the employer's convenience, and with respect to his own business activity, since he did not provide evidence of how much time he spent performing the activity there in comparison to other locations. The taxpayer also attempted to deduct expenses for travel and meals associated with his job search within his profession. The taxpayer presented records of the travel but failed to prove its business purpose, so the court held that those expenses werenondeductible.
Sec. 165: Losses
Legislation enacted on Sept. 29, 2017,9 provided benefits for victims of hurricanes Harvey, Irma, and Maria. For qualified disaster-related personal casualty losses from those hurricanes, the act removes the requirement that personal casualty losses must exceed 10% of the taxpayer's AGI to be deductible and allows nonitemizers to increase their standard deduction by the amount of their net disaster loss. Additionally, victims of the hurricanes can use their 2016 income to calculate the 2017 earned income tax credit and refundable portion of the child tax credit. The legislation waives the 10% penalty on pre-age-59½ retirement account payouts of "qualified hurricane distributions" of up to $100,000 in a tax year, and the income tax due on those distributions can be spread over a three-year period. Any amounts recontributed to the account during the three-year period will be treated as rollovers, and any tax previously paid on those amounts can be recovered by filing an amended Form 1040, U.S. Individual Income Tax Return. Victims with Sec. 401(k) accounts can borrow up to the lesser of $100,000 or 100% of the account balance, and loan repayments can be deferred.
Sec. 166: Bad debts
The taxpayer was denied a business bad debt deduction in Rutter.10 The taxpayer was a scientist in the field of biotechnology who in 2002 incorporated a company that developed technology to remotely monitor patients' health. Even though the taxpayer was the driving force behind the newly formed company, he did not own any of its common stock. Between 2000 and 2009, the taxpayer advanced more than $80 million to the company. Promissory notes were executed for, and any interest was paid on, only approximately $14 million of the advances. Additionally, the taxpayer did not seek repayment of any of the outstanding principal.
In 2009, after the company failed to form successful partnerships with health care, pharmaceutical, and technology companies, the taxpayer decided to take a bad debt loss deduction for a portion of his advances to the company on a first-in, first-out basis and reported a business bad debt loss of $8.55 million on his 2009 Schedule C.
The court denied the deduction, determining that the advances were equity investments rather than bona fide debt. The court further found that even if the advances were considered debt, they would be nonbusiness debt and therefore nondeductible under Sec. 166, because the taxpayer was not in the business of lending money.
Sec. 170: Charitable, etc., contributions and gifts
A number of charitable easement cases highlighted the importance of having easement documents that are well-draftedand overseen by legal and accounting professionals. Other cases highlighted proper recordkeeping, substantiation, and valuation requirements when claiming charitable contributions.
Real estate remainder interest: In RERI Holdings I, LLC,11 a partnership was denied a $33 million noncash charitable deduction for a contribution of a remainder interest in real estate because the Form 8283, Noncash Charitable Contributions, attached to its tax return failed to include the partnership's original cost of the remainder interest. The failure to disclose the cost of the remainder interest could not be excused on the grounds of substantial compliance, since its disclosure would have alerted the IRS to a potential overvaluation of the remainder interest. Therefore, the partnership's Form 8283 did not satisfy the requirements of Regs. Sec. 1.170A-13(c)(4)(ii)(E).
Facade easement: In Big River Development, L.P.,12 a partnership was allowed a $7 million noncash charitable deduction for a facade easement. Although the written acknowledgment issued by the recipient charity did not indicate that no goods or services were provided, the easement deed explicitly stated that the charity supplied no goods or services in exchange for the gift of the easement, and that the deed reflected the entire agreement of the parties. As such, the easement deed fulfilled the requirements of Sec. 170(f)(8)(B), the Tax Court held.
Contemporaneous written acknowledgment: In 310 Retail, LLC,13 the IRS denied a partnership a noncash charitable deduction of a $26.7 million facade easement because no separate contemporaneous written acknowledgment was received from the charity, and the easement deed contained no references to goods or services. In this case, the partnership first argued that an amended Form 990, Return of Organization Exempt From Income Tax, filed seven years after the gift, which disclosed the gift and stated that no goods or services were provided, satisfied the requirement. Following 15 W. 17th St., LLC,14which was decided after this case had been filed, the Tax Court found that this alternative reporting measure did not satisfy the contemporaneous written acknowledgment requirement. However, the Tax Court further found that, as was the case in Big River Development, L.P. (described above), the deed of easement for the gift satisfied the requirement and held that the taxpayer was therefore entitled to the deduction.
In perpetuity: In Palmolive Building Investors, LLC,15 a partnership's noncash charitable deduction for a facade easement was denied because the easement was subject to a mortgage and therefore not protected in perpetuity. The taxpayer argued that a clause in the easement deed would retroactively amend the deed to cure the defect. However, the Tax Court found that the requirements of Sec. 170 must be satisfied at the time of the gift.
Valuation: In Gardner,16 an avid hunter's noncash charitable deduction for donations of big-game specimens to an ecological foundation was reduced from $1,425,900 to $163,045. The taxpayer's valuation expert concluded it would cost $1,425,900 to conduct 177 safaris to accumulate the specimens the taxpayer donated. The Tax Court noted that replacement cost may be relevant where the property is unique, the market is limited, and there is no evidence of comparable sales; however, the taxpayer's donated specimens were neither world-class trophies nor of museum quality, and there was an active market in specimens like the taxpayer's. The court concluded, therefore, that they were commodities, not collectibles, and that they should be assigned FMV rather than replacement cost. Because the taxpayer provided no evidence that the replacement cost for the specimens exceeded the amount allowed by the IRS, the court upheld the IRS's valuation.
Substantiation: In Ohde,17 the Tax Court reduced a married couple's claimed noncash deduction for 20,000 items given to Goodwill Industries valued at a total of $145,250 to $250. The receipts from Goodwill did not describe any of the items or indicate how many items were donated or their condition, so the court found that the taxpayers' records were not adequate to support their claimed deductions. The court further found that when similar items were grouped together (e.g., clothing, furniture, etc.), items representing over 88% of the claimed value would have required qualified appraisals since they were valued at more than $5,000 each.
Sec. 183: Activities not engaged in for profit
Gambling activity: InBoneparte,18 the taxpayer worked full time as an employee for the Port Authority of New York and New Jersey, which generated almost all of his annual earnings. However,on his 2012 and 2013 tax returns, the taxpayer claimed net losses on Schedule C of $89,116 and $85,783 from his activity as a professional gambler. Most of the expenses he claimed were for auto expenses, travel, and meals and entertainment incurred while on gambling trips to Atlantic City and other locations. Applying the nine factors of Regs. Sec. 1.183-2(b), the Tax Court determined that the taxpayer failed to prove that his gambling activity was a for-profit business activity, and he could not deduct any expenses for his gambling activities on Schedule C.
Businesslike manner: Experience alone did not prove that a taxpayer engaged in a business activity for profit in Stettner.19 In that case, a taxpayer who had over 20 years of experience in car racing sought to deduct losses from a car-racing activity. In applying the Regs. Sec. 1.183-2(b) test to determine whether he operated the activity with the intent to make a profit, the Tax Court found that the taxpayer's experience in the industry, the substantial time he spent on the activity, and the fact that it was his only significant source of income weighed in his favor.
However, it found that these factors were heavily outweighed by his not running the activity in a businesslike manner, his lack of expertise in running a car-racing business (as opposed to racing cars), the prior failure of his previous similar car-racing business (which had caused the taxpayer to file for bankruptcy), and the personal pleasure he derived from the activity. The court also discounted the fact that the taxpayer reported that the activity had made a profit for three out of its five years, finding that it did not actually make a profit in two of those years and that it was questionable whether it actually did in the third.
Sec. 401: Qualified pension, profit-sharing, and stock bonus plans
The IRS on Aug. 30, 2017, issued News Release IR-2017-138 and Announcement 2017-11, which allowed 401(k) plans and similar employer-sponsored retirement plans to make loans and hardship distributions to victims of Hurricane Harvey and members of their families and relaxed procedural and administrative rules that normally apply to retirement plan loans and hardship distributions. On Sept. 12, 2017, the IRS issued News Release IR-2017-151 and Announcement 2017-13, providing similar relief for victims of Hurricane Irma. The relief applied to loans and hardship distributions made no later than Jan. 31, 2018.
Sec. 469: Passive activity losses and credits limited
IRS regrouping authority: In Hickam,20the Tax Court upheld the IRS's position that brokering real estate mortgages is not a real property trade or business under Sec. 469(c)(7)(C). The taxpayer worked as a mortgage broker as an employee for a company in which he held no ownership, and as an independent contractor for the years under audit (2011—2012). The taxpayer also managed three rental properties in California.
The taxpayer deducted his losses from the three properties on his returns for 2011 and 2012. The IRS disallowed those deductions, asserting that the taxpayer was not a real estate professional and, therefore, the losses were per se passive.
The taxpayer argued that the Tax Court should treat his mortgage brokerage services as performed in real property trades or businesses and that the hours he spent performing those services should be included in determining whether he met the real estate professional test. The court disagreed. The court found that the time spent as a mortgage broker did not constitute a real property trade or business activity, which is defined in Sec. 469(c)(7)(C): "any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business." The court stated that the mortgage brokering business related to loans, not to real property, so it was not a real property trade or business. Without including those hours, the court determined that the taxpayer did not qualify as a real estate professional, so the losses from his rental properties were per se passive.
Restricted stock ownership and real estate professional status: In Action on Decision (AOD) 2017-07, the IRS announced it will not follow the district court's holding in Stanley.21 In that case, the taxpayer husband had claimed that his participation in a real estate activity through a company in which he held at least 5% ownership qualified for purposes of Sec. 469, although his shares were restricted. The IRS argued unsuccessfully that since the shares were restricted and not treated as outstanding under Sec. 83, they did not constitute ownership under Sec. 469(c)(7)(D)(ii), and thus his work for the company could not be grouped with his real estate rental activity for purposes of determining material participation. The court held in favor of the taxpayers, noting that no authority allows applying Sec. 83 to the passive-activity rules of Sec. 469.
In the AOD, the IRS stated that the court also incorrectly held that the taxpayers in Stanley could group their aggregated rental real estate activity with other, nonrental trade or business activities under Regs. Sec. 1.469-4. According to the IRS, the court misinterpreted Regs. Sec. 1.469-9(e)(3)(i) and did not adequately reconcile its language with the language in Regs. Sec. 1.469-9(e)(1) and Sec. 469(c)(7)(A)(ii).
Real estate professional's expenses: In another case, the IRS challenged numerous items within the individual taxpayer's tax return. The crucial determination was whether the individual qualified as a real estate professional, which would allow her to offset her otherwise per se passive rental losses against her other ordinary income if she materially participated in the rental activities. After considering the strict requirements to be a qualified real estate professional in Sec. 469(c)(B)(7), the court found that she met the requirements.22 The court further found that she materially participated in the rental activities, so the activities were not passive activities and she could deduct the losses. However, the court sustained the IRS's disallowance of most of the taxpayer's claimed unreimbursed employee expenses for lack of substantiation.
Sec. 1001: Determination of amount of and recognition of gain or loss
The IRS ruled in Technical Advice Memorandum 201737011 that a taxpayer who was the CEO and majority shareholder of a self-clearing broker did not realize losses under Sec. 1001 upon transfer of securities from a hedge fund account to the taxpayer's personal trading accounts held at the broker. Although the broker had legal title to the trading account as well as the securities held in the account, the individual taxpayer had exclusive and complete discretion, voting power, and control over the investments in the trading account. Thus, the individual also possessed the economic benefits and burdens associated with the securities transferred to the trading account, and, consequently, the transfers were not sales.
Commission as capital expense: The Court of Federal Claims held that a commission paid by a taxpayer to exercise employer stock options and sell the stock in an initial public offering (IPO) was a capital expense and not an ordinary expense, as he claimed.23 The taxpayer claimed that the commission he paid the underwriters of the IPO was an ordinary expense, under four alternative theories: (1) The transaction was a single-step transaction (a cashless exercise); (2) he was entitled to reduce the amount realized when he paid the underwriters a commission under Sec. 83 or Sec. 1012; (3) the expense was an ordinary and necessary expenditure incurred in a trade or business; or (4) the substance of the transaction should be regarded over its form because he paid the commission to generate ordinary income.
The court concluded that the transaction consisted of two steps — the exercise of the options and then the sale of the stock received in the exercise — and that the commission on the sale of the stock was properly treated as a reduction of the amount received from the sale.
Regarding the taxpayer's arguments for ordinary expense treatment, the court found that although the two steps were executed simultaneously, this did not affect their treatment as separate transactions. The court also found that the exercise was not subject to Sec. 83 or Sec. 1012 because the taxpayer could have exercised his options without paying the commission to the underwriters. The court rejected the argument that the commission was a business expense, as the taxpayer was not in the trade or business of selling securities but was in the trade or business of being an employee. It rejected the taxpayer's substance-over-form claim, because this theory focused only on the exercise of the options, which resulted in ordinary income, and ignored the second step of selling the shares, which resulted in a capital gain.