Current developments in taxation of individuals.

• Author: Baldwin, David R.

EXECUTIVE SUMMARY

* Proposed regulations would eliminate the requirement to include a copy of a Sec. 83(b) election with a taxpayer's return.

* The IRS issued final regulations that provide rules regarding the term "taxpayer" for purposes of applying the exclusion from gross income of cancellation-of-debt income of a grantor trust or a disregarded entity.

* The IRS acquiesced to the Ninth Circuit's Voss decision, in which the court held that the Sec. 163(h)(3) mortgage deduction limits apply on a per-individual basis.

* Rev. Proc. 2016-53 extended the time in which taxpayers in disaster areas can elect to claim casualty losses on their tax return for the year preceding the disaster year.

* The IRS ruled that the unexpected birth of a child counted as an unforeseen circumstance, which allowed the taxpayers to exclude gain from the sale of their principal residence without meeting the normal two-out-of-five-year requirement.

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This article covers recent developments in the area of individual taxation, including cases involving trade or business expenses; proposed regulations on the Sec. 83(b) election; IRS acquiescence in a case involving mortgage deductions; and a taxpayer-friendly ruling on unforeseen circumstances and the sale of a principal residence. The items are arranged in Code section order.

Sec. 36B: Refundable Credit for Coverage Under a Qualified Health Plan

In the case U.S. House of Representatives v. Burwell, (1) the U.S. House of Representatives sued the secretary of the Health and Human Services Department for violating Article 1, Section 9, Clause 7, of the U.S. Constitution by spending monies not approved by Congress when the Patient Protection and Affordable Care Act (PPACA) was passed in 2010. (2) This case involves Sections 1401 and 1402 of PPACA. Section 1401 provides tax credits to make insurance premiums affordable (it enacted Sec. 36B, the premium tax credit) and was funded by adding it to the list of permanently appropriated tax credits and refunds in PPACA. Section 1402 reduces deductibles, co-pays, and other means of "cost sharing" by insurers and was not funded in PPACA.

The question before the court was whether Section 1402 can be funded through the same permanent appropriation as Section 1401. The District Court for the District of Columbia ruled that there was no justification for funding Section 1402 reimbursements through the same permanent appropriation as funded Section 1401 and therefore prevented the use of unappropriated monies to fund reimbursements under Section 1402. The court also issued an injunction enjoining any further reimbursements under Section 1402 until a valid appropriation was in place, but stayed the injunction pending any appeal.

Sec. 61 : Gross Income Defined

Dynasty trust's life insurance contract: In Estate of Morrissette, (3) the Tax Court ruled that because a dynasty trust received no additional benefit beyond that of the current life insurance protection, the trust was the deemed owner of the life insurance contract. As a result, the economic benefit regime applies to the split-dollar life insurance arrangements.

In this case, the decedent created dynasty trusts benefiting her three sons and their respective families. A buy-sell agreement was then entered into that provided that, upon the death of a son, the surviving sons and their dynasty trusts would purchase the deceased sons interest in a family company. As part of this agreement, the dynasty trusts and the decedent's revocable trust entered into a split-dollar life insurance arrangement.

The court ruled that as the dynasty trusts had no current or future access to the cash value of the policies and no economic benefit beyond current life insurance protection that was provided, the revocable trust was the deemed owner of the policies and thus the economic benefit regime was appropriately applied to value the decedent's gifts to the dynasty trusts.

Settlement proceeds: The IRS announced (4) that it disagreed with the Tax Court in Cosentino, (5) in which the court concluded the settlement proceeds the taxpayers received from their accounting firm were excludable from gross income. The taxpayers held an interest in a partnership and, on the advice of their accounting firm, entered into an abusive tax shelter to artificially increase their basis in the partnership. They later disposed of their interest in the partnership in a like-kind exchange and recognized a small gain, although none of the deferred gain was recognized. Upon learning that the transaction was an abusive tax shelter, the taxpayers filed an amended return to report their participation in the tax shelter and sued their accounting firm.

The Tax Court held that the settlement proceeds received from the lawsuit were not required to be reported as gross income as they were excludable from income because the proceeds represented a return of lost capital.

In its nonacquiescence, the IRS explained that it believed the settlement proceeds the taxpayers received were compensation from the accounting firm for a portion of the federal income tax the taxpayers owed, not a restoration of. lost capital. As a result, the IRS believed the settlement proceeds should be included in the taxpayers' gross income.

Sec. 71: Alimony and Separate Maintenance Payments

Among other issues, the Leslie (6) case addressed whether a taxpayer must report as alimony income received from her ex-husband under a marital settlement agreement (MSA). The MSA gave the taxpayer the right to 10% of any fee her former husband, an attorney, received for representing a certain client. The Tax Court concluded that this payment was in fact alimony since, under California law, the payments would have terminated upon the taxpayer's death. Accordingly, the court ruled the payment constituted alimony rather than a property settlement.

While the taxpayer was entitled to the alimony payment in the year the IRS claimed, she was not required to report the alimony until the subsequent year. For the year under review, the taxpayer's former spouse deposited the funds into an account that the taxpayer did not open herself. As the taxpayer was not aware of the funds deposited, had no control of the funds, and did not have constructive receipt of the funds, the alimony was not reportable until the subsequent year when the taxpayer in fact became aware of the funds.

Sec. 72: Annuities; Certain Proceeds of Endowment and Life Insurance Contracts

In IRS Letter Ruling 201625001, the taxpayer, who intended to roll over a distribution from Annuity 1 into Annuity 2, instead mistakenly had the funds deposited into his checking account. The taxpayer later contributed the erroneously distributed funds to Annuity 2. The taxpayer requested a ruling from the IRS that the transaction be treated as a tax-deferred exchange under Sec. 1035(a)(3). The IRS ruled that the transaction did not qualify as an exchange and was taxable in the year the proceeds were received.

Sec. 83: Property Transferred in Connection With Performance of Services

The IRS issued final regulations, (7) applicable to property transferred on or after Jan. 1, 2016, that eliminate the requirement that a copy of a taxpayer's Sec. 83(b) election be attached to and submitted with the taxpayer's individual return for the year in which the election is made.

When an individual is compensated with property for services he or she has performed, the difference between the fair market value (FMV) of the property and the amount paid for the property is included in the individual's income in the tax year his or her right to the property is transferable or no longer subject to a substantial risk of forfeiture. If the individual files an election under Sec. 83(b) no later than 30 days after the date the property is transferred, he or she instead includes the property's FMV in income at the time of the transfer.

Before the IRS issued this regulation, taxpayers were required to attach their Sec. 83(b) elections to their individual income tax returns, which the IRS learned many taxpayers wishing to e-file were unable to do because commercial tax software did not always permit a copy of the election to be attached to the e-filed return. To address this problem, the regulations eliminate the requirement that a taxpayer submit a copy of the election with his or her tax return. The taxpayer must still file an Sec. 83(b) election with the IRS no later than 30 days after the date that the property is transferred to the taxpayer.

Sec. 104: Compensation for Injuries or Sickness

A number of taxpayers were denied exclusion under Sec. 104 for damages paid that were not related to personal physical injury or personal sickness. In Braddock, (8) the payment by a long-term care company to avoid the cost of litigation did not qualify as a claim for personal injuries or sickness. In Tritz, (9) the district court ruled in summary judgment that the payments received were for emotional distress and not physical injury or sickness. In George, (10) the Tax Court ruled that payments for workplace discrimination were not excludable under Sec. 104 as they were not related to physical injury or sickness.

Sec. 108: Cancellation of Debt

Definition of "taxpayer": The IRS issued final regulations defining a "taxpayer" for the purpose of excluding cancellation-of-debt (COD) income for bankruptcy and insolvency purposes under Sec. 108 for a grantor trust or disregarded entity. (11) The final regulations are substantially similar to the proposed regulations issued in 2011. For the bankruptcy or insolvency exclusion to apply, the owner of the grantor trust or the disregarded entity must be under the jurisdiction of a court in a Title 11 case. It is not sufficient for the grantor trust or disregarded entity to be in Tide 11 bankruptcy while the owner is solvent.

Bank overdraft: In Newman, (12) the Tax Court ruled that a taxpayer could exclude COD income due to an...