Current developments in taxation of individuals.

• Author: Baldwin, David R.

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 December 2021. The update was written by members of the AICPA Individual & Self-Employed Tax Technical Resource Panel. The items are arranged in Code section order.

Sec. 24: Child tax credit

The IRS updated its frequently asked questions (FAQs) regarding the child tax credit, (1) listing all prior FAQs by date issued as well as adding new ones dated Oct. 4, 2021, and Nov. 8, 2021. The IRS explained that FAQs will not be relied on by the IRS to resolve a case because they are not published in the Internal Revenue Bulletin, but a taxpayer who reasonably relies on the FAQs will have a defense to penalties. One of the latest FAQs as of this writing is Q-A17, which explains the procedure for updating the IRS when 2021 income will be significantly different from 2020's.

Sec. 32: Earned income tax credit

In Griffin, (2) the Tax Court allowed an aunt to claim the earned income tax credit (EITC) for her niece and two nephews. The court went through the requirements for dependency and determined that each of the children was a qualifying child, then looked at the tests for the child tax credit and the EITC. The IRS had disallowed the credits because the children resided at times with their father and the aunt did not meet the residency requirement. The court found that the evidence, including the testimony of the aunt, showed the children stayed with the aunt at her home more than half of the tax year.

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

Household income for advance premium tax credit (APTC): In Knox, (3) the taxpayers omitted Form 8962, Premium Tax Credit, to reconcile payments of the APTC. Their income included lump-sum Social Security benefits from two prior years, and they elected under Sec. 86(e) to limit the amount they included in gross income to the sum of the increases in gross income that would have resulted if the income had been taken into account in the prior tax years to which it was attributable. The Tax Court, following its decisions in Johnson (4) and other prior cases, found that the Sec. 86(e) election does not reduce modified adjusted gross income (MAGI) for the APTC. In the taxpayers' case, including the lump-sum Social Security payments attributable in the prior years put them over 400% of the federal poverty line, and thus the taxpayers were required to repay the excess credits they received.

Constitutionality: In Amburgey, (5) the taxpayers were relying on the Texas (6) case that held the Patient Protection and Affordable Care Act (7) unconstitutional, to excuse them from having to pay back the APTC they had received. The Tax Court found that the Fifth Circuit's reasoning in Texas did not apply in the taxpayer's case and further that the judgment of the Fifth Circuit in that case was vacated by the U.S. Supreme Court in June 2021. (8) Thus, because their adjusted gross income (AGI) was more than 400% of the federal poverty line, the taxpayers had to pay back the APTC of over $15,000.

Failure to maintain essential health care coverage: An attorney sued both the Treasury Department and Treasury Secretary Janet Yellen on the basis that the government does not have the power to require citizens to pay a tax if they do not have essential health care coverage. The Second Circuit affirmed a New York district court in saying that the plaintiff lacked standing to sue. He failed to demonstrate that he had suffered a legal injury because he actually had essential health care coverage and failed to show how he would be penalized for failing to disclose the coverage to the IRS on his return. (9)

Sec. 61: Gross income defned

2020 unemployment benefits exclusion: After announcing the plan in a June 2021 news release,10 the IRS sent more than 8.7 million refunds to identified taxpayers who had paid taxes on unemployment compensation that, under the American Rescue Plan Act (ARPA), (11) was excluded from income.

In addition to screening returns to identify those eligible to exclude up to $10,200 of unemployment compensation benefits, the IRS also identified and corrected returns that would be eligible for the EITC, premium tax credit, and recovery rebate credit based upon excluding up to $10,200 of the allotted unemployment income. For further discussion of this topic, see Sec. 85, below.

Unreported income--settlements of attorney malpractice: In Holliday (12) (also discussed below under Sec. 1041), the Tax Court upheld the IRS's determination that the petitioner failed to report income received from a lawsuit settlement, which, in fact, was related to a second lawsuit. One of the petitioner's two lawsuits was related to her divorce and the other was a malpractice lawsuit against her divorce attorney.

The petitioner's former spouse filed for divorce in March 2010. As part of the divorce proceedings, the petitioner participated in, and settled through, a mediation process. During the mediation process, the petitioner objected to the mediated settlement agreement; however, her objections were not sustained by the divorce court. In May 2012, following the agreed final decree that was entered in April 2012, the taxpayer's attorney filed for a new trial requesting an additional settlement, stating that she received less than her equal share. The motion for a new trial was denied, and the taxpayer's attorney was supposed to file for an appeal but failed to do so.

In October 2013, the taxpayer filed a malpractice lawsuit against her divorce attorney, accusing him of negligence and gross negligence and seeking, among other things, damages for "pecuniary and compensatory losses," including "damages for the past and future mental anguish, suffering, stress, anxiety, humiliation, and loss of ability to enjoy life." In October 2014, the defendant and her divorce lawyer entered into a settlement agreement of $175,000. Of this amount, the taxpayer's malpractice attorney scooped up $73,500.

Upon filing her 2014 Form 1040, U.S. Individual Income Tax Return, the taxpayer reported no "Other income" on line 21. In a "Line 21 statement" she listed the $101,500 of settlement income from the malpractice suit but offset the income by subtracting the same amount with the description "Misclassification of lawsuit recovery of marital assets." The IRS issued a notice of deficiency for tax on $101,500 but later amended the claim for tax on the entire $175,000.

The taxpayer argued that the settlement proceeds were a nontaxable return of capital because they compensated her for the portion of her marital estate that she "was rightfully and legally entitled to, but did not receive, due to the legal malpractice of " her divorce attorney. The IRS argued and the Tax Court agreed that the settlement proceeds were clearly from a settlement agreement in lieu of damages for legal malpractice and were, therefore, taxable. In addition, the income to be included was to be grossed up by the legal fee that her malpractice attorney was paid, and such legal fee was to be deducted on Schedule A, Itemized Deductions, not netted against the settlement proceeds received.

Wages--frivolous claims sanctions: In Muhammad, (13) the Tax Court upheld the IRS's determination that the petitioner incorrectly and frivolously excluded her wages from her Form 1040.

During 2016, the petitioner was employed by a university and earned wages in the amount of $48,535. In addition to her wages, she had a federal income tax of $1,770, Social Security tax of $3,009, and Medicare tax of $703. The wages and all withholdings were reported on Form W-2, Wage and Tax Statement.

The petitioner filed a Form 1040-EZ, Income Tax Return for Single and Joint Filers With No Dependents, f o r the 2016 tax year, at which point she did not include the Form W-2 with her return and instead filed a Form 4852, Substitute for Form W-2, Wage and Tax Statement, reporting $0 wages and all the listed withholding, ultimately resulting in a refund of all withholding, less the $2 tax liability she reported on her tax return.

The petitioner received a deficiency notice in which the IRS adjusted her income to include all of her wage income, resulting in a tax deficiency, and imposed an accuracy-related penalty. The taxpayer challenged the IRS's determinations in Tax Court arguing that the income she received was not categorized or taxed as "wages" since she did not engage in the "exercise of Federal privileges."

Noting that this was a timeworn tax protester argument relying on a misreading of Sec. 3401(c), which no court had ever accepted, the court upheld the IRS's determinations. Because the argument was frivolous, and the court had repeatedly informed the taxpayer that it was, the Tax Court concluded that a Sec. 6673 frivolous position penalty was appropriate. However, because the taxpayer testified that she was unemployed and the Sec. 6673 penalty would cause her hardship, the Tax Court imposed a penalty of only $250.

Secs. 67 and 212: 2% foor on miscellaneous itemized deductions

In Monroe...