Developments in individual taxation.

• Author: Baldwin, David R.

This article is a semiannual review of recent developments in the area of individual federal taxation. It covers cases, rulings, and guidance on a variety of topics issued during the six months ending November 2020. The items are arranged in Code section order.

Sec. 1: Tax imposed

The IRS issued Rev. Proc. 2020-45, which provides the 2021 dollar amounts for most Code sections that are adjusted annually by inflation. In addition to the updated tax rate tables, new figures are added for the kiddie tax, capital gains rate, adoption credit, child tax credit, lifetime learning credit, and earned income tax credit. The revenue procedure also takes into account increased penalties in the SECURE Act, (1) the updated estate tax exclusion amount, and many other figures.

Sec. 24: Child tax credit

Credit applies to qualifying relative: Under the law known as the Tax Cuts and Jobs Act (TCJA), (2) Sec. 24 was amended to temporarily provide for a $500 nonrefundable credit for qualifying dependents other than qualifying children. Proposed regulations were published in June 2020 and finalized in October 2020. (3) The regulations clarify an issue raised regarding a statutory cross-reference in Sec. 24(h)(4) to "a qualifying child described in subsection (c)."The regulations clarify (in Regs. Sec. 1.24-1) that the statutory cross-reference is a reference to the definition of qualifying child in Sec. 24(c), rather than the definition of qualifying child in Sec. 152(c).

Child must be a qualifying child:

In Bethune, the Tax Court denied the child tax credit the noncustodial parent claimed for her two children because Form 8332, Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent, was not attached to her return. She relied on the divorce agreement's indication that she could claim the exemption. Although her husband signed the form shortly before she filed her petition in Tax Court, he had claimed the children on his return. Without Form 8332's being attached to her return, neither child was considered qualifying.

A similar result was reached in Bidzimou. (5) The taxpayer was the noncustodial parent who was awarded tax exemptions by the divorce settlement but did not obtain Form 8332.

Sec. 32: Earned income tax credit

Qualifying children: In Brzyski, (6) the Tax Court denied the taxpayer the earned income tax credit (EITC). For purposes of the credit, he claimed as qualifying children his fiancee's children. He claimed to have married the fiancee over dinner in Kansas, a state that allows common law marriage, unlike Missouri and California--the two states where the taxpayer resided. The court found that the children were not qualifying children of the taxpayer and, in addition, it found he was not entitled to the credit as a taxpayer without qualifying children because his earned income exceeded the phaseout threshold for a credit for that status.

Sec. 36B: Premium tax credit

Final regulations: The IRS released final regulations (7) under Secs. 36B and 6011 that clarify that the TCJA's elimination of the personal exemption does not affect one's ability to claim the premium tax credit. The guidance in Notice 2018-84 was incorporated in the final regulations. Proposed regulations issued in May 2020 were not changed. (8)

2021 inflation adjustments: The IRS issued Rev. Proc. 2020-36 with indexing adjustments for some provisions of the premium tax credit. The applicable percentage table and required contribution percentage (now 9.83%) were updated by this revenue procedure, effective for plan years beginning in 2021.

Excess advance premium tax credits: In Abrego, (9) the taxpayers purchased medical insurance because they expected a refund due to the premium tax credit although they were eligible for Medicare. Their tax return was delinquent and did not include Form 8962, Premium Tax Credit, or claim a deduction for self-employed medical insurance premiums. The IRS determined that the taxpayers were not entitled to a premium tax credit and were thus required to pay back the entire advance premium tax credit they received.

The court allowed the taxpayers to apply the self-employed medical insurance deduction to the premium tax credit, which reduced the taxpayers' household income below 400% of the federal poverty line (398%). Therefore, they were entitled to a portion of the premium tax credit claimed on their original tax return. While the excess advance premium tax credit they received was calculated by the court to be almost $3,400, it held they were only required to pay back $2,500 of the excess because their household income was more than 300% but less than 400% of the applicable federal poverty line.

Sec. 61: Gross income defined

Leave-based donation program under COVID-19 pandemic: In Notice 2020-46, the IRS provided guidance on payments under an employer leave-based donation program to aid victims of the ongoing COVID-19 pandemic. Generally, under a leave-based donation program, an employee may choose to forgo his or her vacation, sick, or personal leave to allow his or her employer to make a cash payment to a Sec. 170(c) organization and have that amount excluded from his or her gross income. Employees electing to exclude the income may not claim a Sec. 170 charitable deduction for the value of the leave. Employers that make those cash payments may deduct them as either Sec. 170 charitable contributions or Sec. 162 business expenses, depending on whether they otherwise meet the requirements of those sections.

In response to the COVID-19 pandemic, employer payments under a leave-based donation program may be excluded from employees'gross income if they are (1) made to the Sec. 170(c) organization for the relief of victims of the COVID-19 pandemic in the affected geographic area and (2) paid to the Sec. 170(c) organizations before Jan. 1, 2021.

Income received considered compensation, not a loan: In Novoselsky, (10) the Tax Court upheld the IRS's determination that upfront "litigation support" payments the taxpayer, a class action litigation attorney, received were includible in his gross income. The taxpayer argued that the payments were nontaxable loans because he was obligated to repay them out of his attorney's fees award if the litigation was successful.

The IRS argued, and the Tax Court agreed, that since the taxpayer had no obligation to pay counterparties anything if the litigation were unsuccessful, he did not have an unconditional obligation to repay the amounts paid to him, and therefore the payments could not be classified as a loan. Instead, the payments were compensation for services expected to be rendered. Furthermore, the classification of the payments as a loan failed under the multifactor test because the parties did not treat the payments as loans and there was no formal promissory note, fixed repayment schedule, stated interest rate, collateral or security, or payment of principal or interest.

Sec. 67: 2% floor on miscellaneous itemized deductions

In McKenny, (11) the court dealt with whether legal fees incurred by the taxpayer were a business deduction or a miscellaneous itemized deduction. The legal fees were related to the taxpayer's malpractice lawsuit against his accountant arising out of advice regarding structuring his business as an S corporation. To determine the proper characterization of the expenses, the court applied the origin-of-the-claim doctrine, under which the characterization of an expense is determined by reference to "the origin and character of the claim with respect to which an expense was incurred."

Though the court noted that the lawsuit was "related to" and "regarding" the business operations, it determined that the lawsuit was personal in character and origin since the taxpayer brought the suit, not the business, and the malpractice claim alleged malpractice as to the services provided to the taxpayer, not the business. In short, the court stated, the lawsuit's main contention was that the accountant failed to help the taxpayer reduce his personal tax liability, not that the accountant failed to adequately support the business's income-producing activities. As personal expenses of the taxpayer, the legal expenses were miscellaneous itemized deductions deductible to the extent that they exceeded 2% of the taxpayer's adjusted gross income (AGI).

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

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