Directions in individual taxation.

Author:Baldwin, David R.


* A survey of recent court decisions and guidance can help keep practitioners' awareness current regarding common issues arising in individual income tax returns.

* As cases discussed in this article demonstrate, practitioners should be well-versed in the requirements to establish that a taxpayer materially participated in an activity.

* Whether support payments qualified as deductible alimony and whether distributions from individual retirement accounts and qualified plans were subject to tax continued to be frequent subjects of litigation.

This article covers recent developments in the area of individual taxation, including the treatment of support payments and IRA and qualified plan distributions, the Sec. 469 material participation rules, and the taxability of state economic development credits. The items are arranged in Code section order.

Sec. 48: Energy Credit

A reflective roof can qualify for the solar energy credit to the extent that the reflective roof's cost exceeds a standard roof's cost, according to IRS private rulings. (1)

Sec. 61: Gross Income Defined

The Tax Court in Shah (2) upheld the IRS's determinations after examination that the taxpayers were not entitled to various expenses deducted on their personal and corporate returns since they failed to substantiate the amounts and/or their business purpose and to establish a profit motive. In addition, the Tax Court found that the bank deposits method used to reconstruct the corporation's income was an acceptable method to determine income that the corporation had failed to report.

In another case, the Tax Court held that a physician received cancellation-of-debt (COD) income from forgiveness of a loan he received as part of a recruiting agreement with a rural hospital. (3)

Sec. 66: Treatment of Community Income

The Tax Court in Mottahedeh (4) held that the IRS used a permissible method of reconstructing the married taxpayers' unreported income and properly treated this income as community property attributable one-half each to the husband and the wife. The taxpayers operated a business that taught tax-evasion techniques, which they applied to their own financial situation by having customers pay cash, avoiding banks, and not keeping financial records or filing tax returns. The Tax Court found that the IRS's reconstruction of the taxpayers' taxable income through its investigation of their business and reliance on average spending statistics from the U.S. Bureau of Labor Statistics was valid and that the business was a joint effort between both spouses. Thus, the income from the business was held to be community property.

The Ninth Circuit held that the Tax Court in Hiramanek (5) properly determined that a former spouse was not jointly and severally liable for a tax deficiency since she signed a joint tax return under duress, based on the former spouse's testimony at trial. The Ninth Circuit agreed with the Tax Court that she was entitled to equitable relief under Sec. 66(c) because equitable relief resulting from the operation of a community property law may be available, even if the requirements for traditional relief are not satisfied, when it would be inequitable to hold the requesting spouse liable for the unpaid tax or deficiency.

Sec. 67: 2% Floor on Miscellaneous Itemized Deductions

In Peterson, (6) the Tax Court held that a police officer improperly deducted unreimbursed business expenses on Schedule A, Itemized Deductions, of his tax return. Under Sec. 67(a), miscellaneous itemized deductions are allowed only to the extent they exceed 2% of adjusted gross income. Moreover, to be deductible as unreimbursed employee business expenses, the expenses must be incurred through the performance of services as an employee, and the taxpayer must not have the right to reimbursement for such expenses from his or her employer. The court found that the taxpayer failed to prove he met these requirements.

Sec. 71: Alimony and Separate Maintenance Payments

The Tax Court disallowed an alimony deduction for spousal maintenance payments that were based on a contingency related to a child's living with the taxpayer's ex-wife. (7) The divorce instrument contained a provision that allowed for maintenance to be paid to the taxpayer's ex-wife in the form of mortgage payments on the marital residence until either the mortgage was paid off or the oldest child no longer resided with the ex-spouse in the marital residence. Since this event was a contingency relating to the child of the payer spouse, under Sec. 71(c)(2), the amount of maintenance payments had to be treated as fixed by the divorce instrument as child support and not deductible as alimony.

In Hampers, (8) the Tax Court determined that a taxpayer was not entitled to an alimony deduction for payment of his ex-wife's current attorney's fees as required by their divorce decree, which also obligated him to pay her future attorney's fees. The divorce decree was silent regarding termination of the payments upon the death of the payee spouse, and state law was not clear on the issue, so the court held that the requirements of Sec. 71(b)(1)(D) were not met. Therefore, the payments were not alimony.

In another case, the Tax Court determined that a taxpayer was not entitled to an alimony deduction for 2006 although he made significant support payments to his wife during the year. (9) Although their divorce was finalized during 2006, there was no separation agreement with an alimony provision before the divorce was finalized, and the 2006 final divorce decree was not amended to include an alimony provision until 2007. Thus, because none of the 2006 support payments were made under a qualifying agreement, the court held that the payments did not constitute alimony under Sec. 71(b)(1)(A).

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

In McKnight, (10) the Tax Court approved the IRS's imposition of the 10% additional tax imposed under Sec. 72(t) against a taxpayer who received a distribution from a retirement plan before age 59%. The court found that the taxpayer failed to prove that any exception applied to this distribution, and he was unable to produce documentation to support his claim that he rolled over a portion of the distribution into another qualified plan within 60 days of receiving it.

The Tax Court in El (11) determined that a portion of the taxpayer's loan from his qualified plan constituted a deemed distribution. The court found that it was taxable under Sec. 72(p)(2)(A)(ii) because the outstanding loan balance in the taxpayer's account was more than the greater of one-half of his nonforfeitable accrued benefit or $10,000. The Tax Court also concluded that the deemed distribution was subject to the additional 10% tax imposed under Sec. 72(t).

The taxpayer in Morles (12) took a withdrawal from his qualified plan before age 59% and used the distribution to pay rent to prevent eviction. He claimed the distribution was excluded from income because he took it due to economic hardship. The Tax Court held the IRS had properly determined that it was a taxable distribution subject to a 10% early-withdrawal tax under Sec. 72(t) because there is no exclusion under that subsection for economic hardship.

The taxpayer also took a distribution from an IRA that he failed to include in his income. While he claimed the amount of this distribution was funded by a nondeductible IRA contribution, he had never reported the contribution as such on Form 8606, Nondeductible IRAs. Even though the taxpayer did not comply with the reporting requirements, the court held that he was allowed to consider the nondeductible contribution as his investment in the contract. However, the court held that only part of the IRA distribution amount was nontaxable as an investment in the contract, noting that Sec. 72(e)(3) requires an IRA distribution to be allocated between taxable income and investment in the contract pursuant to a formula.

In Letter Ruling 201510060, a taxpayer was receiving a series of substantially equal periodic payments from her IRA. The acquisition of the entity holding her IRA account by another entity resulted in the distribution of two additional payments to her in the year of acquisition from the IRA, in violation of her direction. The taxpayer claimed in her ruling request that she did not intend to modify the series of substantially equal periodic payments and had no reason to believe the financial institution would make the two additional distributions. She also provided a document from the entity that confirmed that the two additional payments were made due to the acquisition. The IRS ruled that the additional distributions were made in error and should not be considered a modification of a series of substantially equal periodic payments under Sec. 72(t) (4) and thus were not subject to the 10% additional tax on early distributions.

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

The taxpayer in Brinkley (13) took the position that income he received as a result of a merger of his employer with another corporation and that was reported to him as ordinary compensation income was derived wholly from the sale of his stock in the employer and qualified for long-term capital gain treatment. The IRS acknowledged that the Sec. 83(b) election filed by the taxpayer permitted subsequent appreciation in the stock to be taxed as capital gain and that any gain recognized from the exchange of stock for consideration in the acquisition was capital. The IRS argued, however, that the taxpayer's merger-based income in excess of the determined value of his stock was taxable as ordinary income. The Tax Court held that under the merger agreement that the taxpayer signed, the income at issue was deferred compensation that was taxable as ordinary income.

Sec. 86: Social Security and Tier 1 Railroad Retirement Benefits

The taxpayers in McCarthy (14)...

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