This article covers recent developments in individual taxation. The items are arranged in Code section order.
Sec. 23: Adoption Expenses
In Field, (1) an adoption expense credit was denied to a taxpayer who filed her return using married-filing-separate status. The taxpayer claimed that the denial of the credit was unconstitutional. The Tax Court upheld the joint filing requirement for purposes of the adoption credit as valid under the Equal Protection Clause of the Constitution. It did not matter that the taxpayer had adopted the children before she married and her husband did not adopt them. Generally, if a taxpayer is married at the end of a tax year, the credit can only be claimed if the taxpayer and his or her spouse file a joint tax return.
Sec. 68: Overall Limitation on Itemized Deductions
The American Taxpayer Relief Act of 2012 (2) restored a limitation on itemized deductions, but with new thresholds for when the limitation applies. For 2013, the adjusted gross income (AGI) thresholds are $250,000 for single filers, $300,000 for married couples filing jointly, and $275,000 for filers using the head-of-household status. These amounts will be adjusted for inflation in subsequent years, (3)
President Barack Obama's fiscal year 2014 budget proposal (4) includes an expansion of the limitation on itemized deductions for higher-income individuals. This proposal would cap the tax benefit of itemized deductions to 28% of their amount. This cap would also apply to other specified deductions (such as moving expenses), as well as certain exclusions (such as tax-exempt bond interest and employer-provided health insurance).
Sec. 104: Compensation for Injuries or Sickness
Scott (5) involved the question of how much of a firefighter's pension was taxable when his retirement was due to a service disability. The taxpayer was injured on the job when he had more than 36 years of service and was entitled to pension payments. His monthly retirement pension amount was $9,913, and his disability pension was $5,148. He was entitled to collect only the higher amount. In 2006, the payor of the pension reported to the taxpayer and IRS that the difference between these two amounts, $4,765 per month, was taxable (for the year, the reported taxable amount was $61,430). The taxpayer originally reported that amount on his return but then filed an amended return seeking a refund on the position that, because he retired due to a permanent service-connected disability, none of the pension income was taxable under Sec. 104 and Regs. Sec. 1.104-1(b).
The government relied on Rev. Rul. 80-44, (6) which holds that if a person is entitled to receive the greater of a service pension or a service-connected disability pension and the service pension is greater, the difference between the two amounts is taxable. The district court agreed with this interpretation.
The court found that the taxpayer's reliance on the Ninth Circuit's decision in Picard (7) was misplaced. In that case, a police officer's disability pay was reduced when he later qualified for retirement pay. In this case, the taxpayer's retirement pay was greater than his disability pay. Thus, the court held, there was no "conversion" of the disability pay into regular retirement pay. The court noted that the taxpayer "receives a portion of both pensions--at least for federal income tax purposes."
In Smallwood, (8) the taxpayer received $995,000 to settle her legal complaint alleging workplace race and gender discrimination and related claims. She paid tax on the award less the contingent fee paid to her attorney (almost 50%), but then sought a refund, claiming that the award was excludable under Sec. 104. At issue was whether the award was received for personal injuries.
The court noted that under Sec. 104(a)(2), damages received for emotional distress are excludable only if the distress is due to physical injury or physical sickness or to the extent the damages do not exceed medical costs attributable to the emotional distress. The court had to determine whether the payments to the taxpayer were intended to compensate her for physical injuries, noting that a settlement agreement is important in making this determination. If the agreement is not specific, a court next looks to the payor's intent.
In case pleadings, the taxpayer stated that she developed "Hashimoto's autoimmune disease" due to the stress, as well as a number of other ailments, including vertigo, vomiting, and low blood pressure, that required hospitalization and medication. Based on the evidence presented, the court found that whether any portion of the settlement payment was intended to be for physical injuries or physical sickness was a genuine issue of material fact. However, it held that she could not prevail, as a matter of law, because her complaint did not extensively concern physical injuries or sickness.
Sec. 108: Income From Discharge of Indebtedness
Under Secs. 108(a)(1)(E) and (h), discharge-of-indebtedness income from qualified principal residence debt of up to $2 million ($1 million for married taxpayers filing separately) is excluded from gross income. The American Taxpayer Relief Act of 2012 extended this exclusion to qualified principal residence debt discharged before Jan. 1, 2014.
In Rev. Proc. 2013-16, (9) the IRS provided guidance for homeowners participating in the Home Affordable Modification Program's Principal Reduction Alternative (HAMP PRA). To the extent that a borrower under HAMP PRA uses a property as his or her principal residence or the property is occupied by the borrower's legal dependent, parent, or grandparent without rent being charged or collected, the borrower can exclude from gross income under the general welfare exclusion the PRA payments HAMP makes to the investor in a mortgage loan. But the borrower must include these payments in gross income to the extent the property is used as a rental property or is vacant and available to rent.
Sec, 117: Qualified Scholarships
A series of IRS letter rulings (10) examined exempt private foundations' grant-making procedures for providing scholarships to dependent children of employees of a specified company or other eligible student recipients. The IRS found that the awards constituted qualified scholarships within the meaning of Sec. 117 and were excludable from the gross income of the recipients, subject to the limitations in Sec. 117(b).
Sec. 121: Exclusion of Gain From Sale of Principal Residence
The IRS issued proposed regulations (along with FAQs) (11) that include guidance on the interplay of the new 3.8% surtax on net investment income and gains imposed by Sec. 1411 and the exclusion of gain from the sale of a principal residence under Sec. 121 (up to $250,000 for a single taxpayer and $500,000 for married taxpayers filing jointly). Gain on a post-2012 sale of a principal residence in excess of the excluded amount increases net investment income for purposes of the 3.8% surtax and net capital gain under the general tax rules. This excess gain thus could be subject to the net investment income tax imposed by Sec. 1411. The entire gain on the sale of a home not covered by this exclusion (e.g., a second home) could be entirely includible in net investment income.
Sec. 152: Dependent Defined
In a Tax Court case, (12) the IRS challenged a dependency exemption, child tax credit, and an additional earned income tax credit that a taxpayer claimed for 2008 with respect to the infant son of his half-brother. The child lived with the taxpayer more than one-half of 2008, during which the taxpayer contributed $150 per month for food, diapers, clothing, and shoes for the child. The taxpayer's total income for the year was $9,559.
The court held that the taxpayer's nephew was not a qualifying relative of the taxpayer under Sec. 152(d), but the nephew was the taxpayer's qualifying child under Sec. 152(c). Therefore, the taxpayer was entitled to the dependency exemption deduction and the credits. A qualifying child is an individual who: (1) bears a specified relationship to the taxpayer, (2) shares the same abode for more than half the tax year, (3) meets the specific age requirement, and (4) does not provide over one-half of his or her own support. The court rejected the IRS's position that the child did not live with the taxpayer at least half the year because it was based only on an informal statement the taxpayer made to an unidentified IRS representative and was rebutted by the taxpayer's statements on multiple other occasions. The IRS also argued that the taxpayer was not the correct person to take the dependency exemption deduction under the Sec. 152(c)(4) tie-breaker rules, but the Tax Court found that the taxpayer was the only person who qualified to take the dependency exemption deduction, so the tie-breaker rules did not apply.
Practice tip: This case provides two key points in tax planning. First, the requirements for a qualifying relative versus a qualifying child are different. It is important to ask about the relationship of all household members before determining who may take an exemption. Second, proper documentation of financial support should be maintained in case a dependency issue ever comes into question.
In Begay, (13) the taxpayer was a tribal elder of the Navajo Nation and claimed a dependency exemption, head-of-house-hold filing status, an earned income tax credit, and a child tax credit for a "clan relative," claiming the child as a "nephew" on her 2009 tax return, even though the child was not related to her in any of the ways specified for a qualifying child under Sec. 152(c)(2) or for a qualifying relative under Secs. 152(d)(2)(A) through (G). Originally, the IRS sent a notice of deficiency that disallowed the dependency exemption, but after review, the IRS conceded that the taxpayer did satisfy the requirements for the dependency exemption because the child was her qualifying...