Individual taxation developments.

• Author: Cook, Ellen

This article covers recent developments affecting individual taxation. The items are arranged in Code section order.

Sec. 1: Tax Imposed

Notice 2011-64, (1) which amplifies and supersedes Notice 2006-101, (2) updates the list of U.S. tax treaties that meet the requirements for obtaining reduced capital gains rates under Sec. l(h)(1l)(C)(i)(II) on some dividend payments, as provided for under the Jobs and Growth Tax Relief Reconciliation Act of 2003. (3)

Sec. 2: Definitions and Special Rules

The Tax Court denied a divorced father/ noncustodial parent head-of-household filing status for the year during which he was in divorce proceedings and lived outside the marital home and apart from his two minor children. (4) The court found that Sec. 2(b)(l) 's requirement to maintain the principal place of abode for a qualifying child or dependent was not met and the taxpayer had not filed Form 8332, Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent. The court also denied the child tax credit.

Sec. 24: Child Tax Credit

On September 1, 2011, the Treasury Inspector General for Tax Administration (TIGTA) issued a report (5) stating that unauthorized workers received $4.2 billion in the refundable additional child tax credit (ACTC) in 2010. The report found that claims for the credit by workers who lack proper documentation have risen 354.5% from $924 million m 2005. TIGTA made six recommendations, some of which the IRS will address.

The IRS will work with Treasury's Office of Tax Policy to seek clarification on whether refundable tax credits (or the refundable portion of tax credits) such as the ACTC may be paid to those who are not authorized to work in the United States. If these credits may not be paid, math error authority is needed for the IRS to disallow associated claims for the credits. Based on claims made in processing year 2010, disallowance of the ACTC to filers without a valid Social Security number would reduce federal outlays by approximately $8.4 billion over two years.

In a Tax Court case, (6) the taxpayer had a divorce agreement allowing him to claim one child every year and a second child in odd numbered years as long as he was current with his child support payments. The children lived with the former spouse who refused to sign Form 8332. The taxpayer was denied the dependency exemption and was not allowed to claim a child tax credit under Sec. 24. The court sympathized with the taxpayer but was bound by statute.

Sec. 25A: Hope and Lifetime Learning Credits

On August 24, 2011, the Congressional Research Service issued Higher Education Tax Benefits: Brief Overview and Budgetary Effects. (7) The report provides a brief overview of the higher education tax benefits that are currently available to students and their families. It contrasts higher education tax benefits with traditional student aid, presents a brief history of higher education tax policy over the past 60 years, summarizes key features of the available tax benefits, and provides Joint Committee on Taxation (JCT) estimates of revenue losses resulting from individual tax provisions.

A comprehensive table is included that provides information on various aspects of each tax benefit including the type of benefit (credit, deduction, etc.), the annual dollar amount of the benefit, what expenses qualify for the benefit, what level of education the benefit can be claimed for, income levels at which the benefit phases out, and any aspects of the benefit that are expiring during the 112th Congress.

Sees. 25C and 25D: Nonbusiness Energy and Residential Energy-Efficient Property Credits

In Letter Ruling 201130003, (8) the IRS approved a taxpayer's proposed methodology for allocating the costs of qualified energy-efficiency improvements to his home, enabling him to maximize his energy credits (under Sees. 25C and 25D). The expenses eligible for these credits must be made on or in connection with a dwelling unit located in the U.S. and owned and used by the taxpayer as his principal residence (as defined in Sec. 121), and originally placed in service by the taxpayer.

Sec. 31: Tax Withheld on Wages

The Tax Court upheld tax fraud penalties for a taxpayer who failed to remit payroll tax withholding through his closely held corporation. (9) He filed his Form 1040, U.S. Individual Income Tax Return, and claimed credit for taxes withheld from a Form W-2, Wage and Tax Statement, from the company he owned. Since the taxpayer knew the taxes were not paid to the government, the Tax Court held he had fraudulently underpaid his tax by claiming a credit for taxes withheld from his wages.

Sec. 36: First-Time Homebuyer Credit

The Tax Court held that a first-time home-buyer was entitled to a tax credit under Sec. 36 even though the seller held title until all installment payments had been made, and did not occupy the house for the year the credit was claimed because it needed renovations. (10) The court held that the benefits and burdens had shifted to the buyer when he signed the contract for deed, and that Sec. 36 required a prospective analysis of whether a home will be occupied by the taxpayer as his principal residence for qualification.

Under Sec. 36, the term "principal residence" has the same meaning as used in Sec. 121, which excludes a limited amount of gain on the sale of a home if, during the five-year period ending on the sale or exchange, it has been owned and used by the taxpayer as his principal residence for periods aggregating two or more years.

The Tax Court differentiated between the Sec. 121 retrospective analysis, which considers whether the taxpayer has occupied a primary residence for two years or more, and the Sec. 36 prospective analysis, which considers whether the taxpayer will occupy a home as his or her principal residence.

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

In August 2011, the IRS published proposed regulations (11) relating to the health insurance premium tax credit enacted by the Patient Protection and Affordable Care Act (12) and the Health Care and Education Reconciliation Act of 2010 (13) as amended. The regulations provide guidance, including a number of examples, to individuals who enroll in qualified health plans through affordable insurance exchanges and claim the premium tax credit and to exchanges that make qualified health plans available to individuals and employers.

Sec. 61: Gross Income Defined

Letter Ruling 20113.9003 (14) involved a consolidated group, G, in the mortgage lending business. Certain members of G engage in mortgage servicing activities. These members of G provide an interest subsidy to members of the military, under which they make interest payments on behalf of the military borrowers to the mortgage owners. The borrowers are fully liable on the loan if G becomes insolvent. The IRS ruled that this arrangement was not a debt modification under Regs. Sec. 1.1001-3 because the subsidy arrangement does not modify the legal relationship between the owner of the mortgage and the borrower.

In addition, the IRS, following the reasoning of Rev. Rul. 76-75 (15) and the particular facts, held that the subsidy is income to the borrowers under Sec. 61 and represented deductible interest under Sec. 163 to G.

The IRS further ruled that under Sec. 6041, if the subsidy is $600 or more, G must issue a Form 1099. G must also issue a Form 1098, Mortgage Interest Statement, for the interest expense under Sec. 6050H.

Sec. 71: Alimony and Separate Maintenance Payment

The Grosjean case involved a $50,000 payment from an ex-husband to his ex-wife to help her qualify for a mortgage on the marital home in her own name. (16) The ex-husband treated the payment as alimony. The ex-husband also obtained an arbitration award finding that the payment was for maintenance rather than child support. The Tax Court held that the payment was not alimony. Under Sec. 71(b) and case law, the taxpayer must receive payments per a written divorce or separation instrument for them to be alimony. Here, the $50,000 payment was not called for by the written documents. The court also noted that state court adjudications retroactively received are "generally disregarded" for federal tax purposes.

Sec. 108: Income from Discharge of Indebtedness

The IRS issued Prop. Regs. Sec. 1.108-9 that would provide guidance in applying Sec. 108 bankruptcy and insolvency exclusions for cancellation of debt (COD) income to grantor trusts and disregarded entities. The proposed regulations would clarify the meaning of the term "taxpayer" as used in Sec. 108, with regard to a grantor trust or disregarded entity. The regulations would apply to COD income occurring on or after the date they are published as final regulations.

In Chief Counsel Advice (CCA) 201135030, (17) the IRS concluded that, under Regs. Sec. 1.446-4, a taxpayer could not defer the recognition of the part of the unamortized hedge gain from an anticipatory interest rate hedge allocable to repurchased debentures, where the taxpayer elected to defer the recognition of COD income realized on the repurchase of the debentures under Sec. 108(i).

The Tenth Circuit held that the insolvency exception did not apply to the taxpayers' discharge of indebtedness income attributable to the termination of a variable life insurance policy. (18) The court rejected the taxpayers' claim that their insolvency had been stipulated and found that the taxpayers were not insolvent at the time of the termination of the policy.

Sec. 117: Qualified Scholarships

In CCA 201117026, (19) the IRS reaffirmed an earlier CCA (20) concluding that amounts paid by a university to postdoctoral fellows under research grants, other than the National Research Service Award (NRSA) grants, were subject to Federal Insurance Contributions Act (FICA) taxes. The facts indicated the existence of an employment relationship between the university and the non-NRSA fellows.

Under Sec...