Individual taxation: recent developments.

Author:Baldwin, David R.
Position:Cover story


* The IRS announced that payments for identity theft protection services could be excluded from gross income if received after a data breach.

* The Ninth Circuit reversed the Tax Court and allowed an unmarried couple to each deduct mortgage interest for personal residence indebtedness of $1.1 million.

* Although a taxpayer was denied deductions under Sec. 280E for expenses in his marijuana business, the IRS allowed Washington state marijuana businesses to treat a state excise tax as part of cost of goods sold.

* In two recent cases, the Tax Court considered whether under state law, payments made by a taxpayer to an ex-spouse were made pursuant to an obligation that ended at death and therefore qualified as alimony.

* The basis of stock sold was the issue in two cases with very different results, and the party that prevailed demonstrated the wisdom of seeking professional help.


* A number of recent significant developments affect taxation of individuals.

* As many of the cases illustrate, it is crucial for taxpayers to keep good contemporaneous records to substantiate any of their deductions, whether charitable or business-related.

* Significant proposed regulations regarding innocent spouse relief are discussed.

This article covers recent developments in the area of individual taxation, including cancellation-of-debt (COD) income; a hobby loss case where the taxpayer prevailed with the IRS, but not with the state taxing authority; theft and casualty losses; and a number of home office deduction cases. The items are arranged in Code section order.

Sec. 24: Child Tax Credit

The Eighth Circuit held that income tax refunds attributable to additional child tax credits are protected from creditors in bankruptcy because they are meant to be welfare payments, which are exempt from the bankruptcy estate under applicable Missouri state law. (1)

Sec. 61: Gross Income Defined

In Announcement 2015-22, the IRS stated that an individual whose personal information may have been compromised in a data breach will not have to include in gross income the value of identity protection services provided by the entity that experienced the data breach. Additionally, the IRS stated that an employer whose employees' data may have been compromised will not have to include the value of identity protection services in the employees' gross income. This announcement does not apply to identity protection services received for reasons other than a data breach or to cash received in lieu of identity protection services.

Sec. 62: Adjusted Gross Income Defined

The taxpayer in Cutler, (2) a principal in a law firm, took the position he could deduct on his Schedule E, Supplemental Income and Loss, the state nonresident income taxes paid on his share of his partnership's income. The Tax Court agreed with the IRS that the taxes must be deducted on Schedule A, Itemized Deductions, as the taxpayer failed to show that the taxes were either expressly or constructively imposed on the partnership itself.

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

In Letter Ruling 201532026, the taxpayer, who was a nonspouse beneficiary under two separate annuity contracts, elected a 10-year payout option and timely provided the relevant election forms to the companies that issued the contracts. However, due to a competing claim from a second beneficiary and the resulting legal dispute, the two annuity companies froze the distributions. The alternative claim was resolved more than a year after the death of the annuity owner. As such, although the taxpayer timely elected the 10-year payout option, since the annuity companies did not begin distributions until more than a year after the annuity owner's death, the letter ruling concluded that the entire proceeds payable to the taxpayer as a designated beneficiary must be paid out within five years of the annuity owner's death.

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

Proposed regulations (3) would eliminate the requirement that a copy of the taxpayer's Sec. 83(b) election be submitted with his or her individual tax return for the year the property is transferred. This change was made because commercial software for e-filing does not always allow taxpayers to submit a Sec. 83(b) election. According to the preamble to the regulations, the service center that receives the election already generates an electronic copy, which eliminates the need for the taxpayer to submit a copy with the return.

Sec. 108: Income From Discharge of Indebtedness

In Dunnigan, (4) the taxpayer was unable to pay back amounts borrowed on a line of credit for his appraisal business. The credit agreement provided that the taxpayer was both individually, and on behalf of his appraisal business, jointly and severally liable, and the taxpayer promised to pay all loans and all other debts, obligations, and liabilities of every kind and description arising out of all account transactions authorized by the taxpayer.

The taxpayer received a Form 1099-C, Cancellation of Debt, from the creditor reporting COD income, and he included it with his return along with a written note stating that the creditor told him that he was not liable for repayment of the canceled debt. He noted that he had explained to the creditor that he had a serious cancer problem and that he was 76 years old; thus, the creditor marked "no" in box 5 of the Form 1099-C indicating that the taxpayer was not personally liable for the debt. The taxpayer also noted that the local IRS office suggested that he explain the situation at the time of filing and that the IRS told him it would likely come under "hardship" rules. Therefore, he did not include the COD income on his return.

The Tax Court concluded that the credit agreement provided that the taxpayer was individually and severally liable for repayment of the credit line, not withstanding the contrary box 5 indication. Further, the court found the taxpayer's rebanee on alleged statements of the creditor and IRS employees was not persuasive. Moreover, the court held that the taxpayer's hardship was not the type that permitted excluding COD income, and that he had not proved he was insolvent or bankrupt, which would have allowed him to exclude the income. Therefore, the court held the taxpayer was taxable on the COD income.

Sec. 121: Exclusion of Gain From Sale of Principal Residence

In DeBough, (5) the taxpayer excluded gain on the installment sale of his personal residence under Sec. 121 and later reacquired the property after the buyers defaulted. The Tax Court determined that, under Sec. 1038, the taxpayer must recognize long-term capital gain on the reacquisition equal to the amount of installment payments received less the amount of gain previously recognized to "[ensure] that tax treatment of the transactions matches the underlying economic reality." None of the gain that was excluded under Sec. 121 could be excluded under this calculation. The Tax Court pointed out that Sec. 1038 provided a limited exception from gain recognition where the residence was resold within one year of reacquisition, which did not apply to the taxpayer.

On appeal, the taxpayer argued that limiting the "special rule" to only those taxpayers who resell a principal residence within one year of reacquisition was unduly harsh. However, the Eighth Circuit disagreed and affirmed the Tax Court's decision, finding that the taxpayer was not entitled to the principal-residence exclusion because he had not resold the property within one year. (6)

Sec. 122: Certain Reduced Uniformed Services Retirement Pay

In Taylor, (7) the taxpayer originally included in taxable income all military retirement income reported as taxable on his Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., on his 2006, 2007, and 2008 income tax returns. However, after advice from an acquaintance and before he filed his 2009 tax return, he filed amended returns for 2006,2007, and 2008 excluding a portion of this pay. On each amended return, the taxpayer claimed a refund by treating the taxable amount as excludable from income. Included with each amended return was a statement showing how the amount of the exclusion was computed. The taxpayer based his refund claims on Sec. 122, which excludes the amount of any reduction in an individuals military retirement pay pursuant to the individuals survivor's annuity election under the Retired Serviceman's Family Protection Plan under 10 U.S.C. Section 1431. The IRS paid the refunds, and there is no record of an attempt to recover them.

On the taxpayers self-prepared 2009 federal income tax return, the taxpayer's military retirement pay reported as taxable on Form 1099-R was shown but not included in the income reported as taxable on that return. For the years 2006-2009, the taxable portion of the taxpayer's military retirement pay did not include his disability income or the amount paid to his former spouse pursuant to their divorce. Further, the taxpayer had not previously made a survivor's annuity election as required under Regs. Sec. 1.122-1(d). Therefore, the Tax Court found that Sec. 122 and its corresponding regulations did not permit the exclusion that the taxpayer claimed.

However, the Tax Court held that the taxpayer was not hable for the 20% accuracy-related penalty under Sec. 6662 for a substantial understatement of income tax. Even though there was no basis for the claimed exclusion, the court noted that the IRS's having allowed the refund claims for 2006,2007, and 2008 could lead a reasonable person to believe that the basis for the exclusion had merit.

Sec. 162: Trade or Business Expenses

In Fetter Ruling 201536006, the IRS determined that a taxpayer's litigation costs attributable to patent infringement were deductible as ordinary and necessary expenses. The taxpayer filed a...

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