Individual taxation report.

• Author: Cook, Ellen D.

EXECUTIVE SUMMARY

* Taxpayers in the 15% or lower tax brackets have a 0% capital gains rate for tax years beginning after 2007.

* The IRS provided guidance on when a person is a qualifying relative for purposes of the dependency exemption.

* A 2% shareholder-employee in an S corporation may now be able to claim the deduction for self-employed health insurance premiums.

* The IRS provided guidance on what constitutes qualified performance-based compensation for purposes of the Sec. 162(m) limit on the deduction of compensation.

* The IRS withdrew regulations on when accounts or notes receivables are acquired for services rendered within the meaning of Sec. 1221(a)(4).

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This article covers recent developments affecting taxation of individuals, including legislation, regulations, and IRS guidance. The items are arranged in Code section order.

Sec. 1: Tax Imposed

Thanks to changes made by the Jobs Growth and Tax Relief Reconciliation Act of 2003, (1) taxpayers in the 15% or lower tax brackets have a 0% capital gains rate for tax years beginning after 2007 and before 2011. (2)

Sec. 55: Alternative Minimum Tax Imposed

The Tax Court held (3) that the Sec. 6654 estimated tax penalty is not part of a taxpayer's regular income tax liability and thus does not reduce the taxpayer's alternative minimum tax (AMT). The Service increased the taxpayers' regular tax liability for the tax year at issue (due to a math error) and also assessed a penalty for failure to pay estimated tax. The taxpayers argued that the estimated tax penalty should be included in their regular tax liability when calculating their AMT. The court held that because "regular tax liability" means taxes imposed under chapter 1 of the Code (4) and the Sec. 6654 estimated tax penalty is imposed under chapter 68 of the Code, the Service correctly omitted the amount of the penalty when calculating the taxpayers' AMT liability.

Sec. 62: Adjusted Gross Income Defined

The Office of Chief Counsel advised (5) that a plan that merely treats payments to employees that had previously been treated entirely as wages as being partially payments of wages and partially reimbursements of expenses was not an accountable plan because it violated the business connection requirement for accountable plans in Regs. Sec. 1.62-2(c). In the case at issue, an employer, who required employees to provide their own tools for use in their jobs, set up a plan that characterized part of the participating employees' wages as nontaxable reimbursements for the amounts the employees spent on tools used in their jobs.

See. 104: Compensation for Injuries or Sickness

A taxpayer received damages through a settlement for an action brought for discrimination in the workplace. The Tax Court held that because there was no payment for tort-like personal injuries, the amount received was not excludible from income under Sec. 104. (6) The court stressed that the nature of the claim as detailed in the settlement agreement is relevant in determining if Sec. 104 applies. If the settlement agreement does not expressly state the purpose of the payment, then the intent of the payor is relevant to determine the purpose. The court held that "although the belief of the payee is relevant to that inquiry, the character of the settlement payment hinges ultimately on the dominant reason of the payor in making the payment."

In April 2008, the Supreme Court declined to hear the Murphy (7) case, in which a taxpayer sought to recover income taxes she paid on compensatory damages for emotional distress and loss of reputation she was awarded in an administrative action against her former employer. This case is notable because the DC Court of Appeals originally held (in an opinion that it ultimately vacated) that taxing compensatory damages was a violation of the 16th Amendment because compensatory damages were not income.

Sec, 152: Dependent Defined

Qualifying relative: Notice 2008-5, (8) issued on December 18, 2007, provides guidance under Sec. 152(d) for determining whether an individual is a qualifying relative for whom the taxpayer may claim a dependency exemption under Sec. 151(c). As such, the notice affects some family-based benefits for which a taxpayer may be eligible based on the presence of a qualifying relative, including, for example, in the case of a physically or mentally disabled individual, the Sec. 21 child and dependent care credit.

Sec. 152(d)(1)(D) provides that an individual is not a qualifying relative of the taxpayer if the individual is a qualifying child of any other taxpayer. Since the adoption of the "uniform definition of a child" and amendments to Sec. 152 defining "qualifying child" and "qualifying relative" as part of the Working Families Tax Relief Act of 2004, (9) commentators have noted some of the unintended consequences of the new law. For example, in a February 6, 2006, letter to the Service, the National Association of Enrolled Agents presented several problem scenarios, including the following:

Example 1: A 30-year-old man, A, who lives with and completely supports his 28-year-old girlfriend, B, and her 5-year-old son, C, could claim the girlfriend as a dependent under the qualifying relative rules (assuming the relationship does not violate law)...