Individual taxation report: recent developments.

• Author: Cook, Ellen D.

EXECUTIVE SUMMARY

* The American Recovery and Reinvestment Act of 2009 contained a number of changes to individual income tax provisions. The act changed the rules for many credits (such as the child tax credit) and introduced the new making work pay credit in Sec. 36A. It also increased the AMT exemption amounts, increased the NOL carryback period for eligible small businesses, and added a standard deduction for taxes on qualified motor vehicles.

* In response to current events, the IRS issued a revenue procedure and a revenue ruling dealing with the treatment of losses from Ponzi schemes; however, the guidance leaves many questions unanswered.

* The Tax Court rebuffed the IRS in two innocent spouse cases, holding in one that the regulatory two-year limitation for seeking equitable innocent spouse relief was invalid and in the other that the standard of review in a case where the taxpayer is challenging a denial of innocent spouse relief is the de novo standard instead of the abuse of discretion standard.

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This article covers recent significant developments affecting taxation of individuals, including cases, IRS guidance, and legislative changes. The items are arranged in Code section order.

Sec. 24: Child Tax Credit

While the amount of the child tax credit remains at $1,000 per dependent child under age 17, under the American Recovery and Reinvestment Act of 2009 (ARRA), (1) the refundable portion is increased for tax years 2009 and 2010. Specifically, the child tax credit is refundable to the extent of 15% of the taxpayer's earned income in excess of $3,000 (lowered from $8,500). Beginning for tax year 2009, a qualifying child for the purposes of the child tax credit must also be the taxpayer's dependent.

Sec. 25A: Hope and Lifetime Learning Credit

Effective for tax years beginning after December 31, 2008, the Sec. 25A Hope credit, renamed the American opportunity tax credit by ARRA, is increased to a maximum of $2,500 per year (100% of the first $2,000 of qualifying expenses and 25% of the next $2,000), with 40% of the credit refundable.

The credit phases out for taxpayers with adjusted gross incomes (AGIs) between $80,000 and $90,000 ($160,000 and $180,000 for married taxpayers filing jointly). ARRA extended the credit to all four years of college and expanded the definition of qualifying expenses to include course materials. Congress has directed Treasury to study (1) how to coordinate the education credits with the federal Pell Grant program and (2) the feasibility of requiring students to perform community service for purposes of the education credits.

Secs. 25C and 25D: Residential Energy Credits

ARRA included changes to a range of energy tax incentives for individuals and businesses, including credits for installing energy-efficient equipment or building components (Sec. 25C) and residential energy-efficient property (Sec. 25D), plug-in electric drive vehicles (Sec. 30D), and renewable energy production (Sec. 45).

Sec. 32: Earned Income Credit

For tax years 2009 and 2010, the earned income tax credit percentage for families with three or more qualifying children is increased from 40% to 45%.2

Sec. 36: First-Time Homebuyer Credit

Effective for home purchases after December 31, 2008, and before December 1, 2009, ARRA increased the amount of the first-time homebuyer credit from $7,500 to $8,000 ($4,000 for married taxpayers filing separately). A first-time homebuyer is an individual who had no ownership interest in a principal residence in the United States during the three-year period prior to the purchase of the home to which the credit applies. The taxpayer may elect to take the credit on the 2008 return by treating the purchase as though it were made on December 31, 2008.

Further, taxpayers who remain in the home for 36 months are not required to repay the credit. In any case, no amount is required to be recaptured after the death of the taxpayer. The credit phases out for AGI between $75,000 and $95,000 ($150,000 and $170,000 AGI for joint fliers).

Notice 2009-123 explains how to divide the new homebuyer's credit when two or more unmarried individuals purchase the principal residence. The notice provides several examples on how to claim the credit.

Sec. 36A: Making Work Pay Credit

New Sec. 36A allows a credit against income tax in the amount of the lesser of 6.2% of an individual's earned income or $400 ($800 for married filing jointly). Net earnings from self-employment that are included in taxable income qualify. In addition, earned income for these purposes includes combat pay excluded from gross income under Sec. 112.

Effective for tax years 2009 and 2010, the credit is intended to effectively offset an individual's share of FICA on the first $6,452 of earnings. The credit is phased out at a 2% rate for individuals whose modified adjusted gross income exceeds $75,000 ($150,000 for married taxpayers filing jointly). The credit is not available to nonresident aliens, individuals who may be claimed as a dependent by another taxpayer, or any estate or trust. It may be claimed through a reduction in wage withholding or in a lump sum on the tax return filed for the year the wages were earned.

The credit will be reduced by the onetime economic recovery payments of $250 provided by the Veterans Administration, Railroad Retirement Board, and Social Security Administration under ARRA Sections 2201 or 2202. New Schedule M, Making Work Pay Credit and Government Retiree Credits, is used to be sure the proper credit amount is claimed.

Sec. 55: Alternative Minimum Tax

ARRA increased the AMT exemptions for 2009 to $70,950 for a joint return, $46,700 for single taxpayers and heads of household, and $35,475 for married taxpayers filing separately. Commonly referred to as the "AMT patch," this measure comes with an estimated cost of $70 billion to provide AMT relief to an estimated 26 million taxpayers. ARRA also extends the rule allowing nonrefundable personal tax credits to offset AMT to tax years beginning in 2009.

Sec. 56: Adjustments in Computing AMT

A change enacted as part of ARRA allows for up to a five-year carryback of AMT net operating losses (NOLs) of eligible small businesses for tax years beginning or ending in 2008. (4 However, the 90% limit on use of AMT NOL did not change (a proposal to change to 100% did not become law).

Sec. 57: Items of Tax Preference

Interest income from private activity bonds issued in 2009 and 2010 will not be a tax preference item. (5) This also includes bonds issued in 2009 and 2010 to refund a bond issued from 2004 to 2008.

Sec. 61: Gross Income Defined

School board reimbursements: The IRS stated that parents of a disabled child who received reimbursement from the school board per the Individuals with Disabilities Education Improvement Act of 2004 (IDEA) did not have to include the payments in income. (6) The information letter states, "It is also a long-standing position of the Internal Revenue Service that in a nonemployment context, reimbursements for expenses incurred by a taxpayer on behalf of another are not includible in the taxpayer's gross income." These types of payments have been held to be, in essence, those of the school board because it is obligated to provide the services. Thus, when the board reimburses the parent for incurring the payments, such payments are not income. (7)

Katrina incentive payments: In another information letter, the taxpayer received an incentive payment under the Deficit Reduction Act of 2005, (8) where the secretary of Health and Human Services provided $50 million to Louisiana for health care due to Hurricane Katrina. (9) The state used the funds to entice health care professionals to the area. Payments were for sign-on bonuses, malpractice insurance, relocation costs, and technology. The Service noted that there was no exclusion for such payments and that Sec. 6159 and the filing of Form 9465, Installment Agreement Request, provide the only relief by possibly allowing the taxpayer additional time to pay his or her tax liability.

Jury duty travel allowance: The IRS affirmed that an individual does not need to include in gross income any mileage and subsistence allowance received for jury duty. (10) The rationale is per Jernigan, (11) which held that such payments were not similar to nondeductible commuting expenses but instead were to enable the court to carry out its functions. However, the payment for jury service (attendance fee) is taxable.

Statutory contingency payment: A payment by an employer to the employee's attorney was held to be gross income to the employee. (12) The Ninth Circuit reasoned, "Green's employer's payment to her attorney (whether court-ordered or not) reduced her own payment obligation accordingly and was thus constructively received by Green." This treatment led to an AMT consequence for Green. While the court noted that it was sympathetic, it was unable to change the "unfairness" of the result.

Personal injury awards: Due to a stop-payment order on a check to purchase a used car that turned out to be defective, wife (W) was arrested for an insufficient funds check. (13) The charges were later dropped. While W was held against her will, she suffered no physical injury. She did see a psychologist a few times, with the charges covered by her medical insurance. W brought suit against the car dealer and the bank. Through mediation, she was awarded $49,000 from the bank.

W was told by her attorney, the mediator, and the bank's attorney that the settlement was not taxable. Husband (H) and W self-prepared their tax return and did not report the $49,000 settlement award. The bank did issue W a Form 1099-MISC, Miscellaneous Income, noting the settlement amount. H and W later received a deficiency notice from the IRS.

At issue was whether the settlement proceeds were excludible under Sec. 104(a)(2). A two-part test must be met for an award to be excluded under Sec...