Individual taxation: Report of recent development.

Author:Baldwin, David R.

This article is a semiannual review of recent developments in the area of individual federal taxation, including issues of deductible alimony, trade or business expenses, and recognition of loss. The items are arranged in Code section order.

Sec. 36B: Refundable credit for coverage under a qualified health plan

On July 24, 2017, the IRS issued final regulations relating to the Sec. 36B premium tax credit and the deduction for health insurance costs for self-employed individuals. (1) The final regulations address issues including eligibility of victims of spousal abuse or abandonment to claim the credit, certain allocation issues that arise in reconciling advance credit payments with the actual credit amount, and the calculation of the Sec. 36B(f)(2)(B) repayment limitation for taxpayers claiming the self-employed medical insurance deduction.

The regulations provide for a certification process for a married victim of domestic abuse or abandonment to claim the Sec. 36B credit. They also provide guidelines for situations involving multiple families or divorced taxpayers covered under a single medical plan.

Sec. 61: Gross income defined

Payments received by a taxpayer because a bank engaged in improper home mortgage foreclosure practices were held to be taxable where the payments were made from a settlement fund for which the taxpayer did not have to show financial harm to be eligible. (2)

Sec. 71: Alimony and separate maintenance payments

Divorce or separation agreement: In 2006, while still married to his wife, the taxpayer in Mudrich (3) earned a bonus for services he provided. The taxpayer filed for divorce in January 2007 and received the bonus he earned in 2006 during 2007. In June 2007, the taxpayer executed an agreement with his ex-wife under which she would receive half of the bonus, net of withholding taxes, and he would include the full amount of the bonus in gross income on his 2007 tax return. When the taxpayer filed his 2007 tax return, he included the full amount of the bonus and claimed a deduction for the bonus payment he made to his ex-wife as alimony. The Tax Court concluded that the bonus agreement was not a divorce or separation instrument, so the payment was not alimony because it was not mandated by a divorce or separation agreement as required under Sec. 71(b)(1)(A).

Oral modification: Another case addressed by the Tax Court involved whether a taxpayer was entitled to deduct as alimony more than the amount he was required to pay by the marital separation agreement. (4) The taxpayer separated from his wife in 2009 and divorced her in 2010. The taxpayer's separation agreement required him to pay his ex-wife $2,000 per month in spousal support until their marital residence was sold, when the payments would increase to $8,000 per month. Given the troubled real estate market in 2009, the taxpayer was unable to sell the home, so the taxpayer and his ex-wife agreed orally to modify the separation agreement. Under this modification, prior to the sale of the marital residence, the taxpayer paid his ex-wife $5,000 per month instead of the amount ordered by the court. The court found that the oral modification of the separation agreement did not meet the requirements of Sec. 71, and, therefore, the amounts the taxpayer paid to his ex-wife in excess of the $2,000 per month required by the separation agreement were not deductible as alimony on the taxpayer's return.

Sec. 83: Property transferred in connection with performance of services

In Austin, (5) the Tax Court held that restricted stock was subject to a substantial risk of forfeiture when issued and not substantially vested, as the IRS contended. The court noted that neither of the taxpayers, two men who worked together in a company they founded, held a controlling position in the company, so neither of them could unilaterally remove the restrictions on the stock. Additionally, if either taxpayer failed to perform his duties or left the company before the restrictions ended, the other taxpayer had an incentive to insist on enforcement of the forfeiture provision, which provided that each would lose 50% of the value of his stock if he were to leave the company within five years, so it was likely the agreement would be enforced.

The IRS further contended that the fair market value (FMV) of the stock was taxable income to the taxpayers when the restrictions on the stock lapsed on Jan. 1, 2004. Prior to this date, the taxpayers reorganized their business. They claimed that in the reorganization they had "surrendered" their original shares and acquired replacement shares in exchange for a promissory note, and they reported the difference between the FMV of the replacement shares and the promissory note as compensation income.

The court concluded that the "surrender" and "repurchase" transactions lacked economic substance, and thus each taxpayer was required to report as compensation income an amount equal to the FMV of the stock on the day the restrictions lapsed, to the extent this amount exceeded the taxpayer's basis in those shares.

Also addressed was a "special dividend" received by the taxpayers. The court concluded that, due to the amounts included in income from the lapse of the stock restrictions, the taxpayers received an increase to their basis. Thus, the receipt of the special dividend was a nontaxable event, as each taxpayer had sufficient basis in his shares to absorb the special dividend.

Sec. 162: Trade or business expenses

Travel: In Barrett,'' the IRS denied the taxpayer a deduction for business-related travel expenses because it determined that the city the taxpayer traveled to was his tax home. The taxpayer and his spouse resided in Nevada, where the spouse had a job and the couple had several rental properties. The taxpayer had worked as a self-employed video producer since the mid-1980s. The company for which he primarily worked had video studios in Washington, D.C., and as part of his work agreement with the company, he was required to travel there to use its editing facilities.

The taxpayer testified that 75% of his work related to video production was performed outside Washington and conducted from his office in Nevada. When he was required to travel to Washington, he spent an average of two weeks there. The taxpayer deducted the travel-related expenses for trips to Washington on his Schedule C, Profit or Loss From Business. The IRS denied the deduction on the basis that his tax home was in Washington, and his work of over 21 years was permanent rather than temporary.

The court held in favor of the taxpayer. Because the taxpayer performed a substantial portion of his work in Nevada, plus the fact that he and his wife lived together in Nevada and had rental properties that the taxpayer assisted in maintaining, the taxpayer's travel to Washington only to complete the production process for just a few sporadic weeks did not support the position of the IRS that the taxpayer's tax home was in Washington. However, the court disallowed expenses claimed beyond those previously allowed by the IRS, for lack of substantiation.

Substantiation: Larkin involved a married couple residing in the United Kingdom during the years in question while the husband was employed by a multinational law firm. (7)

The IRS disallowed many of the deductions claimed by the taxpayers on their Schedule C. In the majority of the instances, the taxpayers failed to provide documentation to support their claims for deductions and credits associated with several of the husband's business endeavors. These claims included home office expenses, depreciation for a home computer, medical expenses, home mortgage interest, casualty losses, and charitable contributions. Of these, the husband provided limited documentation, and the court disallowed most of them. The court allowed the taxpayers to deduct a few expenses for which it found credible support, primarily items stated on the husband's Schedule K-1 from the law firm. The court found the husband's credibility lacking, relying on his testimony only when other evidence supplied additional support.

Business purpose: An individual taxpayer was denied deductions for numerous unreimbursed employee expenses, charitable deductions, and home office expenses claimed on his 2011 income tax return. (8) At trial, the taxpayer failed to address a claim for a deduction of tax preparation and attorneys' fees, and it was disallowed. The taxpayer asserted that his unreimbursed employee expenses fee under his employer's unofficial policy rather than the employer's written reimbursement policy. Due to the taxpayer's failure to provide either the written policy or proof of this unofficial policy, the deduction for the unreimbursed employee expenses was disallowed. The taxpayer claimed deductions for unreimbursed meals and other travel expenses of donating his services to a charitable foundation, which were disallowed...

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