New directions in individual taxation.

• Author: Baldwin, David R.

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

Sec. 61: Gross Income Defined

In Nelson, a Tax Court decision upholding the IRS's deficiency determination was affirmed on appeal.(1) The taxpayer was a commercial pilot who earned $154,749 in 2005, and $264,640 in 2008, but reported zero income on his returns. He asserted that his private-sector employment was not subject to federal taxation. The Tax Court held that the taxpayer received compensation in exchange for his services and that his arguments otherwise were frivolous.

Sec. 62: Adjusted Gross Income Defined

In one summary Tax Court opinion, the issue was whether a neurosurgeon's trade or business deductions were properly deducted on Schedule C, Profit or Loss From Business (Sole Proprietorship), or as miscellaneous itemized deductions on Schedule A, Itemized Deductions.(2) The Tax Court determined that, because the petitioner was an employee and not a sole proprietor, the expenses were deductible on Schedule A.

Sec. 66: Treatment of Community Income

Under Sec. 66, married couples in a community property state who do not file joint tax returns are generally required to report half of their community income. State law determines who owns income from community property. In one case, the Tax Court held that the taxpayer was required to report half of the community property income attributable to her ex-husband's share in a new LLC that she was not aware existed.(3) Although the husband formed the LLC after they separated, it was before they divorced. All that mattered was whether they were still married at the time the LLC was formed.

Sec. 71: Alimony and Separate Maintenance Payments

An above-the-line deduction may be claimed for alimony or separate maintenance payments during the tax year if that payment meets four requirements under Sec 71(b)(1): (1) The payer must make the payment under a divorce or separation agreement; (2) the agreement must not specifically designate the payment as not includible in the recipient spouse's gross income under Sec. 71 and not deductible by the payer spouse under Sec. 215; (3) legally separated spouses under a decree of divorce or separate maintenance must not be members of the same household when payments are made; and (4) the payer's obligation to make the payment must end at the death of the payee spouse.

In McNealy, the Tax Court concluded that a lump-sum equalization payment was a property settlement and not alimony because it did not meet the second and fourth requirements.(4) The court found that the marital settlement agreement clearly stated that the equalization payment in question was intended to ensure the equitable division of property and that the obligation to make the payment would not terminate at death.

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

The Tax Court upheld an additional 10% tax on an early IRA distribution because the taxpayer failed to prove she was entitled to any of the exceptions under Sec. 72.(5)

In Roberts, the Tax Court held that a divorced taxpayer was not required to include distributions from his IRA in his gross income.(6) The taxpayer's ex-wife requested the distributions before their divorce without his knowledge by forging the taxpayer's signature. Since the distributions were not taxable, the 10% additional tax also did not apply.

Under Sec. 72, amounts actually distributed from retirement accounts are taxable income to the distributee in the tax year in which they are distributed. If a taxpayer receives a distribution before retiring, only the amounts allocable to the taxpayer's investment in the contract are excludable from income, and only to the extent the contributions were included in income. In Cahill, the Tax Court determined that the taxpayer did not establish that any part of the distribution met either of those requirements.(7)

In another case, the taxpayer was required to include IRA distributions (including one for $6) in his income in the year he received the distributions.(8) The taxpayer claimed the $6 distribution was the result of an accounting dispute, but he failed to provide an explanation of this dispute and acknowledged he had received the money.

In Black, the Tax Court held that the taxable amount of a gross distribution under Sec. 72 resulting from the termination of .a taxpayer's whole life insurance policy included both the amount of the outstanding loans taken against the policy and the capitali7ed interest accrued on the loans.(9) The court found that the interest was part of the bona fide indebtedness that was satisfied with proceeds of the policy upon termination. The Tax Court concluded in a similar case that income received from the surrender of a life insurance contract was taxable under Sec. 72 to the extent it exceeded the taxpayer's investment in the contract. (10)

In Ellis, the Tax Court found that the taxpayer was liable for the Sec. 72(0 penalty on an IRA distribution because he did not meet any of the exemptions and was not 591/2 at the time. (11) Also, the court determined that the taxpayer engaged in a prohibited transaction with the IRA because he was a disqualified person with respect to the IRA and he transferred assets to the IRA for his own use or benefit. The IRA under review in this case held a 98% interest in the taxpayer's used car business/LLC and the LLC paid the taxpayer compensation. The court held that the prohibited transaction resulted in a distribution of all the assets from the IRA as of the first day of the year the transaction took place and that the value of the assets was includible in the taxpayer's income in that year.

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

The IRS issued final regulations for Sec. 83 relating to property transferred in connection with the performance of services that provide several clarifications regarding whether a substantial risk of forfeiture exists in connection with the transfer of property. (12)

In Letter Ruling 201405008, the IRS ruled that a Sec. 83(b) election by a taxpayer was valid. The taxpayer mailed the 83(b) election to the IRS as required by the regulations but failed to attach a copy to his or her current-year return as is also required. The Service determined that this failure did not affect the election's validity.

In Crescent Holdings, LLC, the taxpayer entered into an employment agreement that provided that, if he served as the LLC's CEO for three years, he would receive a restricted 2% interest in a newly formed LLC/part-nership. (13) The taxpayer resigned before the three-year period and forfeited his interest. The Tax Court held that the nonvested 2% partnership capital interest was a capital interest transferred in exchange for the performance of services that was subject to Sec. 83. Because the taxpayer did not own the capital interest under Sec. 83, the court further held that the undistributed partnership income allocations attributable to the interest should not be recognized as income to the taxpayer.

In Austin, the Tax Court addressed whether a substantial risk of forfeiture existed where S corporation shareholders received restricted stock under an employment agreement that required them to perform substantial future services and also provided that they would receive less than fair market value (FMV) if they were terminated for cause during the stated employment period.' The Tax Court found that the term "discharged for cause" as used in Regs. Sec. 1.83-3(c)(2) does not necessarily have the same meaning as the taxpayers gave it in their agreements and that the term referred to termination for serious misconduct, which is highly unlikely to occur. In the taxpayers' case, the court held that, under the terms of the employment agreement, a substantial risk of forfeiture existed.

EXECUTIVE SUMMARY

* The Tax Court held that a taxpayer in a community property state whose husband, after the couple separated but before they divorced, formed a company she did not know about, had to report her share of the community income from the company because they were technically still married.

* In a change of position, the IRS announced that qualified Medicaid waiver payments will be treated as Sec. 131 nontaxable qualified foster care payments regardless of whether the care provider is related to the eligible individual.

* The Tax Court found that despite a conciliation agreement that indicated he was not his son's custodial parent, a taxpayer who proved his son spent more nights with him than with the mother was entitled to the dependency exemption.

* The IRS issued a notice on virtual currency that provides that general tax principles that apply to property transactions will apply to virtual currency and discusses the practical results of this treatment.

Sec. 104: Compensation for Injuries or Sickness

In several recently issued private letter rulings, the IRS has ruled that, under Sec. 104, damages or other compensation related to physical injury were properly excluded from the taxpayers' gross income. (15)

In Simpson, the taxpayer received a payment to settle a discrimination claim against her former employer. The Tax Court determined that this payment did not qualify for the Sec. 104(a)(1) income exclusion for amounts received under the worker's compensation law because the settlement agreement did not comply with California statutory requirements and thus the payment was made under a private contract rather than under the worker's compensation statute.' Because the settlement did contain elements of compensation for physical personal injury and sickness, the taxpayer was entitled to exclude part of the award, however.

The Tax Court held in another case that a payment a taxpayer received from his former employer to settle a discrimination complaint did not qualify for an...