Recent developments in individual taxation.

• Author: Baldwin, David R.

This article is a semiannual review of recent developments in the area of individual federal taxation. It analyzes several hobby loss cases, cases on qualifying as real estate professionals, and two innocent spouse cases, among many other key topics affecting individuals. The items are arranged in Code section order.

Sec. 1: Tax imposed

P.L. 115-97 (known as the Tax Cuts and Jobs Act (TCJA)) introduced new tax rates for individuals, effective for 2018 through 2025, with a new top rate of 37% instead of 39.6%. (1) Special brackets apply for children with unearned income. (2)

The system for taxing capital gains and qualified dividends did not change under the TCJA, except that the income levels at which the 15% and 20% rates apply were altered (and will be adjusted for inflation after 2018). For 2018, the 15% rate will start at $77,200 for married taxpayers filing jointly, $51,700 for heads of household, and $38,600 for other individuals. The 20% rate will start at $479,000 for married taxpayers filing jointly, $452,400 for heads of household, and $425,800 for other individuals. (3)

Sec. 24: Child tax credit

The TCJA increased the amount of the child tax credit to $2,000 per qualifying child for 2018 through 2025. (4) The maximum refundable amount of the credit is $1,400. The act also created a new nonrefundable $500 credit for qualifying dependents who are not qualifying children. The threshold at which the credit begins to phase out was increased to $400,000 for married taxpayers filing a joint return and $200,000 for other taxpayers.

Sec. 36: First-time homebuyer credit

A bankruptcy court determined that the first-time homebuyer credit is dischargeable as a general unsecured debt in bankruptcy. (5) First-time homebuyers who purchased a home between April 9, 2008, and May 1, 2010, were required to pay the credit back at the rate of 62/s% a year for 15 years beginning two years after the home's purchase. The taxpayer purchased a home in 2008 and claimed the tax credit on her 2008 income tax return. In 2017, the taxpayer filed a voluntary petition for bankruptcy listing the credit as a general unsecured debt of $4,000. The IRS filed a proof of claim listing a priority claim in the amount of $393, the outstanding tax liability for the year, taking the position that the repayment was a tax that arose each year, not a loan, and therefore not a prepetition claim dischargeable in bankruptcy.

The bankruptcy court decision focused on whether the repayment was the payment of a debt under the Bankruptcy Code. The existence of a valid bankruptcy claim rests on whether a claimant had a right to payment and whether that right arose prior to the bankruptcy filing. The court noted that the IRS has consistently referred to the repayment of the homebuyer's credit as a repayment both in news releases and the instructions for Form 5405, Repayment of the First-Time Homebuyer Credit. Because the IRS had a right to payment that was a prepetition claim and that was not a priority tax debt, it was therefore dischargeable in bankruptcy.

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

Eligibility: In Keel, (6) the Tax Court held that a taxpayer could not disregard cancellation-of-debt (COD) income in determining her eligibility for the premium tax credit. Since the COD income pushed the taxpayer over the income eligibility threshold, she had to repay the advance premium tax credits paid on her behalf for that year.

Determination of coverage: In February 2018, the IRS provided questions and answers about the employer shared-responsibility payment for a large employer that does not offer health coverage to its full-time employees. These FAQ affect the determination of coverage and calculation of the premium tax credit, as these questions and answers may help determine whether an employee has minimal essential coverage in a particular month. (7)

Sec. 61: Gross income defined

State credits: The Ginsburg case involved a taxpayer who had participated in a New York state program that provided an incentive to investors to rehabilitate certain areas in the state. (8) In this program, New York provides state income tax credits to taxpayers who meet the requirements of the Brownfield Redevelopment Tax Credit program, which is designed to encourage reclamation of land contaminated by industrial use by applying a percentage of a project's costs against a corporation's franchise tax or an individual's income tax liability Any excess amount may be deferred to another tax year or credited as an overpayment of state taxes. New York does not tax any portion of the credit as income.

From 2004 to 2011, the taxpayers acquired and restored an abandoned shoe factory, a property located in a Brownfield site, and converted it into a residential rental building in Brooklyn. New York certified the taxpayers' Brownfield program application in December 2011. As a result, the taxpayers were to receive a payment from New York representing 10% of their site preparation and tangible property expenses, which would first be applied as a credit against their New York state income tax liability. The taxpayers could then choose to have any remaining credit deferred to another year or transferred directly to them as a cash payment.

In 2013, the taxpayers received a payment from New York for $1,864,618, the credit amount that exceeded their 2011 state income tax liability. The taxpayers did not include the $1.8 million payment as income on their 2013 federal tax return, arguing that (1) the tax credit was not income, but a recovery of capital; and (2) even if the credit was income, it was excludable (a) as a nontaxable contribution to capital, (b) under the "tax benefit rule," or (c) under the "general welfare" exclusion. The IRS argued that while the portion of the tax credit that reduced the taxpayers' state tax liability to zero is not taxable by law, the $1.8 million excess credit payment was income under Sec. 61 and not subject to any exclusion.

The Court of Federal Claims held that the excess state credit paid to the taxpayers was subject to federal income tax and did not qualify for any exclusion or exception from income. Federal law designates how state-created legal rights or interests will be taxed. As the taxpayers never actually paid $1,864,618 to the state as tax, to label the $1.8 million payment a refund would allow the state and the taxpayers to manipulate federal income tax laws. The excess Brownfield program credit was in substance a cash transfer from the state to the taxpayers with no strings attached since the taxpayers were free to save, spend, or transfer the excess credit. Thus, the cash payment was an accession to wealth for the taxpayers.

Further, no exclusions or exceptions to Sec. 61 gross income applied. Because there was no sale, the excess credit was not a return of capital. The state did not pay for a partnership interest in the project; therefore, the payment was not a nontaxable contribution to capital. The tax benefit rule was inapplicable since the payment was not a refund of previously paid taxes. Lastly, the payment was not need-based and therefore was not excludable from income as welfare.

S corporation income: In Enis (also discussed under Sec. 165), (9) the taxpayer-wife, who was a shareholder in an S corporation, had excluded income from that corporation, claiming she did not have beneficial ownership of the shares. She argued she did not have beneficial ownership because the other shareholders had removed her powers to exercise her rights as a shareholder by not sharing financial information with her. However, the court found that she had retained beneficial ownership of the shares despite the conflicts and therefore had to include her pro rata share of the corporation's income in her income. The court noted that she did not cite any authority for the proposition that a shareholder could exclude income from an S corporation because of poor relationships with other shareholders.

Sec. 63: Taxable income defined

The TCJA increased the standard deduction for the years 2018 through 2025. The new standard deduction is $24,000 for married taxpayers filing jointly, $18,000 for heads of household, and $12,000 for all other individuals. (10) The TCJA did not change the additional standard deduction for elderly and blind taxpayers.

Sec. 66: Treatment of community income

Taxpayers Doran Kraus and Leanne Lao married in 1988 and divorced in 2010. During the marriage, Kraus was the sole income earner and took responsibility for the couple's finances, including reporting and paying federal income taxes. Kraus failed to file several tax returns and to pay the tax. In 2006, the IRS recorded a notice of federal tax liens against Kraus for his 2001-2004 federal income taxes. In 2009, the IRS assessed civil penalties against Kraus for frivolous tax submissions. In 2012, the IRS granted Lao "innocent spouse relief" under Sec. 66, relieving her of any personal tax liability for items of community income attributable to Kraus. And, in 2016, the IRS refiled a Notice of Federal Tax Lien for Kraus's 2001-2004 federal income taxes. Among other items at issue in this case, a district court addressed the IRS's ability to foreclose on its tax liens on the subject property.

The court held that, while Sec. 66 innocent spouse relief prevented the assessment of a tax against Lao individually in any separate property she possessed, it did not affect the ability of the IRS to pursue collection remedies against her interest in community property. (11) Kraus's tax liabilities all arose during Lao and Kraus's marriage, and the liens attached when those liabilities were assessed. Under Washington law, "all debts of each spouse that are acquired during the marriage attach to the marital community as a whole" and "[o]ne spouse's tax liabilities are presumed to be community debts if they are incurred during marriage." (12)

The court...