Recent developments in individual taxation.

• Author: Baldwin, David F.L.
• Position: INDIVIDUALS

This article is a semiannual review of recent developments in the area of individual federal taxation. It covers cases, rulings, and guidance on a variety of topics issued during the six months ending May 2020. The items are arranged in Code section order.

Sec. 36B: Premium tax credit

Constitutional challenge: In 2020, the Supreme Court agreed to hear a major challenge to the Patient Protection and Affordable Care Act (PPACA). (1) The case the justices will hear was brought by Texas and 17 other states. They argue that when Congress, in 2017, reduced the Sec. 5000A penalty for failure to maintain medical insurance to zero, this action rendered the entire PPACA unconstitutional.

Suspension of personal exemption deduction: The IRS issued proposed regulations in May to clarify that the reduction of the personal exemption to zero does not affect the calculation of the premium tax credit. (2) Under the PPACA, the amount of premium tax credit is calculated based on the number of personal exemptions claimed on the taxpayers individual income tax return. Under the law known as the Tax Cuts and Jobs Act (TCJA), (3 4) for tax years after 2017, the "exemption amount" is zero. The proposed regulations adopt the substance of Notice 2018-84.

Sec. 61: Gross income defined

Fraudulent failure to report business income: In the Isaacson* case, the Tax Court upheld the IRS's determination that a cash-method taxpayer not only underreported his business income but did so with fraudulent intent. The taxpayer, a disbarred attorney and former tax litigation specialist, was determined to have a S2.6 million deficiency and a corresponding SI.9 million civil fraud penalty for omitting from income his 60% contingency fee for services he rendered in 2007.

The taxpayer argued that the 60% contingency' fee was not yet his and was held in trust for his clients; however, the court found that he had dominion and control over the funds, and they were held in a personal account and used for his personal enjoyment.

Based on the petitioner's sophistication, education, and prior experience, the court found that he underpaid his income tax with fraudulent intent.

Bank deposits analysis shows underreporting: In Collins, (5) the Tax Court ruled in the IRS's favor in a case where a tax return preparer underreported his income. When questioned, the taxpayer claimed that the income shown via bank deposits was a cash hoard he and his spouse had saved at home. But based on the IRS's reconstruction of the bank deposits, as well as the number of tax returns processed under his PTIN and firm's EIN and the historical perreturn fee cost, the Tax Court found the taxpayer had underreported his income and was subject to civil fraud penalties.

Sec. 67: 2% floor on miscellaneous itemized deductions

In Near, (6) married taxpayers claimed they were entitled to deduct certain unreimbursed business expenses on their 2015 federal income tax return (as miscellaneous itemized deductions subject to the 2%-of-adjusted-gross-income floor). The Tax Court rejected their argument, explaining that when employees have a right to reimbursement for expenditures related to their status as employees but fail to claim such reimbursement, the expenses are not deductible as unreimbursed business expenses because they are not "necessary," citing the Ninth Circuit's decision in Orvis. (7)

Sec. 72: Annuities; certain proceeds of endowment and life insurance contracts

Constitutional challenge to earlywithdrawal penalty: In Conard, (8) the Tax Court rejected a taxpayer's constitutional challenge to having to pay the 10% additional tax on early distributions received from a qualified retirement plan. She argued, essentially, that the 10% additional tax discriminates against people who are under age 591/2, not disabled, and not eligible for any other exception. Unpersuaded by her arguments, the court held that the early-withdrawal penalty did not violate her right under the U.S. Constitution to equal protection under the law.

Sec. 104: Compensation for injuries or sickness In a private letter ruling, (9) the IRS found that the amount a taxpayer received in settlement of a lawsuit for personal injury, including emotional distress, was nontaxable.

The taxpayer contracted with a fertility clinic to provide her with a suitable anonymous donor egg and to perform in vitro fertilization. The clinic failed to test the donor egg and embryo that the taxpayer was implanted with, and shortly after birth of the taxpayer's child, genetic testing revealed a specific gene that causes a genetic condition. The genetic condition caused the taxpayer's child to suffer from multiple physical, cognitive, and behavioral disabilities.

The taxpayer sued the fertility clinic on the premise that the clinic's failure to perform the gene test was negligence, making it liable for personal injuries to the child because of the genetic condition and for the taxpayer's emotional distress. The IRS agreed in the letter ruling that the money the taxpayer received in settlement for both the physical injuries and the related emotional distress was excludable from the calculation of gross income (except for amounts that reimbursed the taxpayer for medical expenses that were incurred and previously deducted).

Sec. 108: Income from discharge of indebtedness

Student loan discharge: In a Tenth Circuit case, Hamilton, (10) the court held that a couple were unable to avoid tax on $160,000 of discharged student loans because, in the same year the discharge was granted, they also received a nontaxable partnership distribution of more than $300,000. Even though they moved the partnership distribution funds to a savings account owned by their son to create insolvency, they exercised effective control over the money. The court found that under the substancc-over-form doctrine, the money was included in the Hamiltons' assets for determining whether they were insolvent. Because they were solvent after taking that money into account, they were required to pay income tax on the canceled debt.

Student loan discharge safe harbor: The IRS extended its safe-harbor relief from recognizing cancellationof-debt (COD) income for students whose loans were discharged because their schools were closed or as a result of certain types of fraud. (11)

Taxpayers within the scope of this revenue procedure will not recognize gross income as a result of the discharge. Also, the IRS will not assert that a creditor must file information returns and furnish payee statements for the discharge of any indebtedness within the scope of the revenue procedure. To avoid creating confusion, the IRS strongly recommends that these creditors not furnish students or the IRS with a Form 1099-C, Cancellation of Debt.

Sec. 131: Certain foster care payments

In Action on Decision 2020-02, the IRS announced that it will acquiesce in Feigh (12) in result only. The case concerns the tax treatment of Medicaid waiver payments when determining eligibility for the earned income tax credit (EITC) and the additional child tax credit (ACTC).

The taxpayers, who received Medicaid waiver payments for the care of their adult disabled children in their own home, excluded the payments from gross income but included them in earned income to claim an EITC and an ACTC. Agreeing with the taxpayers, the Tax Court held that even though the IRS (in Notice 2014-7) continues to allow taxpayers to treat such payments as excludable under Sec. 131, the Service cannot reclassify a taxpayer's income through a notice so that it no longer qualifies as earned income for determining eligibility for the EITC or the ACTC.

Sec. 162: Trade or business expenses

Unreimbursed employee expenses: In Near (13) (also discussed above under Sec. 67), an attorney claimed a deduction for what were deemed to be unreimbursed employee...