This article covers developments from the past year affecting taxation of individuals, including last year's tax relief, health care, and small business legislation, regulations, cases, and IRS guidance. The items are arranged in Code section order.
Sec. 32: Earned Income
Erroneous EITC payments: In October 2011, the IRS issued proposed regulations that would require return preparers to submit to the IRS documentation of taxpayers' eligibility for the earned income tax credit (EITC).1 The proposed regulations, under the Sec. 6695(g) preparer due diligence provisions, would require preparers to submit Form 8897, Paid Preparer's Earned Income Credit Checklist, to the IRS. Currently, return preparers are required only to keep the form or the information it requires in their records. The proposed regulations also would subject preparers' firms to the same penalty for a lack of due diligence concerning EITC claims. Firms, however, could not claim the defense available to preparers--that their office's EITC due diligence procedures are reasonably designed and routinely followed and that the failure was isolated and inadvertent. The proposed regulations would be effective when finalized, for tax years ending on or after December 31, 2011.
Also in October, Congress increased the Sec. 6695(g) preparer penalty for failing to exercise due diligence with respect to an EITC claim from $100 to $500 per failure for returns required to be filed after December 31, 2011. The provision was included in a free-trade agreement with South Korea. (2)
Earlier in 2011, a Treasury Inspector General for Tax Administration (TIGTA) report (3) revealed that, despite improvements in the IRS's ability to detect them, in fiscal 2009 the IRS continued to pay out between $11 billion and $13 billion in erroneous EITC payments. The TIGTA report noted that the Government Accountability Office (GAO) had listed improper EITCs as the second-highest dollar amount of improper payments of all federal programs. TIGTA also noted that the IRS estimates that 23%-28% of EITC payments continue to be erroneous, showing little improvement since the 2002 inception of reporting estimates to Congress. The report summarizes IRS attempts to improve compliance and reduce fraud as well as TIGTA recommendations to do the same. In April 2011, the GAO reported (4) that erroneously claimed EITCs for fiscal 2010 were estimated at $16.9 million, jumping almost 38% from fiscal 2009.
EITC retention in bankruptcy: A bankruptcy court (5) approved a couple's chapter 13 plan, stating that, absent unusual circumstances, debtors receiving the EITC or the Sec. 24(d) additional child tax credit (ACTC) or both may retain $2,000 of their tax refunds--the combination of the $1,000 refund the same court had determined in In re Leigh (6) and up to $1,000 of EITC or ACTC. However, if either the EITC or the ACTC or both total less than $1,000, the maximum the debtors may retain is the $1,000 available to all debtors and the amount of their EITC or ACTC, the court held.
Sec. 36: First-Time Homebuyer Credit
The first-time homebuyer credit expired in 2010 (eligible home purchasers must have entered into a written binding contract before May 1, 2010, and the purchase must have closed on or before September 30, 2010), but it continues to be a subject of litigation and IRS guidance.
Purchase from relative: In Nievinski, (7) the Tax Court held that an individual who had purchased a home from his parents did not qualify for the first-time homebuyer credit. The taxpayer had taken the credit based on his accountant's directions and the fact that Form 5405, First-Time Homebuyer Credit and Repayment of the Credit, did not clearly prohibit buying a home from relatives. In court, the taxpayer further argued that IRS Publication 4819, Important Information About the First-Time Homebuyer Credit, did not expressly explain that home purchases from family members do not qualify for the credit.
The court held that Form 5405 and Publication 4819 provide general instructions and do not purport to provide all rules and limitations applicable to the credit. The apparent failure of some IRS publications to explain the limitation has no effect on the authority of Sec. 36(c), the court held. Sec. 36(c) (3) clearly states that the credit is not available to a taxpayer who purchases a home from a related person, and Sec. 36(c) (5) clarifies that related persons include direct ancestors such as parents.
Principal residence: In a chief counsel advice (CCA) (8) the IRS allowed the credit to a taxpayer who had lived partly in a storage shed on the construction site of his new home. The taxpayer's previous residence on the site had been destroyed by fire more than three years earlier. In late 2008, the taxpayer began constructing a new home on the same property and lived 40% of the time in a storage shed/dwelling unit on the property. The storage shed had a stove, refrigerator, bathroom, sleeping apparatus, and heat. The taxpayer lived the rest of the time with his girlfriend. The Chief Counsel's Office was asked whether the taxpayer met the first-time homebuyer credit requirement that the taxpayer not have owned a principal residence in the three-year period before purchasing the home for which the credit is claimed.
The Chief Counsel's Office ruled that the storage shed/dwelling unit was a residence for purposes of Sec. 121 because under Regs. Sec. 1.121-1 (e) (2), the term "dwelling unit" has the same meaning as in Sec. 280A(f)(l). Under Regs. Sec. 1.280A - 1, a dwelling unit could be a house, apartment, condominium, mobile home, boat, or similar property that provides basic living accommodations such as sleeping space, toilet, and cooking facilities. However, the unit was not considered the taxpayer's principal residence because the taxpayer did not spend the majority of his time there as required by Regs. Sec. 1.121-1(b). Therefore, the taxpayer met the definition of a first-time homebuyer because he had not owned a principal residence within the three years prior to the date of purchase of the new home (in this case, the occupancy date). The taxpayer could include only the cost of constructing the new home in calculating the credit.
Longtime resident credit: In CCA 201104040, (9) the IRS wrote that a taxpayer who completed construction of and occupied a new home on land that was the site of the taxpayer's previous home that had been owned and used for the required time10 could qualify for the $6,500 maximum credit as a longtime resident. The taxpayer would not include any basis in the land as part of the purchase price of the new home because the land purchase was not near enough in time to the construction of the new home.
TIGTA report: In March 2011, TIGTA issued its final audit report (11) on the homebuyer credit and other refundable credits. The report includes estimates of fraudulently filed returns, TIGTA's recommendations to the IRS in each problem area, and the IRS response to each. Implementation of the recommendations should reduce fraud related to credits promulgated in more recent legislation.
Sec. 53: Credit for Prior-Year Minimum Tax Liability
The IRS Office of Chief Counsel was asked whether restrictions on the computation of regular taxes owed by recipients of Sec. 965 dividends also apply for purposes of computing the minimum tax credit under Sec. 53. (12) Specifically, the taxpayer was interested in whether the floor on taxable income under Sec. 965(e)(2)(A) precludes the reduction of alternative minimum taxable income (AMTI) below the amount of nondeductible dividends for purposes of computing the limit on minimum tax credits under Sec. 53(c).
The chief counsel stated that Sec. 965(e)(2)(A) unambiguously precludes the reduction of taxable income below the amount of nondeductible dividends and that AMTI is derived from regular taxable income. Further, Sec. 55(b)(2) defines AMTI as taxable income modified only under Sees. 56-58, and nothing in those sections provides for eliminating nondeductible Sec. 965 dividends.
Sec. 61: Gross Income Defined
General welfare exclusion: Notice 2011-14 (13) provides guidance on the nontaxability of certain payments made to or on behalf of certain individual homeowners by state housing finance agencies or the federal Department of Housing and Urban Development's Emergency Homeowners' Loan Program. Such payments may be nontaxable under the general welfare exclusion because they are intended to help financially distressed individuals. The notice's guidance includes a safe harbor for affected individuals who deduct mortgage interest and lists various types of financial relief programs it covers.
Taxation of employee annuities; Rev. Rul. 2011-7 (14) discusses four scenarios in which a defined contribution plan is terminated with certain distributions made to participants or beneficiaries. The ruling explains the tax treatment of the termination action and whether the distributions are subject to tax.
Sec. 83: Property Transferred in Connection with Performance of Services
Two recent court cases dealt with stock-based compensation paid to corporate officers and when and how the stock should be valued. In Gudmundsson, (15) on July 1, 1999, the taxpayer received as an officer of his employer a grant of restricted stock of the employer corporation subject to a one-year holding period. Based on the stock's market price on the day the taxpayer received approximately 73,000 shares, his Form W-2, Wage and Tax Statement, reported the value at just under $1.3 million. Gudmundsson reported this amount on his 1999 tax return. By the end of 1999, the stock price had dropped by almost half, and by the one-year anniversary of his receiving the stock, when it became freely marketable, the price had dropped by $14 per share to a little more than one-fifth its original value.
In 2003, Gudmundsson filed an amended return for 1999 modifying his income...