This article covers recent developments in individual taxation – Part 1. The items are arranged in Code section order.
Sec. 23: Adoption Expenses
In Field, [1 ]an adoption expense credit was denied to a taxpayer who filed her return using married-filing-separate status. The taxpayer claimed that the denial of the credit was unconstitutional. The Tax Court upheld the joint filing requirement for purposes of the adoption credit as valid under the Equal Protection Clause of the Constitution. It did not matter that the taxpayer had adopted the children before she married and her husband did not adopt them. Generally, if a taxpayer is married at the end of a tax year, the credit can only be claimed if the taxpayer and his or her spouse file a joint tax return.
Sec. 68: Overall Limitation on Itemized Deductions
The American Taxpayer Relief Act of 2012  restored a limitation on itemized deductions, but with new thresholds for when the limitation applies. For 2013, the adjusted gross income (AGI) thresholds are $250,000 for single filers, $300,000 for married couples filing jointly, and $275,000 for filers using the head-of-household status. These amounts will be adjusted for inflation in subsequent years. 
President Barack Obama’s fiscal year 2014 budget proposal  includes an expansion of the limitation on itemized deductions for higher-income individuals. This proposal would cap the tax benefit of itemized deductions to 28% of their amount. This cap would also apply to other specified deductions (such as moving expenses), as well as certain exclusions (such as tax-exempt bond interest and employer-provided health insurance).
Sec. 104: Compensation for Injuries or Sickness
Scott  involved the question of how much of a firefighter’s pension was taxable when his retirement was due to a service disability. The taxpayer was injured on the job when he had more than 36 years of service and was entitled to pension payments. His monthly retirement pension amount was $9,913, and his disability pension was $5,148. He was entitled to collect only the higher amount. In 2006, the payor of the pension reported to the taxpayer and IRS that the difference between these two amounts, $4,765 per month, was taxable (for the year, the reported taxable amount was $61,430). The taxpayer originally reported that amount on his return but then filed an amended return seeking a refund on the position that, because he retired due to a permanent service-connected disability, none of the pension income was taxable under Sec. 104 and Regs. Sec. 1.104-1(b). The government relied on Rev. Rul. 80-44,  which holds that if a person is entitled to receive the greater of a service pension or a service-connected disability pension and the service pension is greater, the difference between the two amounts is taxable. The district court agreed with this interpretation. The Court found that the taxpayer’s reliance on the Ninth Circuit’s decision in Picard  was misplaced. In that case, a police officer’s disability pay was reduced when he later qualified for retirement pay. In this case, the taxpayer’s retirement pay was greater than his disability pay. Thus, the Court held, there was no “conversion” of the disability pay into regular retirement pay. The court noted that the taxpayer “receives a portion of both pensions—at least for federal income tax purposes.”
In Smallwood,  the taxpayer received $995,000 to settle her legal complaint alleging workplace race and gender discrimination and related claims. She paid tax on the award less the contingent fee paid to her attorney (almost 50%), but then sought a refund, claiming that the award was excludable under Sec. 104. At issue was whether the award was received for personal injuries. The Court noted that under Sec. 104(a)(2), damages received for emotional distress are excludable only if the distress is due to physical injury or physical sickness or to the extent the damages do not exceed medical costs attributable to the emotional distress. The Court had to determine whether the payments to the taxpayer were intended to compensate her for physical injuries, noting that a settlement agreement is important in making this determination. If the agreement is not specific, a court next looks to the payor’s intent. In case pleadings, the taxpayer stated that she developed “Hashimoto’s autoimmune disease” due to the stress, as well as a number of other ailments, including vertigo, vomiting, and low blood pressure, that required hospitalization and medication. Based on the evidence presented, the Court found that whether any portion of the settlement payment was intended to be for physical injuries or physical sickness was a genuine issue of material fact. However, it held that she could not prevail, as a matter of law, because her complaint did not extensively concern physical injuries or sickness.
Sec. 108: Income From Discharge-of-Indebtedness
Under Secs. 108(a)(1)(E) and (h), discharge-of-indebtedness income from qualified principal residence debt of up to $2 million ($1 million for married taxpayers filing separately) is excluded from gross income. The “American Taxpayer Relief Act of 2012” extended this exclusion to qualified principal residence debt discharged before Jan. 1, 2014. In Rev. Proc. 2013-16,  the IRS provided guidance for homeowners participating in the Home Affordable Modification Program’s Principal Reduction Alternative (HAMP PRA). To the extent that a borrower under HAMP PRA uses a property as his or her principal residence or the property is occupied by the borrower’s legal dependent, parent, or grandparent without rent being charged or collected, the borrower can exclude from gross income under the general welfare exclusion the PRA payments HAMP makes to the investor in a mortgage loan. But the borrower must include these payments in gross income to the extent the property is used as a rental property or is vacant and available to rent.
Sec. 117: Qualified Scholarships
A series of IRS letter rulings  examined exempt private foundations’ grant-making procedures for providing scholarships to dependent children of employees of a specified company or other eligible student recipients. The IRS found that the awards constituted qualified scholarships within the meaning of Sec. 117 and were excludable from the gross income of the recipients, subject to the limitations in Sec. 117(b).
Sec. 121: Exclusion of Gain From Sale of Principal Residence
The IRS issued proposed regulations (along with FAQs)  that include guidance on the interplay of the new 3.8% surtax on net investment income and gains imposed by Sec. 1411 and the exclusion of gain from the sale of a principal residence under Sec. 121 (up to $250,000 for a single taxpayer and $500,000 for married taxpayers filing jointly). Gain on a post-2012 sale of a principal residence in excess of the excluded amount increases net investment income for purposes of the 3.8% surtax and net capital gain under the general tax rules. This excess gain thus could be subject to the net investment income tax imposed by Sec. 1411. The entire gain on the sale of a home not covered by this exclusion (e.g., a second home) could be entirely included in net investment income.
Sec. 152: Dependent Defined
In a Tax Court case,  the IRS challenged a dependency exemption, child tax credit, and an additional earned income tax credit that a taxpayer claimedfor 2008 with respect to the infant son of his half-brother. The child lived with the taxpayer more than one-half of 2008, during which the taxpayer contributed $150 per month for food, diapers, clothing, and shoes for the child. The taxpayer’s total income for the year was $9,559.
The Court held that the taxpayer’s nephew was not a qualifying relative of the taxpayer under Sec. 152(d), but the nephew was the taxpayer’s qualifying child under Sec. 152(c). Therefore, the taxpayer was entitled to the dependency exemption deduction and the credits. A qualifying child is an individual who: (1) bears a specified relationship to the taxpayer, (2) shares the same abode for more than half the tax year, (3) meets the specific age requirement, and (4) does not provide over one-half of his or her own support. The court rejected the IRS’s position that the child did not live with the taxpayer at least half the year because it was based only on an informal statement the taxpayer made to an unidentified IRS representative and was rebutted by the taxpayer’s statements on multiple other occasions. The IRS also argued that the taxpayer was not the correct person to take the dependency exemption deduction under the Sec. 152(c)(4) tie-breaker rules, but the Tax Court found that the taxpayer was the only person who qualified to take the dependency exemption deduction, so the tie-breaker rules did not apply. Practice tip: This case provides two key points in tax planning. First, the requirements for a qualifying relative versus a qualifying child are different. It is important to ask about the relationship of all household members before determining who may take an exemption. Second, proper documentation of financial support should be maintained in case a dependency issue ever comes into question.
In Begay,  the taxpayer was a tribal elder of the Navajo Nation and claimed a dependency exemption, head-of-household filing status, an earned income tax credit, and a child tax credit for a “clan relative,” claiming the child as a “nephew” on her 2009 tax return, even though the child was not related to her in any of the ways specified for a qualifying child under Sec. 152(c)(2) or for a qualifying relative under Secs. 152(d)(2)(A) through (G). Originally, the IRS sent a notice of deficiency that disallowed the dependency exemption, but after review, the IRS conceded that the taxpayer did satisfy the requirements for the dependency exemption because the child was her qualifying relative as an unrelated household member under Sec. 152(d)(2)(H). The dependency exemption and head-of-household filing status therefore were allowed, but not the tax credits, which require a qualifying child. The taxpayer claimed that denying qualifying child status for a clan relative violated her constitutional rights under the Free Exercise Clause of the First Amendment to the U.S. Constitution, but the Tax Court did not accept her arguments. With respect to her First Amendment claim, the taxpayer argued that Navajo culture and tradition obligate clan members to provide for children of other members as if they were their own and that the denial of qualifying child status due to the Sec. 152(c) relationship classification hindered the fulfillment of her religious bligations. However, the Tax Court found that the taxpayer had not shown that the denial placed a substantial burden on her in fulfilling that obligation. The court stated that the tax benefit from Sec. 152(c)(2) does not condition the receipt of the benefit on the taxpayer’s fulfilling or not fulfilling her obligation to the clan relationships or the specific obligation to the child in question. Therefore, the taxpayer was not forced to choose between following the tenets of her religion and receiving a governmental benefit.
Sec. 162: Trade or Business Expenses
In Guy,  the IRS denied the taxpayer’s deduction for a portion of legal fees incurred for challenging his reassignment from research to clinical pursuits by his university employer. The taxpayer claimed that the legal fees were legitimate business expenses, since his research led to the receipt of a profit-making patent. The court agreed. However, it allowed only a portion of the claimed expenses. The taxpayer deducted $17,600 in legal fees on his 2007 tax return (of which $17,500 was claimed at trial) but had paid $10,000 of that amount in 2006. As a cash-basis taxpayer, he therefore lost the portion of the claimed expenses above those paid in 2006 and was subject to a Sec. 6662(a) accuracy-related penalty as well.
In Striefel,  a taxpayer received notice from the IRS that his 2008 tax return had been selected for audit, specifically his expenses on Schedule C, Profit or Loss From Business, as an independent contractor providing field engineering services. Subsequent to that notice, but before the scheduled audit, he was diagnosed with a fatal medical condition and was told he would likely die shortly. Following his release from a hospital, the taxpayer destroyed all his business records. The court rejected his attempts to use secondary-source records to substantiate his claimed expenses (particularly travel, lodging, and meals and entertainment). In upholding an accuracy-related penalty, the court said, “Although petitioner was understandably upset at the time, his actions were not justifiable, reasonable, or prudent under the circumstances.”
Sec. 163: Interest
In Letter Ruling 201316003,  the IRS granted an individual an extension of time to make an election on Form 4952, Investment Interest Expense Deduction, to treat qualified dividend income and net capital gains as investment income under Sec. 163(d)(4)(B).
The taxpayer, relying on his paid tax return preparer, failed to make a timely election to treat qualified dividend income and net capital gains as investment income. The tax preparer did not advise the taxpayer of the election’s availability when preparing his return. In the subsequent year, when the taxpayer questioned the tax preparer about the interest expense carryover, the tax preparer discovered the availability of the election that had been missed in the prior year. He then advised the taxpayer to submit a ruling request to file a late election under Regs. Secs. 301.9100-1 and -3, which the IRS granted.
Sec. 165: Losses
Goeller  exhibits a significant change in thinking on how “theft” should be defined for Sec. 165 purposes. Over a nine-year period, husband and wife taxpayers invested about $900,000 in a business that bought and sold residential real estate and invested in mortgages and in tandem investments. The taxpayers received interest income and return of capital from the company over these years. In 2004, the taxpayers requested that the company return $260,000 to them, but it was experiencing financial troubles that escalated to bankruptcy. The taxpayers had an unsecured loss of $708,000, which they argued included a theft loss of approximately $407,000. This loss resulted in a net operating loss (NOL) in 2004 and a carryback. The IRS argued there was no NOL.
In determining whether there was a theft loss for Sec. 165 purposes, the Court of Federal Claims observed that both parties cited Edwards v. Bromberg  for the proposition that theft is to be determined based on state law. Thus, according to the parties, the issue was whether the appropriate state law should be that of Ohio, where the company was located and where the taxpayers lived when they first started investing in it, or California, where the taxpayers moved in 1998. The Court questioned why state law should control the application of Sec. 165. It noted that Regs. Sec. 1.165-8(d) provides that theft includes “larceny, embezzlement, and robbery.” The Court observed that other terms used in Sec. 165, such as “storm” and “shipwreck,” were not defined by state law but by their ordinary meaning, saying: While the Court is hesitant to replow a field that has been so extensively cultivated, it is obliged to do so, as none of the precedents adopting state law are binding here. Try as it might, the court cannot resist concluding that the idea that Sec. 165(c)(3) somehow incorporates state criminal law into what is otherwise a federal taxing statute is a non sequitur. On close examination, the contrary view—that state law is controlling—appears to be a shibboleth that, by constant repetition, has become embedded in the jurisprudence of Sec., 165.. The Court further noted that “having the deductibility of a theft loss under Sec., 165 (c) turn on a specific state’s criminal statutes runs counter to the interpretative rules generally applicable to the construction of federal taxing statutes.”  In addition, the Court considered rules of statutory construction, including:Words should be defined by their “ordinary, contemporary, common meaning.”  “[W]here Congress uses terms that have accumulated settled meaning under . . . the common law, a court must infer, unless the statute otherwise dictates, that Congress means to incorporate the established meaning of these terms.”  Deductions are allowed only if “there is a clear provision therefore.”  Further, the Court observed that, typically, state law is relevant under federal law only in defining property interests. The Court found no reason to resort to state law to define theft and that “uniform administration of the federal revenue statutes” justifies use of a standard definition of the term. The Court then referred to the definition from Black’s Law Dictionary. “These well-accepted definitions of ‘theft’ make reference here to state law unnecessary,” the court said, continuing with a lengthy discussion of case law to support not relying on state law to define theft.  The Court denied both the IRS’s motion for summary judgment and the taxpayer’s cross-motion for summary judgment, as more facts were needed to resolve the issues as reframed by the Court. The Court described an approach for ultimately resolving the issue of whether taxpayers are entitled to a theft loss under Sec. 165(c)(3), under which the court would need to answer four questions:
Did the business’s conduct constitute a theft? Was the theft loss, if any, discovered by the taxpayers in 2004? In 2004, was there any reasonable prospect of recovering the funds lost? What is the amount of the theft loss, if any?
Footnotes1 Field, T.C. Memo. 2013-111. 2 American Taxpayer Relief Act of 2012, P.L. 112-240. 3 Sec. 68(b). 4 General Explanations of the Administration’s Fiscal Year 2014 Revenue Proposals (Greenbook), pp. 134–5 (April 2013). 5 Scott, No. 2:12-cv-00389-ODW (C.D. Cal. 4/5/13). 6 Rev. Rul. 80-44, 1980-1 C.B. 34. 7 Picard, 165 F.3d 744 (9th Cir. 1999). 8 Smallwood, No. EDCV 12-00023 VAP, (C.D. Cal. 12/28/12). 9 Rev. Proc. 2013-16, 2013-7 I.R.B. 488. 10 IRS Letter Rulings 201310044 (3/8/13), 201310042 (3/8/13), 201308031 (2/22/13), 201306024 (2/8/13), 201306025 (2/8/13), 201304009 (1/25/13), 201304010 (1/25/13), 201302042 (1/11/13), 201252019 (12/28/12), 201251021 (12/21/12), 201250026 (12/14/12), 201249017 (12/7/12), 201245028 (11/9/12), and 201241013 (10/12/12). 11 REG-130507-11; see Prop. Regs. Sec. 1.1411-4(h), Example (4); FAQ No. 10. 12 Oliver, T.C. Memo. 2013-117. 13 Begay, T.C. Memo. 2013-17. 14 Guy, T.C. Memo. 2013-103. 15 Striefel, T.C. Memo. 2013-102. 16 IRS Letter Ruling 201316003 (4/19/13). 17 Goeller, No. 10-731T (Fed. Cl. 3/20/13). 18 Edwards v. Bromberg, 232 F.2d 107 (5th Cir. 1956). 19 Goeller, slip op. at 7. 20 Id., slip op. at 8. 21 Quoting Perrin, 444 U.S. 37, 42 (1972). 22 Quoting Neder, 527 U.S. 1, 21 (1999). 23 Quoting INDOPCO, Inc., 503 U.S. 79, 84 (1992). 24 Goeller, slip op. at 11.
Editor Notes: Karl Fava is a principal with Business Financial Consultants Inc. in Dearborn, Mich. Jonathan Horn is a sole practitioner specializing in taxation in New York City. Daniel Moore is with D.T. Moore & Co. LLC in Salem, Ohio. Susanne Morrow is a tax partner with EY in San Francisco. Annette Nellen is a professor in the Department of Accounting and Finance at San José State University in San José, Calif. Teri Newman is a partner with Plante & Moran PLLC in Chicago. Miguel Reyna is the sole owner of Reyna CPAs PLLC in Dallas. Kenneth Rubin is a partner with RubinBrown LLP in St. Louis. Amy Vega is a senior tax manager with Grant Thornton LLP in New York City. Donald Zidik is a manager with McGladrey LLP in Boston. Mr. Horn is chair and the other authors are members of the AICPA Individual Income Tax Technical Resource Panel. For more information about this article, contact Mr. Horn at email@example.com.
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