This article covers recent developments in individual taxation – Part 3. The items are arranged in Code section order.

Sec. 1016: Adjustments to Basis

A U.S. District Court found that the taxpayers (a foreign national couple) provided sufficient evidence to support their claim that their improved property’s tax basis was higher than its purchase price. [40] The court accepted the couple’s accountant’s entries on an IRS Adjusted Basis Worksheet that their lawyer testified was prepared in reliance on contemporaneous documentation, in addition to building permits, settlement statements, and photographs of property improvements.

Sec. 1031: Exchange of Property Held for Productive Use or Investment

The Tax Court found that a couple’s real property was not used in a trade or business or as an investment at the time of a Sec. 1031 like-kind exchange. [41] The couple could not provide sufficient evidence for their intent to turn their property into a bed and breakfast. The Court also found that the taxpayers’ use of the property as their personal residence four days after the sale closed showed a clear presumption of non-business intent.

In another case, [42] the Tax Court found that an individual taxpayer’s sale of his house qualified as a like-kind exchange in which the house sold had been rented to an unrelated party, and the house purchased was rented to the taxpayer’s son. The Tax Court rejected the IRS’s contention that the son’s use of the residence did not qualify for nonrecognition treatment because it was used by the son’s family for personal purposes and the taxpayer charged his son rent that was below market value. The Tax Court found that the rent paid was sufficient because the son also performed substantial home improvement work on the residence.

Sec. 1211: Limitation on Capital Losses

The Second Circuit affirmed the Tax Court’s decision finding an individual taxpayer to be an investor in securities and not a trader, as the taxpayer’s activities showed he intended to profit through capital appreciation and not short-term oscillations in stock prices. [43] The Second Circuit agreed with the Tax Court’s opinion that the taxpayer did not trade with the “frequency, extent, and regularity” indicating an intent to realize short-term profits by catching “the swings in the daily market movements.” [44] The Second Circuit also found that the low volume of the taxpayer’s trades indicated that he was not in a trade or business. Therefore, the court held, his losses were capital rather than ordinary and were limited by Sec. 1211(b).

Sec. 1221: Capital Asset Defined

The Tax Court held that a loss realized from the taxpayer’s abandonment of an option to purchase real property was ordinary and not capital. [45] The Court found that the taxpayer purchased the option with the intent to subdivide and develop the property and that the taxpayer spent approximately 20 hours per week working on the property. The court concluded that the taxpayer would have held the property primarily for resale to customers in the ordinary course of his business and not as an investment.

Secs. 1401 and 1402: Tax on Self-Employment Income

In Specks, [46] the taxpayer, a Houston police officer, provided security services to third parties during his off-duty hours. He wore a Houston Police Department uniform and carried his personal firearm when performing the security services. The purchasers of his services did not train, supply, or equip him. The taxpayer reported income he received from providing security services as “other income” on his 2008 tax return. The issue decided by the Tax Court was whether the taxpayer was an employee or an independent contractor with respect to his security services. The taxpayer contended that he was an employee of those for whom he provided security services and, thus, the amounts paid to him by the third parties were not subject to self-employment tax. The Court weighed seven common law factors to determine that he was an independent contractor:

(1)  Which party possesses the right to control the details and means by which the work is performed

(2)  Which party invests in the facilities used in the work

(3)  The opportunity of the individual for profit and loss

(4)  Whether the principal has the right to discharge the individual

(5)  Whether the work is part of the principal’s regular business

(6)  The permanency of the relationship

(7)  The relationship the parties believe they are creating [47]

After giving greater weight to the right-of-control factor, the Court concluded that the taxpayer failed to meet his burden of proof to establish his status as an employee and sustained the IRS’s determination of self-employment tax liability.

In Howell, [48] the Tax Court determined that payments to married taxpayers by a limited liability company (LLC) reported as guaranteed payments on the LLC’s partnership return were remuneration subject to self-employment tax rather than, as the taxpayers contended, distributions of income to a limited partner. The taxpayers formed the California LLC as a medical technology company that provided software and hardware to hospitals. The wife was the record owner of a 60% capital interest in the LLC, and an unrelated individual owned 40%. The wife could dissolve the company at any time and could appoint its manager. She was entitled to receive an allocation of net profits or losses in proportion to her capital interest. During the years at issue, the company’s principal place of business was the couple’s residence. The wife signed company documents and discussed marketing strategies, and her personal credit card was used to make purchases on its behalf. The company’s Form 1065, U.S. Return of Partnership Income, reported guaranteed payments to the couple. On their untimely filed joint federal income tax returns, they reported the payments as part of distributive shares of partnership income to the wife as passive income not subject to self-employment tax. The couple argued that under Sec. 1402(a)(13), the wife was a passive investor and not subject to self-employment tax. Subsequently, they argued instead that the payments were distributions from the LLC. The court cited Renkemeyer, Campbell & Weaver LLP, [49] in which the Tax Court held that certain members of a law firm that operated as a limited liability partnership were not limited partners for purposes of Sec. 1402(a)(13) because the distributive shares received arose from legal services they provided on behalf of the firm in their capacity as partners. Sec. 1402(a)(13) provides that a limited partner may exclude his distributive share of income from net earnings from self-employment, except for guaranteed payments for services actually rendered to or on behalf of the partnership to the extent they are established to be in the nature of remuneration for those services. In the instant case, the Tax Court held that the payments were guaranteed payments that were subject to self-employment tax because the wife was more than a passive investor and provided services to the partnership. Noting that the services provided by the wife were minimal, the Court suggested that if the taxpayers had documented the extent to which the payments were not for services rendered, the payments might have escaped self-employment tax. In a field attorney advice memorandum dated March 29, 2013, and released in early May, the IRS Office of Chief Counsel (OCC) advised that Pennsylvania’s elected constables were not subject to self-employment tax but were employees for purposes of FICA and income tax withholding. [50] The OCC concluded that the constables were covered by an agreement under Section 218 of the Social Security Act. [51] The Social Security Administration had determined that the constables were covered under the state’s Section 218 agreement. Secs. 3121(b)(7)(E) and (d)(4) provide that individuals performing services covered by a Section 218 agreement are employees for FICA tax purposes. The memorandum further concluded that the constables’ compensation was not solely fee-based, as described by Sec. 1402(c)(1). If it had been (and the constables had not been covered by a Section 218 agreement) they may have been subject to self-employment tax. The Self-Employment Contributions Act (SECA) tax is imposed on net earnings from self-employment derived by an individual from any trade or business. [52] The general rule is that performing functions of a public office does not constitute a trade or business. [53] However, if compensation for the performance of those functions is solely on a fee basis, it is a trade or business. With respect to FICA, the memorandum determined, based on a common law analysis, that the constables were employees. They were also considered employees for the purposes of income tax withholding under Sec. 3401(c) because they were elected officials. Since a county controlled the payments to the constables, it was the statutory employer under Sec. 3401(d)(1).

Sec. 6654: Failure by Individual to Pay Estimated Income Tax

In Brennan, [54] an individual taxpayer asked the Tax Court to review a collection due process (CDP) appeal determination by the IRS Office of Appeals regarding a levy to collect unpaid income tax and penalties. The court found that the taxpayer was barred from asserting reasonable cause to challenge the penalties imposed under Secs. 6651(a)(1) and (2) and 6654. The taxpayer failed to file his 2008 income tax return. As a result, in April 2010, the IRS prepared a substitute for return and issued a notice of deficiency in August 2010 that included the tax shown on the substitute for return and penalties. The taxpayer did not request a redetermination of the tax liability and penalties, and therefore the IRS assessed the tax and penalties and later issued a final notice of intent to levy to collect the amount unpaid. In response to the final notice, the taxpayer requested a CDP hearing, claiming that the substitute for return did not consider deductions to which he was entitled. Following the request for a hearing, the taxpayer filed a late 2008 tax return showing an amount due that was less than that assessed on the substitute for return. The IRS accepted the return and adjusted the unpaid liability to reflect the taxpayer’s self-reported liability. Additionally, the IRS reduced the penalties and interest to reflect those that would be properly calculated on the reduced liability.

At the CDP hearing, the taxpayer argued that the total amount assessed by the IRS was greater than the amount shown on the self-reported tax return that was filed. The taxpayer was informed that the difference was due to the penalties and interest. The Office of Appeals issued a notice of determination in support of the previously issued levy notice. in January 2012, upon receipt of the Notice of Determination, the taxpayer filed a petition for review of the determination, claiming that he had reasonable cause with respect to his failure to file and pay tax and that the penalties should be abated. The Tax Court found that the taxpayer did not timely raise his reasonable-cause defense, which should have been raised in August 2010 upon receipt of the notice of deficiency.

In Kanofsky, [55] the Third Circuit affirmed a Tax Court decision upholding the IRS’s calculation of a taxpayer’s tax liability and penalties. The IRS disallowed certain claimed business and rental expense deductions. The appellate court also found the taxpayer liable for the tax and penalties under Secs. 6651(a)(1) and (2) and 6654. The taxpayer failed to submit returns or pay taxes for 2006 and 2007. The taxpayer’s income during these years included wages, Social Security payments, dividends, capital gains, and pension distributions. On Forms W-4E, Employee’s Withholding Allowance Certificate, filed with his employer, the taxpayer claimed exemption from federal tax withholding, and he did not make estimated tax payments. As a result of his failure to file and pay taxes due, the IRS assessed tax and penalties in a deficiency notice sent to the taxpayer. Upon receipt of the notice, the taxpayer unsuccessfully challenged the assessments in the Tax Court and appealed to the Third Circuit. Under Sec. 6001, taxpayers bear the burden of establishing that they are entitled to claimed deductions. The taxpayer claimed that he was entitled to deductions under Sec. 162 for ordinary and necessary expenses of a trade or business, but that the IRS and the Tax Court had unfairly prevented him from presenting evidence at trial that proved he was entitled to the deductions. According to the Third Circuit, the taxpayer had been allowed to present numerous documents in his Tax Court trial that substantiated expenses, and the court had properly admitted those that were relevant into evidence. Thus, the appellate court upheld the Tax Court’s decision that the taxpayer failed to meet his burden of proof that he was entitled to the disallowed deductions or did not owe the taxes or penalties the IRS had assessed.

In Christman, [56] married taxpayers sought a refund of penalties assessed under Secs. 6651(a)(2) and 6654 for tax years 1996 through 1998. In 2000, the taxpayers were audited by the IRS, which determined that, during the years in question, the taxpayers improperly treated losses from securities trading as ordinary rather than capital, and assessed additional tax and penalties. The taxpayers attempted to negotiate with the IRS, which abated the penalties fully for 1996 and partially for 1997 and 1998. The penalties abated were those under Sec. 6651(a)(2) but not those under Sec. 6654. The taxpayers filed suit in the Court of Federal Claims to recover the balance of the penalties. They claimed that under Sec. 6651(a)(2), a reasonable-cause exception should have been deemed by the IRS to excuse their failure to timely pay and that under Sec. 6654, a waiver exception excused their failure to pay estimated taxes. They also claimed that because the IRS had abated the Sec. 6651(a)(2) penalty in full for 1996, it was required to do so for 1997 and 1998. The Court rejected the reasonable-cause claim with respect to both penalties. The arguments in support of a reasonable-cause exception were either erroneous or could not be made under the substantial-variance doctrine because the taxpayers had not made them in their refund claim. The Court rejected the second claim regarding inconsistency in the abatement of the penalty because under well-established law, each tax year is treated separately, and the taxpayers had not cited any binding precedent in support of their argument.

 

Footnotes

40 Yiu, No. 11-875 (D.N.J. 9/26/12).

41 Yates, T.C. Memo. 2013-28.

42 Adams, T.C. Memo. 2013-7.

43 Van der Lee, No. 12-226-ag (2d Cir. 10/25/12).

44 Quoting Estate of Yaeger, 889 F.2d 29, 33 (2d Cir. 1989).

45 Sutton, T.C. Summ. 2013-6.

46 Specks, T.C. Memo. 2012-343.

47 Weber, 103 T.C. 378, 387 (1994), aff’d, 60 F.3d 1104 (4th Cir. 1995); Rosato, T.C. Memo. 2010-39.

48 Howell, T.C. Memo. 2012-303.

49 Renkemeyer, Campbell & Weaver, LLP, 136 T.C. 137 (2011).

50 Field Attorney Advice 20131801F (5/3/13).

51 Social Security Act of 1935, P.L. 74-271, §218, codified at 42 U.S.C. §418.

52 Secs. 1401 and 1402(a).

53 Sec. 1402(c)(1); Regs. Sec. 1.1402(c)-2(a).

54 Brennan, T.C. Memo. 2013-123.

55 Kanofsky, No. 12-3738 (3d Cir. 4/5/13).

56 Christman, No. 11-717 (Fed. Cl. 3/6/13).

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 jmhcpa@verizon.net.

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