Tag Archive for Sec. 162

Developments in Individual Taxation – Part I

• The IRS issued proposed regulations permitting deductions for certain local lodging expenses.

• In Veriha, the Tax Court held that the Sec. 469 self-rental rule applied to a taxpayer who owned three companies, a trucking company and two truck-leasing companies, and thus the income from the S corporation truck-leasing company should be recharacterized as nonpassive, while the losses from his LLC truck-leasing company should remain passive.

• In Quality Stores, Inc., the Sixth Circuit held that severance payments paid to terminated employees as a direct result of a workforce reduction are not subject to FICA tax.

• In Rev. Rul. 2012-18, the IRS issued guidance about FICA taxes imposed on tips and the procedures for notice and demand for those taxes under Sec. 3121(q). Under Announcement 2012-50, the rules distinguishing between tips and service charges in the revenue ruling will not apply until 1/1/14.

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This article covers recent developments in individual taxation. The items are arranged in Code Section order and will be presented in Parts I, II and III.
Sec. 1: Tax Imposed

The First and Second Circuits found Section 3 of the Defense of Marriage Act (DOMA) unconstitutional (1). The effect of Section 3 is to deny federal income tax benefits, such as filing joint income tax returns, to same-sex couples. The First Circuit stayed its mandate that Section 3 not apply pending a likely Supreme Court review. The Supreme Court has granted certiorari in the Second Circuit case and will hear arguments on March 27.

Sec. 24: Child Tax Credit

Children of a U.S. citizen and her Israeli spouse, who were born and living in Israel, did not qualify as dependents under Sec. 152(b)(3), which states a dependent must be a citizen or resident of the United States (2).  Therefore, the child care and child tax credits under Sec. 21 and Sec. 24 were denied. The taxpayer also claimed that the IRS’s alternative argument that the credits were being denied because she did not file a joint return, as required by Sec. 21(e), was prohibited by Sec. 7522 because the notice of deficiency did not mention Sec. 21(e). The Tax Court noted Sec. 7522 does not require the IRS to identify all of the Code sections applicable to each tax adjustment.

Sec. 61: Gross Income Defined

In Notice 2012-12 (3) the IRS provides that mandatory restitution payments that victims receive from defendants under 18 U.S.C. Section 1593 (4) are excluded from income.

Sec. 104: Compensation for Injuries or Sickness

In Blackwood, (5) the taxpayer was terminated from her job for accessing her son’s medical records at the hospital where she worked. In the taxpayer’s unlawful termination suit, she indicated she suffered from a relapse of depression symptoms. The taxpayer received $100,000 and a Form 1099-MISC, Miscellaneous Income, reporting the payment, but the taxpayer did not report it on her tax return because she believed it was excludable under Sec. 104.

The Tax Court held for the IRS that the damages were not excludable under Sec. 104(a)(2) even though the underlying action was based on a tort or tort-type right. The taxpayer was unable to show she received damages for physical injuries. A letter from her doctor did not note any physical symptoms. The flush language of Sec. 104(a) also did not help the taxpayer’s case because it states that “emotional distress shall not be treated as a physical injury or physical sickness.” She was also unable to benefit from Sec. 104(a) because she did not show that she used any of the damages for medical care for emotional distress.

Sec. 107: Rental Value of Parsonages

The Supreme Court declined to hear the taxpayer’s appeal in Driscoll (6).  This case involved how the word “a” in the Sec. 107 exclusion from gross income for the rental value of a parsonage should be interpreted when used in the phrase “a home.” Does that mean one home or could it mean two homes? The Tax Court held for the taxpayer, noting that “a home” could have a plural meaning. On appeal, the Eleventh Circuit held for the IRS, noting that “home” has a singular meaning and that income exclusions should be construed narrowly.

Sec. 108: Income From Discharge of Indebtedness

In a case decided by the U.S. Tax Court, the taxpayers did not qualify to exclude income from discharged credit card debt under the exclusion for insolvency in Sec. 108(a)(1)(B) due to a lack of credible evidence presented regarding the fair market value (FMV) of their assets immediately before the discharge (7).  The evidence they submitted was insufficient to establish FMV for federal tax purposes because the documents (tax bills and loan documents) did not describe the property or explain the methodology used to determine the value, and their testimony regarding comparable sales was uncorroborated and was not based on contemporaneous sales.

Rev. Rul. 2012-14 (8) amplifies Rev. Rul. 92-53 (9)  and explains how partners treat a partnership’s discharged excess non-recourse debt in measuring insolvency under Sec. 108(d)(3). To the extent discharged excess non-recourse debt generates cancellation of debt (COD) income that is allocated under Sec. 704(b) and its regulations, each partner treats its part of the discharged excess non-recourse debt related to the COD income as a liability in measuring insolvency under Sec. 108(d).

In Letter Ruling 201228023, (10) the IRS found that a parent corporation’s bankruptcy plan was considered a liquidation plan for tax purposes. None of the debtors will recognize COD income with respect to any of the allowed claims until all distributions are made or if the bankruptcy plan ceases to be a liquidation plan.

Sec. 162: Trade or Business Expenses

After the IRS denied a taxpayer’s deduction for moving expenses, the taxpayer agreed but then tried a uniquely different approach in Tax Court (11).  He tried to claim meals, lodging, and lease cancellation fees as business expenses related to his employment as a restaurant chef. The IRS and the court both agreed that he had changed his tax home when he moved himself and his family and therefore no deduction was allowed.

The IRS issued proposed regulations (12) that would allow a deduction under Sec. 162 for certain local lodging expenses incurred by employers or their employees. The deduction would be allowed under a facts-and-circumstances test. One factor considered in the test is whether the expense is incurred to satisfy a bonafide requirement imposed by the employer. In addition, the regulations contain a safe harbor allowing the deduction in the following circumstances: (1) The lodging is necessary for the person to fully participate or be available for a bonafide business function; (2) it does not exceed five calendar days or occur more frequently than once a quarter; (3) the individual is an employee, and his or her employer requires him or her to remain at the function overnight; and (4) the lodging is not lavish or extravagant and provides no significant personal pleasure or benefit. A simplified version of these rules was already in effect under Notice 2007-47 (13) [which was made obsolete by these regulations].

DeLima (14) could be used as a teaching tool for all the ways taxpayers can fail to substantiate their Schedule C, Profit or Loss From Business, trade or business expenses. The court went through a top 10 list of problems with the claimed expenses including:

• Failure to provide credible evidence on the relative amount of business vs. personal use of her vehicles;

• Failure to establish a business purpose for various expenses, including insurance costs, furniture rental, or lawn maintenance;

• Failure to provide receipts or other proof of equipment purchases and rentals;

• Admitting that her rented home and apartment were entirely mixed personal/business use; and

• Failure to meet the strict substantiation requirements of Sec. 274(d) for travel and entertainment or listed property expenses.

In addition, the taxpayer tried to claim that the IRS examination was barred by statute, even though she had signed a Form 872, Consent to Extend the Time to Assess Tax. This argument and her claim that she had signed the Form 872 under false pretenses were not raised until after the actual trial, and the court rejected them both.

Sec. 163: Interest

In Abarca, (15) the petitioner claimed mortgage interest expense deductions for various rental properties on Schedule E, Supplemental Income and Loss, some of which were purportedly owned in partnership with others. The petitioner was neither named as the borrower for any of the mortgages on these properties nor was he able to prove he was the properties’ legal or equitable owner. In addition, it was unclear whether the properties had been contributed to the various partnerships. It was also apparent that the partnership form was not respected as the petitioner reported the properties as if he owned them individually. In addition, the petitioner was unable to prove that he personally paid all of the interest that he claimed. The petitioner was denied the deductions for any of the mortgage interest claimed on Schedule E for the subject properties. The Tax Court held in Chrush (16) that the petitioner failed to substantiate payments of mortgage interest on Form 1098, Mortgage Interest Statement, and home mortgage interest not reported on Form 1098. The petitioner co-owned the house with a close friend, but the amount reported on the Form 1098 issued to them was far lower than the deduction the petitioner claimed on his tax return, and no bank statements, canceled checks, or other evidence was produced to substantiate that he paid the claimed interest that was not reported on the Form 1098. In addition, the petitioner was unable to prove that he, and not his co-borrower, paid the interest reported on the Form 1098.

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by Karl L. Fava, CPA; Jonathan Horn, CPA; Daniel T. Moore, CPA; Susanne Morrow, CPA; Annette Nellen, J.D., CPA; Teri E. Newman, CPA; S. Miguel Reyna, CPA; Kenneth L. Rubin, CPA; Amy M. Vega, CPA; Donald J. Zidik Jr., CPA.

Edited and posted by Harold Goedde, CPA, CMA, Ph.D. (taxation and accounting)


1 Massachusetts v. United States Dep’t of Health and Human Servs., 698 F. Supp. 2d 234 (1st Cir. 2012); Windsor, No. 12-2335-cv(L) (2d Cir. 10/18/12), cert. granted, Sup. Ct. Dkt. 12-307 (U.S. 12/7/12).

2 Carlebach, 139 T.C. No. 1 (2012).

3 Notice 2012-12, 2012-6 I.R.B. 365.

4 Added by Section 112(a) of Victims of Trafficking and Violence Protection Act of 2000, P.L. 106-386.

5 Blackwood, T.C. Memo. 2012-190.

6 Driscoll, 669 F.3d 1309 (11th Cir.), cert. denied, Sup. Ct. Dkt. 12-153 (U.S. 10/1/12).

7  Shepherd. Memo. 2012-212.

8 Rev. Rul. 2012-14, 2012-24 I.R.B. 1012.

9 Rev. Rul. 92-53, 1992-2 C.B. 48.

10 IRS Letter Ruling 201228023 (7/13/12).

11 Newell, T.C. Summ. 2012-57.

12 REG-137589-07.

13 Notice 2007-47, 2007-1 C.B. 1393.

14 DeLima, T.C. Memo. 2012-291.

15 Abarca, T.C. Memo. 2012-245.

16 Chrush, T.C. Memo. 2012-299.

Donating And Sharing Paid Time Off

Hurricane Sandy highlighted the role of programs that allow employees to donate the value of their unused paid time off (PTO) from work or share it with fellow employees. Following are the main types of programs and their tax treatment.

Standard PTO Charitable Donation Programs

In this type of program, employees may donate the value of their unused or unwanted PTO to a charitable organization. The employer typically pays the organization cash equal to the value of the donated PTO, which the donating employee generally must recognize as taxable compensation income that is subject to income tax and FICA withholding. The amount the employer withholds must be deducted from the employee’s wages, which will reduce the employee’s paycheck in the pay period the donation is made. To avoid reducing the employee’s paycheck, the employer may “gross up” the employee’s pay so that the employee’s after-tax pay is not reduced, or the employer may reduce the donation by the amount required to be withheld. Because the value of the PTO is donated to a charitable organization, the donor employee is allowed a charitable contribution deduction under Sec. 170. The employer is allowed a deduction for the value of the donation as compensation expense under Sec. 162.

Disaster Relief PTO Charitable Donation Programs

In certain situations, the IRS has allowed employees to avoid recognizing the value of PTO donated to a charitable organization as compensation income. The most recent of these situations was in the aftermath of Hurricane Sandy. In Notice 2012-69, the IRS provided that employees who donate unused PTO under a program in which the employer contributes the value of the PTO before Jan. 1, 2014, to a Sec. 170(c) charitable organization for the relief of victims of Hurricane Sandy will not be required to recognize compensation income for the value of the donated PTO. Because the employee does not include the value of the donated PTO in income, he or she is not allowed to take a charitable contribution deduction. The IRS will not assert that the employer will be permitted to deduct the cash payments only under Sec. 170 as a charitable deduction but will allow the employer to deduct the payments as compensation under Sec. 162. Previously, the IRS authorized disaster relief PTO programs in response to Hurricane Katrina (Notice 2005-68), and the Sept. 11, 2001, terrorist attacks (Notice 2001-69).

Standard Leave-Sharing Banks

In another type of program, an employee surrenders an amount of unused accrued PTO that the employer places in a leave-sharing bank. Other employees who have run out of PTO can then draw on the bank for reasons specified by the employer. As with the standard PTO charitable donation program, the employee who surrenders the PTO is required to recognize taxable compensation income equal to the value of the surrendered PTO, unless the arrangement qualifies as one of the two types of leave-sharing plans discussed below. The donating employee is not entitled to a charitable contribution deduction because he or she does not make a contribution to a charitable organization.

Major Disaster Leave-Sharing Plans

In a major disaster leave-sharing plan, PTO surrendered by an employee to the plan is only available to employees adversely affected by any presidentially declared major disaster. If the plan is in writing and meets certain conditions in Notice 2006-59, the donating employee is not required to recognize compensation income and is not allowed a charitable contribution deduction.

The employer may take a compensation deduction under Sec. 162 when payments are made to recipients from the plan, not when the PTO is surrendered to the plan. Recipients of payments from the plan must include them in income, and the employer must treat the payments as compensation and withhold the appropriate income and FICA taxes.

Medical Emergency Leave-Sharing Plan

In a medical emergency leave-sharing plan, PTO an employee surrenders to the plan is available only to employees with medical emergencies. For this purpose, a “medical emergency” is a medical condition of the employee or a family member of the employee that will require the prolonged absence of the employee from duty and will result in a substantial loss of income to the employee because the employee will have exhausted all PTO available apart from the leave-sharing plan. In Letter Ruling 200720017, the IRS approved a plan in which a prolonged absence included intermittent absences related to the same condition or illness. In Rev. Rul. 90-29, the IRS ruled that as long as certain conditions are met, an employee who donates PTO to a medical emergency leave-sharing plan is not required to recognize compensation income for the value of the donated PTO and is not allowed to take a charitable contribution deduction.

The employer may take a compensation deduction under Sec. 162 when payments are made to recipients from the plan, not when the PTO is surrendered to the plan.

Recipients of payments from the plan must include them in income, and the employer must treat the payments as compensation and withhold the appropriate income and FICA taxes.

Outweighing the Burdens

Employers that establish a PTO charitable donation or leave-sharing program can thereby enable their employees to share in relieving hardship, as companies demonstrate their concern for their own employees experiencing difficulties or for their community or the nation at large when disaster strikes. Although maintaining a compliant tax-favored plan may require extra time and expense of administration, many employers are likely to see the benefits as outweighing the burden.

By Jeffrey A. Martin, CPA and G. Edgar Adkins Jr., CPA, senior manager and partner, respectively, with Grant Thornton LLP, Washington, D.C., FEBRUARY 28, 2013.

Edited and posted by Harold Goedde CPA, CMA, Ph.D. (taxation and accounting)