• 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. 1221: Capital Asset Defined
The Tax Court rejected the taxpayers’ claim that a residential property be allowed ordinary loss treatment because the property was not held for sale to customers in the ordinary course of their trade or business (44). The court found that the taxpayers did not intend to occupy the property as their personal residence, but the property was never converted from residential to nonresidential property. Because the taxpayers’ real estate sales lacked frequency, the court found the loss to be a capital loss.
In another case, the court found that income from the sales of real estate lots was ordinary income instead of capital gain as the taxpayers claimed (45) The court found that the taxpayers’ actions were conducted in the ordinary course of a trade or business and not for investment purposes, even though one of the taxpayers was a day trader. The court found that the frequency, continuity, and substantiality of the sales of the lots were significant in comparison to the day-trader activities.
The Ninth Circuit affirmed a District Court’s decision that a qui tam award is ordinary income and not capital gain (46). A qui tam award is allowed under the False Claims Act, (47) which permits an individual to bring suit against a defendant that the individual knows has submitted a false claim to the United States. The Ninth Circuit found that the award did not qualify as a capital asset because the taxpayer did not invest capital in return for the right and there was no accretion in value over cost to any underlying asset.
Sections 1401 and 1402: Tax on Self-Employment Income
Compensation earned from performance of services as an employee is not self-employment income, (48) but compensation earned by a U.S. citizen employed by a foreign government in the United States is an exception to this general rule. In Weaver, (49) the taxpayer worked for the Consulate General of Canada in San Francisco. The court held that a payment to the taxpayer after a period of disability was severance pay subject to self-employment tax. The petitioner had reported the payment as “other income” not subject to self-employment tax that was paid on account of disability and therefore did not constitute wages. The consulate had characterized the payment as severance and calculated the payment based on the petitioner’s length of service and salary. The court agreed with the IRS that the payment was subject to self-employment tax since severance pay is a form of compensation for services (50).
In another case, the taxpayer was an employee of the International Monetary Fund (IMF) (51). U.S. citizen employees of the IMF are subject to self-employment tax on that compensation as no payroll taxes are withheld. The taxpayer did not self-assess the self-employment taxes, but the court relieved the taxpayer of the penalties: The accuracy-related penalty does not apply to any portion of an underpayment if there was reasonable cause for, and the taxpayer acted in good faith with respect to, that portion of the underpayment (52). (This is reminiscent of Treasury Secretary Timothy Geithner who worked at the IMF and was not subject to penalties when he mistakenly did not pay self-employment taxes.)
In an IRS Information Letter (53) the IRS responded to a taxpayer’s question about its position on whether self-employment tax applies to rental payments for farmland by explaining that, although rental payments are normally exempt from the tax, rentals of farmland for agricultural purposes where the farmer materially participates are not exempt. Several years ago, the Eighth Circuit had issued a decision (54) holding that these payments were not subject to the tax, but the IRS issued a nonacquiescence to that decision (55). In the information letter, the IRS reiterated its intent to continue to litigate the issue in cases outside the Eighth Circuit and explained that its interpretation of the exception in Sec. 1402(a)(1) best promotes Congress’s intent that farmers who work for a living have their incomes replaced through coverage under the Social Security system.
The Tax Court held that a trustee should be treated the same as a director and a director is not an employee: The trustee is self-employed and therefore liable for his or her own Social Security and Medicare taxes (56).
Sec. 3101: Employment Taxes on Employees
The Sixth Circuit ruled in Quality Stores, Inc. (57) that severance payments paid to terminated employees as a direct result of a workforce reduction are not subject to FICA tax. In an article discussing the Quality Stores decision, Laura Saunders in her Wall Street Journal Tax Report of October 27, 2012, suggests:
If the company didn’t file a refund claim for FICA taxes but the employee believes she is entitled to one, then often she can file IRS Form 843 [Claim for Refund and Request for Abatement] to make her own claim, according to an IRS spokesman. But the worker must make the claim during the statute of limitations period, which is usually three years after the April 15 due date following the year the severance was received.” (58) The Sixth Circuit’s decision conflicts with the Federal Circuit’s 2008 decision in CSX Corp. (59).
A U.S. District court held that money an individual received to settle an age discrimination lawsuit constituted wages subject to FICA tax withholding because the individual failed to prove otherwise (60).
The Tax Court, sustaining penalties and additions to tax, held that a company was liable for employment taxes on wages paid to masons and laborers the company argued were independent contractors, finding that the requirements for relief under Section 530 of the Revenue Act of 1978 (61) were not satisfied because the company did not file Forms 1099-MISC treating the laborers as independent contractors (62). In addition, the court concluded that the masons and laborers were the company’s employees, basing its decision on common law principles (63).
Sec. 3121: Employment Taxes
In Rev. Rul. 2012-18, (64) the IRS issued guidance updating guidelines regarding FICA taxes imposed on tips and the procedures for notice and demand for those taxes under Sec. 3121(q) when employees failed to report or underreported tips to the employer. (The guidelines, in question-and-answer format, modify and supersede guidance originally published in January 1995 (65)). The new guidelines were supposed to be effective immediately when they were issued, but because the tip vs. service charge rules may require businesses to change their automated or manual reporting systems to comply, the IRS announced that its examiners were being instructed, in limited circumstances, to apply the rules prospectively to amounts paid on or after Jan. 1, 2013 (66). These deadlines were delayed further, so they will now apply to amounts paid on or after Jan. 1, 2014 (67).
Sec. 6013: Joint Returns of Income Tax by Husband and Wife
A district court denied a taxpayer’s duress defense to joint and several liability for a joint return she claimed she signed while medicated and her husband “threatened to tear apart the family” (68). The denial was based on discovery that showed the spouses remained married while living apart for 12 years before filing the joint return. Therefore, although the court believed the wife’s claims that she had been subjected to emotional abuse through most of her marriage, by the time she signed the return at issue, she was no longer under duress. The wife also admitted she had signed the return believing the husband would pay the income tax liability.
Sec. 6015: Relief From Joint and Several Liability on Joint Return
The Tax Court denied a retired engineer relief under Secs. 6015(b), (c), and (f). The taxpayer claimed that the taxable IRA withdrawals he made should not be taxable to him because he made them to comply with a Colorado court’s order to pay spousal and child support (69). He also claimed that the capital gain on stock he sold to pay his ex-wife should be attributed to his ex-wife. The taxpayer’s most interesting claim was that, because he faced jail time if he did not make the court-ordered payments, he was a victim of abuse, which he claimed made him eligible for innocent spouse relief. The court did provide relief for the delinquency caused by the ex-wife’s unreported interest income of $37.
Sec. 6673: Sanctions and Costs Awarded by Courts
In the Ninth Circuit, a taxpayer was found liable for tax and penalties under Secs. 6651(a)(1) and (2) and 6654 for the 2006 tax year and sanctioned for making frivolous arguments under Sec. 6673, affirming a Tax Court bench decision (70). The taxpayer, an employee of Sky West Airlines Inc. (Sky West) for 2006, earned $78,758 in wage income reported on Form W-2, Wage and Tax Statement, from the airline. Additionally, the taxpayer realized capital gain income of $29,079, as reported on a Form 1099-B, Proceeds From Broker and Barter Exchange Transactions. Nonetheless, for that year, the taxpayer filed a tax return reporting zero wages and no capital gains, arguing that he was entitled to exclude his income under Sec. 83. The taxpayer claimed that he had basis in his labor, which he traded to Sky West for compensation of an equal value. As a result, the taxpayer asserted that under Sec. 83(a), “the value of his labor is excluded from gross income.” Additionally, the taxpayer argued that his wage income did not qualify as wages under Sec. 3401(a) and Sec. 3401(b) and that he was not an employee under Sec. 3401(c).
The Tax Court found that the taxpayer’s arguments were the result of a misguided reading of the Code and that the taxpayer constructed arguments based on portions of the Code and regulations that did not apply to him. Based upon these actions, the court upheld the assessment of tax and penalties under Secs. 6651 and 6654 and imposed sanctions for making a frivolous argument under Sec. 6673. The taxpayer’s “actions reflect an appalling lack of competent research and analysis and suggest that he was motivated by goals that are simply not consistent with a good-faith attempt to comply with the obligations imposed on taxpayers by the federal tax system.”
Section 6702: Frivolous Tax Submissions
In October 2012, a district court upheld the IRS’s attempt to collect unpaid federal income taxes and penalties against an individual for late filing, failure to pay, and failure to pay estimated tax penalties under Sec. 6702 (71). Before tax year 2000, the taxpayer filed tax returns and paid tax. In 2000, the taxpayer began filing “zero” tax returns and failed to report complete and accurate information until 2009. Additionally, he requested a refund for the 1999 tax year, claiming that the taxes he paid were illegal. When the taxpayer did not receive a refund and instead was assessed a frivolous return penalty, he met with an IRS settlement officer and said he would pay in full if the officer could produce the Code section that required him to pay the tax. The taxpayer believed that he had no duty to pay and requested that his employer not withhold any tax for the years in question. In 2009, he began reporting income and expenses properly. The court found that the “zero” returns filed for the years at issue were frivolous and proved that the taxpayer did not make honest and reasonable attempts to comply with the law or exercise ordinary business care and prudence in filing his tax returns and paying the tax.
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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)
|43 IRS Letter Ruling 201240006 (10/5/12).||58 Saunders, “When Severance Pay Is Subject to Payroll Tax,” Wall Street Journal|
|44 Bennett, T.C. Memo. 2012-193.||59 CSX Corp., 518 F.3d 1328 (Fed. Cir. 2008).|
|45 Flood, T.C. Memo. 2012-243.||60 Gerstenbluth v. Credit Suisse Securities (USA) LLC, No. 2:11-cv-02525 (JS) (GRB) (E.D.N.Y. 9/28/12).|
|46 Alderson, No. 10-56007 (9th Cir. 7/18/12).||61 Revenue Act of 1978, P.L. 95-600.|
|47 False Claims Act, 31 U.S.C. §§3729–3733.||62 Atlantic Coast Masonry Inc., T.C. Memo. 2012-23.|
|48 Secs. 1402(a) and (c)(2).||63 Id at *13, citing Secs. 3121(d)(2) and 3306(i) and Weber, 103 T.C. 378 (1994), aff’d per curiam, 60 F.3d 1104 (4th Cir. 1995).|
|49 Weaver, T.C. Summ. 2012-52.||64 Rev. Rul. 2012-18, 2012-26 I.R.B. 1032.|
|50 Regs. Sec. 1.61-2(a)(1).||65 Rev. Rul. 95-7, 1995-1 C.B. 185.|
|51 Chien, T.C. Memo. 2012-277.||66 Announcement 2012-25, 2012-26 I.R.B. 1032.|
|52 Sec. 6664(c)(1). In determining whether the taxpayer acted with reasonable cause and in good faith, the guidance in Regs. Sec. 1.6664-4(b)(1) is applicable.||67 Announcement 2012-50, 2012-52 I.R.B. 802.|
|53 IRS Information Letter 2012-0035 (6/29/12).||68 Miles, No. CV 10-2398 CW (N.D. Cal. 3/30/12).|
|54 McNamara, 236 F.3d 410 (8th Cir. 2000).||69 Yosinski, T.C. Memo. 2012-195.|
|55 AOD-2003-03 (10/22/03).||70 Leyva, No. 11-71648 (9th Cir. 9/21/12), aff’g No. 25427-09 (Tax Ct. 1/20/11) (order and decision).|
|56 Blodgett, T.C. Memo. 2012-298.||71 Rodin, U.S. District Court, No. 1:11 CV 1684 (N.D. Ohio 10/9/12).|
|57 Quality Stores, Inc., No. 10-1563 (6th Cir. 9/7/12), reh’g denied (1/4/13).|