Individual taxation report
September 1, 2017
By Members of the AICPA Individual & Self-Employed Tax Technical Resource Panel, including our Darren Neuschwander, CPA
This semi-annual update on developments in individual tax covers cases, rulings, and regulations, including a number of cases involving whether taxpayers qualified as real estate professionals.
Mr. Neuschwander wrote the content in Sec. 162: Trade or business expenses, and Sec. 183: Activities not engaged in for profit.
Current Developments in Taxation of Individuals
By Darren Neuschwander, CPA, March 1, 2017
Sec. 162: Trade or Business Expenses
Substantiation: In Kilpatrick,14 the taxpayer was denied certain business deductions under Sec. 162 as a self-employed CPA. The taxpayer started his own CPA business in 2009 after working with an Atlanta CPA firm for approximately 11 years. He was still working with his former firm until the end of 2010 after he started his own business. The taxpayer operated his new business from his home office. He was denied several deductions on his 2009 and 2010 Schedule C, Profit or Loss From Business, due to lack of substantiation.
For his automobile expenses, the taxpayer prepared and presented a calendar and printouts from MapQuest, both generated in December 2011. The Tax Court found that neither of these items constituted “adequate records” for such usage given that they had been generated two years after the time the business use of the automobile occurred. Additionally, no deduction was allowed for the furnishings (desk, chairs, and a painting) purchased for his home office, as the court found the items to be antiques that “will retain their value,” and the taxpayer offered no proof otherwise.
He was also denied a deduction for a computer he purchased in 2009 as he failed to prove that he used it solely for business given that the computer was not “used exclusively at a regular business establishment” and was not owned or leased by the person operating the business. The taxpayer’s continuing education cost was not deductible because the expenses were actually reimbursable by the CPA firm that he worked for as part of the firm’s annual CPE requirements. Finally, the court denied a business deduction for his cellphone and home internet service because he failed to substantiate the amount of business and personal use.
Education costs: In Kopaigora,15 the taxpayer was entitled to a deduction for education and travel costs as unreimbursed employee expenses under Sec. 162(a). Although the taxpayer was fired from his job after he started his education, the Tax Court noted that being unemployed did not prevent him from continuing his trade or business as a finance and accounting business manager. Because a new employer hired him in a similar position after graduation, the court held for the taxpayer. The court stated that “the courses petitioner chose to fulfill his degree requirements did not qualify him for a new trade or business because he was not qualified to perform new tasks or activities with the conferral of his degree.”
Ordinary and necessary: In Cole,16 the Tax Court denied the taxpayer’s unsubstantiated requests for various deductions on Schedule C of his individual income tax return related to his public-speaking business. In this case, the IRS was challenging the timing of payments made by the taxpayer, as well as whether other expenses fit the definition of “ordinary and necessary.” The taxpayer was able to provide adequate support for legal and professional fees, bookkeeping fees, and internet and computer-related expenses, as well as a few others. The taxpayer included the majority of these deductions originally on Schedule C. The Tax Court found that these expenses were ordinary and necessary expenses under Sec. 162 that were paid and therefore were deductible. However, the court agreed with the IRS that the expenses for travel, meals, and entertainment were not deductible because the taxpayer had failed to meet the strict substantiation requirements imposed on these types of costs.
Sec. 163: Interest
Mortgage interest: In AOD 2016-02, the IRS acquiesced in the Voss decision in the Ninth Circuit.17 The appeals court reversed an earlier Tax Court decision and held that the mortgage deduction limits under Sec. 163(h)(3) apply on a per-individual basis as opposed to a per-property basis. Therefore, for unmarried co-owners of property, the $1.1 million interest deduction per the Sec. 163(h)(3) limitation is actually $2.2 million.
Written documentation: The case of Jackson18 once again highlights the importance of written documentation and testimony. The Tax Court denied the taxpayer an interest deduction under Sec. 163 for “interest” payments that he made to his “domestic partner” girlfriend. The girlfriend was the sole owner of the residence that the couple occupied as their personal residence, and she was the only individual responsible for the mortgage. The taxpayer made a cash payment each month to the girlfriend to pay the interest-only mortgage. Due to lack of receipts for the payments, along with the lack of any written statement obligating the taxpayer to pay the girlfriend the monthly amount (other than a letter from her stating that the taxpayer paid her $1,000 a month), the court found that the taxpayer did not have any ownership interest in the residence. It also noted that the girlfriend did not testify and that this testimony “would have been highly relevant to the question [of] whether she and the petitioner had agreed (expressly or impliedly) that he would hold an interest in the property.”
Sec. 165: Losses
Disaster loss election: Rev. Proc. 2016-53 was issued on Oct. 13, 2016, and was effective immediately, to provide an additional six months for making an election under Sec. 165(i) to claim a disaster loss in the preceding tax year. The election due date is six months after the due date for filing the taxpayer’s federal income tax return for the disaster year (without regard to extension). A taxpayer makes the Sec. 165(i) election with the filing of either an original or amended tax return of the year preceding the disaster year.
Forfeited profits: The Federal Circuit denied the former CEO of Qwest an income tax credit of $17,974,832 for taxes he paid on insider trading profits that he forfeited to the U.S. government. The IRS successfully asserted that the forfeiture was a government penalty, which is not deductible under Sec. 165(c).19
The taxpayer was convicted of insider trading and was required to forfeit his net profit of approximately $44 million from his insider trading and pay a fine of approximately $19 million as a result of his criminal conviction. While the Court of Federal Claims allowed a deduction for the forfeited profits, the Federal Circuit reversed the decision and disallowed the deduction. The Federal Circuit concluded that “allowing a deduction in these circumstances would . . . frustrate public policy,” and that even though the taxpayer reported the gain from the trading activity as income and paid tax on the gain, the forfeited income is a criminal forfeiture and “must be paid with after-tax dollars, just as fines are paid with after-tax dollars.”
– See more at: http://www.thetaxadviser.com/issues/2017/mar/current-developments-taxation-individuals.html#sthash.88uWwyoO.dpuf
Sec. 183: Activities Not Engaged in for Profit
Horse breeding: In Roberts,23 the Seventh Circuit reversed a Tax Court decision in part,24 which disallowed losses from 2005 and 2006 from the taxpayer’s horse-breeding activity under Sec. 183, while it allowed the deductions in later years. The Seventh Circuit questioned the Tax Court’s reasoning that the startup phase of an activity was a hobby, while the later stages were a business. It also stated that the nine factors provided by Regs. Sec. 1.183-2(b) for determining whether an activity has a profit motive are “open-ended” and that the Tax Court “was not . . . required to apply all of those factors” to the taxpayer. In applying the personal pleasure and recreation factor of Regs. Sec. 1.183-2, the Seventh Circuit also noted that “it may have been a fun business, but fun doesn’t convert a business to a hobby.”
Car restoration: In another case, the Tax Court allowed a patent attorney deductions for his activity restoring 1955 and 1956 Plymouth cars.25 The court stated, “Although his manner of carrying on this activity was unsophisticated, it was businesslike.” Given the taxpayer’s experience of operating a business and his expertise in restoring these specific cars, along with his advertising efforts and associated business travel, the court deemed the activity to be for profit.
Hair braiding: In Delia,26 the Tax Court ruled that the taxpayer’s hair-braiding salon business was for profit. Despite little revenue and substantial expenses (mainly rent), along with a history of losses from 2004 to 2012, the court found that the taxpayer had a profit motive. The taxpayer had entered into a long-term lease for a booth in a shopping mall. The court found that it might have been “prudent for her to have exited this business before she did, but the long-term rental contract posed a serious obstacle.” The taxpayer closed her business at the conclusion of the lease agreement. Additionally, the court found that there was no personal pleasure in operating the salon activity. “Although petitioner had a nostalgic fondness for hair braiding, sitting in an empty booth in a shopping mall is not as much fun as (say) riding horses.”
Aircraft leasing: In another case, the taxpayer failed to prove that he engaged in his aircraft leasing activity for a profit, even though it had some positive cash flow.27 In applying the nine factors of Regs. Sec. 1.183-2(b), the court found that the taxpayer failed to avoid “avoidable losses” and that “abandoning unprofitable methods can indicate a profit motive.” Additionally, the court found that despite the taxpayer’s success in unrelated business activities, that success alone does not carry weight in the determination of profit motive for his aircraft leasing activity given that there was no association among the unrelated ventures. Lastly, the fact that the taxpayer had a substantial income from other sources did not support the for-profit motive of the activity. For the years in question (2003 and 2004), the taxpayer reported gross income of $179,787 and $2,980,944 after claiming losses of $517,044 and $773,776, respectively, from the aircraft leasing activity.
Amway products: The multilevel marketing business of selling Amway products was found not to be a for-profit business activity of the taxpayer in Hess.28 The taxpayer reported seven consistent years of Schedule C losses from being a distributor of Amway products. During those seven years, the taxpayer did not seek any outside business advice besides that of his sponsoring distributor; nor was there any overall business plan, invoices to customers, or any financial statements produced for this activity. The only documentation that the taxpayer maintained was receipts to substantiate expenses. Additionally, the taxpayer was not able to provide support for any of his “two to four distributors” he had added to his downline distributors (distributors recruited by the taxpayer) each year from 2005 to 2010. The court concluded that the taxpayer “did not operate [his] Amway activity in a businesslike manner.”