Highlights of 2015 Tax Court Decisions
On June 25, 2015 the Supreme Court ruled in a seminal case upholding the legality of health insurance subsidies under the Patient Protection and Affordable Care Act (ACA). King vs. Burwell challenged the subsidies issued by the IRS on behalf of states that used the federal health insurance exchange, and thus did not set up their own exchanges. The Supreme Court ruled the subsidies to be legal.
The goal of the Affordable Care Act is to achieve near universal health care coverage while lowering health insurance premiums. ACA relies on three interdependent policies to accomplish this goal:
- Reforms to the insurance market that prohibit insurers from denying coverage or charging higher premiums based on an individual’s health status.
- Penalties on taxpayers who do not carry minimum essential health insurance coverage for any month during the year (the individual mandate).
- Subsidies, in the form of tax credits, to those individuals who cannot obtain the required minimum essential coverage through their employers and who instead obtain insurance on an Exchange (the Premium Tax Credit).
Without the Premium Tax Credit, the ACA would have likely crumbled. Had the credit been disallowed in the 36 states where it is available, the individual insurance mandate would have been rendered useless in many situations. Because a great number of taxpayers in those states would find that the cost of insurance would exceed 8% of their household income, and thus they would be exempt from the penalty for failing to carry minimum coverage. Taxpayers, as a result, would have had no financial motivation to purchase insurance until they are sick or injured, which would have the effect of driving up insurance premiums across the board.
MORTGAGE INTEREST DEDUCTIBILITY BY UNMARRIED CO-OWNERS OF REAL PROPERTY
On August 7, 2015, the United States Court of Appeals reversed a Tax Court decision in Voss v. Commissioner, involving the debt limit provisions for unmarried co-owners seeking to deduct mortgage interest for their qualified residences. The panel held that the debt limit provisions of $1.1 million of home debt apply on a per-taxpayer basis to unmarried co-owners of a qualified residence.
This was a tax dispute brought about by two unmarried co-owners of real property, both of whom claimed a home mortgage interest deduction under § 163(h)(3) of the Internal Revenue Code, which allows taxpayers to deduct interest on up to $1 million of home acquisition debt and $100,000 of home equity debt. After audit, the IRS determined that the taxpayers were jointly subject to the $1.1 million dollar provision and thus disallowed a substantial portion of their claimed deductions. The taxpayers challenged the IRS’s assessment in Tax Court, arguing the statute’s debt limits apply per taxpayer, such that they were both entitled to deduct interest on up to $1.1 million of home debt.
The United State Court of Appeals was called upon to decide how the home debt limit provisions apply when two or more unmarried co-owners of a residence claim the home mortgage interest deduction. Although the statute is silent as to unmarried co-owners, it’s inferred from its treatment of married individuals filing separate returns that debt limits apply to unmarried co-owners on a per-taxpayer basis. They reversed the decision of the Tax Court and remanded for a recalculation of the taxpayers’ tax liabilities. It deferred to the Internal Revenue Service’s reasonable interpretation of an ambiguous statute, in which the interpretation would limit unmarried taxpayers in this situation to deduct the same amount as married taxpayers filing jointly.
MORTGAGE INTEREST DEDUCTIBILITY BY A NON-SIGNATORY EQUITABLE OWNER
Home mortgage interest is deductible if it is qualified residence interest. A “qualified residence” is a taxpayer’s principal residence or one other residence (second home.) As noted above, qualified residence interest includes interest on up to $1 million of acquisition indebtedness. This is interest incurred in acquiring, constructing or improving a qualified residence, where the debt is secured by that residence. Qualified residence interest also includes home equity indebtedness, which is any indebtedness, other than acquisition indebtedness, secured by the qualified residence. The limit on home equity indebtedness is $100,000. There are further limitations for married filing separate taxpayers.
In Quin Van Phan, an equitable owner was found to have an ownership interest. The reasons are as follows:
- In 2008, the taxpayer moved into a house in California to help his mother who was unable to care for her property.
- Phan lived in the property from 2008 to 2010, during which time his mother was in the process of divorcing his father, who had moved out prior to 2008.
- As a result of the divorce settlement, Phan’s mother paid his father for his interest in the property, and she became the sole owner.
- In 2011, Phan’s sister and sister-in-law refinanced the mortgage loan for the property. Van was unable to obtain financing at that time, but entered into an oral agreement with mother and siblings that he would pay the mortgage loan and property taxes, and these payments would increase his equity in the home.
- In 2013, Phan’s name was added to the legal title to the property which was previously titled to his parents and brother.
- Since 2010, Phan paid the monthly mortgage payments from his own bank account and deducted $35,880 in home mortgage interest. The mortgage was not in his name.
- In April, 2013, Phan received notice of deficiency disallowing the home mortgage interest deduction and an accuracy-related penalty was imposed.
In order to treat interest as “qualified residence interest,” the indebtedness generally must be an obligation of the taxpayer, and not an obligation of another. However, there is a rule within the Internal Revenue Regulations which provides that even if a taxpayer is not directly liable on a bond or note secured by a mortgage, the taxpayer may deduct the interest paid if the taxpayer is the legal or equitable owner of the property subject to the mortgage. Under California law, an individual can be considered an equitable owner by showing there is an agreement or understanding with the parties evidencing an intent which is different than the deed.
Since Phan had an oral agreement with his family, in addition to paying all the home expenses while living in the home and then ultimately being added to the deed, the Tax Court held that he was being treated as an equitable owner, and therefore, allowed him to deduct the home mortgage interest.
CALIFORNIA – INTERSTATE TAXATION
Harley-Davidson, Inc. v. Franchise Tax Board tested how interstate taxpayers must calculate taxes owed. The Court of Appeals of California was asked to determine if a state provision violates the U.S. Constitution’s Commerce Clause. The provision at issue requires so-called unitary enterprises with businesses both inside and outside the state to use a combined reporting method to calculate taxes owed to California, while companies wholly inside the state can choose that method or one that treats individual entities separately.
Harley-Davidson had been reporting income from its motorcycle business to the state of California, but not income from its financial services business, reasoning that they weren’t related. After an audit, the California Franchise Tax Board found the two business lines were, in fact, related, and assessed additional tax against the company. Harley-Davidson paid $1.8 million in tax and sued for a refund, claiming the differential treatment afforded to intrastate and interstate unitary businesses violated the Constitution’s Commerce Clause.
The Franchise Tax Board conceded that the provision treats in-state and out-of-state taxpayers differently, but said the scheme withstands strict scrutiny because the state has a legitimate reason to impose it. The appellate court concluded that Harley-Davidson’s financial services subsidiaries had sufficient connection to the state to be subject to tax there. Although they argued that the subsidiaries did not have nexus in the state because they didn’t have a physical presence there, the court disagreed, saying agents of the subsidiaries engaged in conduct in the state that was necessary to sustain a market there, such as participating in auctions of repossessed motorcycles.
MARYLAND’S PERSONAL INCOME TAX STRUCTURE IS INVALID
In a 5-4 decision, the Supreme Court held that Maryland’s personal income tax regime violates the dormant Commerce Clause because it results in double taxation of some income earned in interstate commerce. This can amount to an impermissible state tariff and discriminates against interstate commerce.
The state of Maryland imposes a personal income tax on its own residents with two parts; a state income tax with graduated rates, and a county income tax with a single rate that varies by the taxpayer’s county of residence, but is capped at 3.2%. Both components are state taxes, and the Comptroller’s office collects both. Maryland residents who earn income in other states and pay income tax on that income to other states are allowed a credit by Maryland against the state tax but not the county tax. Therefore, income earned from sources outside of Maryland may be taxed twice.
A personal income tax on nonresidents is also imposed by Maryland in two parts: a state income tax on all income earned from sources within Maryland and a special nonresident tax in lieu of county tax. The special nonresident tax is imposed on income earned from sources within Maryland, and its rate is equal to the lowest county income tax rate set by any Maryland county.
This case originated when the Wynnes, who owned stock in an S corporation that did business in 39 states, claimed a credit for taxes paid to other states against their state and county income taxes. The Comptroller of Maryland assessed a tax deficiency, as the state only allowed a credit for state income tax, not county income tax.
The Maryland Court of Appeals evaluated the tax, under a four-part test, to see if a tax applied to an activity with a substantial nexus with the taxing state is fairly apportioned, does not discriminate against interstate commerce and is fairly related to the services provided by the state. The Court determined that the tax failed both the fair apportionment and nondiscrimination parts of the test.
Maryland petitioned the Supreme Court, and on August 1, 2015, they held that Maryland’s personal income tax regime violated the dormant Commerce Clause. Under this clause, states are precluded from taxing an interstate transaction more heavily than an intrastate transaction or imposing a tax that discriminates against interstate commerce by providing a direct commercial advantage to local businesses or subjecting interstate commerce to multiple levels of tax.