Highlights of 2016 Tax Court Decisions

Although 2016 did not have significant tax cases to assist in navigating year-end planning, the following did help clarify certain important questions.

Tax Court Rejects Widow’s Claim of Deceased Spouse’s Unused Tax Credit
In the Tax Court case of Vichich v. Commissioner, it was determined that a deceased taxpayer’s unused deductions or credit carryovers must be used on the last tax return filed by the decedent, or the unused amounts will be lost.

The Tax Court ruled a widow could not use her deceased husband’s alternative minimum tax credit carryover which arose from his exercise of employee stock options prior to their marriage. The Court held, because the credit was generated before they were married, the stock options were not the taxpayer’s, and the credit did not pertain to her. The deceased taxpayer was unable to utilize the credit on the final married filing joint tax return; therefore, it could not carry over to the surviving spouse in subsequent filing years.

Unreimbursed Employee Business Expenses Must Be Ordinary and Necessary; Proof is Needed.
In the case of Tanzi v. Commissioner, a husband and wife were denied deductions of home internet, phone and television expenses as unreimbursed employee business expenses on Schedule A of Form 1040. They characterized these expenses as “electronic support.”

The husband, a college professor, claimed that the internet helped him with self-education while increasing “general knowledge” in his subject areas. To qualify for unreimbursed business expense deductions on a personal income tax return, the expense must be:

• Paid or incurred during your tax year,
• For carrying on a trade or business of being an employee, and Be ordinary and necessary.

An expense is ordinary if it is common and accepted in a trade, business, or profession. An expense is necessary if it is appropriate and helpful to your business.

A taxpayer may deduct internet expense if it is ordinary and necessary in the taxpayer’s trade or business. Although paid receipts were provided, the Court held expenses incurred to enhance “general knowledge” was a personal expense and the deduction for these costs was denied.

The taxpayer was also unable to establish and detail the extent he used the cell phone and home computer for business purposes relative to total use.

Bonuses Paid to Minor Children Found Unreasonable
The deduction of salary requires not only that the expense be ordinary and necessary, but that the amounts paid must be reasonable. When an amount deducted as wages involves a family relationship, the Court looks closely at the transaction to confirm that the payment qualifies as an employer/employee transaction. Payments paid to a dependent child in nature of support are nondeductible. Payments made to a minor child for services rendered in a parent’s business can qualify as a business expense deduction. Such payments must be reasonable.

The owners of Embroidery Express, a family-owned LLC, paid their children wages for assisting with inventory, office and equipment cleaning and lawn care services. The children received W-2 wages between $40,000 and $60,000 annually, for 2004, 2005, and 2006. A majority of the payments were in the form of year-end bonuses based on business profits. Upon audit, the IRS denied these payroll bonus deductions, indicating that the amounts were unreasonable. The Tax Court determined the bonus portion of the W-2 income did not relate to an employer/employee relationship but pertained to support of the children. The regular portion of the salary was allowed as a deduction because it was deemed reasonable for the services rendered.

Real Estate Rental Deductions Require Material Participation
A real estate professional can deduct rental losses from income if the professional is deemed to materially participate in the rental activities. A taxpayer qualifies as a real estate professional if:

• More than one-half of personal services performed in trades or businesses by the taxpayer during the tax year are performed in real property trades or businesses, and
• The taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which her or she materially participates.

A rental activity is treated as a passive activity, and deductible losses will be limited, unless the taxpayer is a real estate professional. For taxpayers with multiple real estate properties, especially for taxpayers with jobs outside of real estate rental operations, meeting the participation rules for each property might prove difficult. The IRS permits certain elections to be made with the filing of tax returns, enabling taxpayers to aggregate multiple real estate activities to meet the material participation threshold.

In Gragg v. United States, the taxpayer was a licensed real estate agent who incurred a loss on rental properties during 2006 and 2007, totaling $78,000. The Graggs contend that once a taxpayer qualifies as a real estate professional, all rental losses are automatically rendered nonpassive and deductible, regardless of material participation. Upon audit, the IRS disallowed the losses because the taxpayer failed to establish material participation in the rental activity. The Court of Appeals for the Ninth circuit agreed with the IRS.