Highlights of 2017 Tax Court Cases
A NUMBER OF COURT CASES IN 2017 COULD SIGNIFICANTLY AFFECT HOW YOU FILE YOUR TAXES.
TAXPAYER MUST PROVE REASONABLE CAUSE AND GOOD FAITH TO AVOID PENALTIESIn the case of Castigliola, et al v Commissioner, TC, the taxpayers failed to subject excess earnings from their professional limited liability company to self-employment tax under the advice of a CPA with over 40 years of experience. The IRS asserted a penalty of 20% to the underpayment attributable to “negligence or disregard of rules or regulations” and “any substantial understatement of income tax.” The court found the penalty for negligence or disregard of the rules or regulations does not apply if the taxpayer establishes that he acted with reasonable cause and in good faith. This includes the reliance on the advice of a tax professional. However to use this exception, the taxpayer must prove through substantial evidence:
- The adviser was a competent professional who had sufficient expertise to justify reliance.
- The taxpayer provided necessary and accurate information to the advisor.
- The taxpayer actually relied in good faith on the adviser’s judgment.
EMPLOYER-OPERATED EATING FACILITIES MUST MEET FIVE REQUIREMENTS
Meal and entertainment expenses are not deductible unless the expenses are associated with the active conduct of a trade or business. If this condition is met, generally 50% of meals and entertainment expenses are deductible, unless an exception applies enabling you to deduct 100%. One exception is when a business maintains an “employer-operated eating facility.”
In the case of Jacobs v. Commissioner, Deeridge Farms Hockey Association claimed the full amount of expenses incurred from meals provided to their professional hockey players and personnel at hotels and cities other than Boston. The team contracted with the hotels for sleeping accommodations and use of the banquet or conference rooms for pre-game meals and snacks, as well as pre-game meetings.
The court looked at the five requirements necessary to qualify an employer-operated eating facility:
- The eating facility is owned or leased by the employer.
- The eating facility is operated by the employer.
- The eating facility is located on or near the business premises of the employer.
- The eating facility meets the revenue/operating cost test.
- The meals must be furnished during, before, or after the employee’s workday.
The IRS concluded the meals were fully deductible, as the taxpayer paid consideration to use the hotel meal rooms to conduct business, contracted with the hotel to operate an eating facility for its employees, and the meals were critical to employee performance and supplied during the workday.
FOLLOW ALL REPORTING REQUIREMENTS TO SECURE CHARITABLE CONTRIBUTION DEDUCTION
In the Tax Court case, RERI Holdings I LLC v. Commissioner, the taxpayer claimed a non-cash charitable contribution deduction and did not complete all areas of Form 8283. The court found that the taxpayer failed to provide substantial compliance, as required by the Internal Revenue Code, by omitting “donor’s cost or other adjusted basis.” This case demonstrates the importance of ensuring all substantiation rules are being followed; otherwise, there is a risk of losing the entire charitable contribution deduction.
LEGAL FEES MUST BE DEDUCTED IN ACCORDANCE WITH INCOME EARNED
In the case of Sas v. Commissioner, TC, the taxpayer received a bonus in 2010 when she became president and CEO of a bank. That same year, the taxpayer was terminated, and the bank filed a complaint attempting to recover the bonus. The taxpayer countersued, claiming employment discrimination, and incurred legal expenses associated with the lawsuit during both 2010 and 2011. In 2011, the taxpayer and the bank signed a settlement agreement, all claims were dismissed, and nothing was paid.
During the same years, the taxpayer maintained an accounting and consulting business separate from her position at the bank. On her 2010 tax return, the taxpayer filed a schedule C with her husband as the sole proprietor. In 2011, she reported income from the business on Schedule E as the co-owner.
The taxpayer argued the legal fees were associated with a claim of discrimination and deductible under ordinary business expenses, as the outcome of the lawsuit could damage the reputation of the accounting business.
The IRS determined the legal fees were deductible as miscellaneous itemized deductions, subject to 2%limitation, because the original claim of the loss arose from her former status as an employee, not the accounting business. The attorney was hired because the bank was attempting to recover the bonus she received from her employment with the bank and was not related to the accounting business.
PAYMENT FROM QUALIFIED SETTLEMENT FUND FOR FORECLOSURE IRREGULARITIES IS FULLY TAXABLE TO RECIPIENT
Clients who receive legal settlements often believe that because they have been awarded damages for a wrong that occurred, the payment is not subject to income taxes. The case of Ritter v. Commissioner involves an award received by a homeowner whose house was taken in a foreclosure proceeding. The taxpayer received a payment, through a special tax entity known as a qualified settlement fund, related to a settlement between the lender and the government to deal with “deficiencies and unsafe or unsound practices in [Chase Bank’s] residential mortgage servicing and in the bank’s initiation and handling of foreclosure proceedings.”
Whether a payment as part of a legal settlement is taxable to the recipient requires a determination of why the damages were being awarded. Was it to reimburse a taxpayer for a specific financial cost that had been incurred, or did it represent addition amounts the taxpayer should have received for the disposition of the home? Unless the taxpayer establishes a reason that corresponds to a specific exception from taxation, the proceeds are taxable.
In this case, the court found that the payment did not meet any criteria that would allow it to be excluded from income because the payments were not for any specific financial injury or harm to the borrowers, and no portion of the award was designated for lost equity.