2020 Federal Income Tax Update

By Keith A. Wood

This is the first of two installments of this article. The second installment will be posted soon on the Tax Section’s blog.

I. Audit Statistics; What Are Your Chances of Being Audited?

In early 2020, the IRS published its 2019 data book, which contained audit statistics for the fiscal year that ended September 30, 2019. Here are the audit statistics for tax returns filed in calendar year 2018 (“CY 2018”):

A. Audit Rates for Individual Income Tax Returns.

Only 0.6% of individual income tax returns filed in CY 2018 were audited (about the same as in CY 2017). Of those audited returns, only 25% were conducted by revenue agents (down from 29%), and the rest were correspondence audits.

Not surprisingly, the audit rates for Schedule C returns were higher than for individual returns. Schedule Cs filed in CY 2018 showing receipts of $100,000-$200,000 had a 2.4% audit rate (up from 2.1% in CY 2018). Schedule C returns filed in CY 2018 showing income over $200,000 had a 1.9% audit rate (same as for CY 2018).

Total Individual Returns Audited                            0.6%

    1. With Schedule C Income:
      $100,000 to $200,000                                      2.4%
      Over $200,000                                                  1.9%
    2. Non-Business Income:
      $200,000 to $1 million                                     0.6%
    3. Income over $1 million                                    3.2%

B. Audit Rates for Partnerships and S corporations. For partnerships, the audit rate for returns filed in CY 2018 was 0.2% (down from 0.4% in CY 2017). For S corporation returns, the audit rate for returns filed in CY 2018 was 0.2% (down from CY 2017).

C. Audit Rates for C corporations. C corporation returns filed in CY 2018 had an audit rate of 1.0%.

Total C corporation Returns Audited                       0.9%

    1. Assets less than $1 million                               0.9%
    2. Assets $1 million to $5 million                         0.8%
    3. Assets $5 million to $10 million                       1.1%
    4. Assets $10 million to $50 million                     4.6%

D. Offers in Compromise. The IRS received 59,000 offers in compromise but accepted only 24,000 of them.

E. Criminal Case Referrals. The IRS initiated 2,886 criminal investigations for fiscal year 2018 (down from 3,019 in FY 2017). The IRS referred 2,130 cases for criminal prosecutions (680 for legal source crimes, 816 for illegal source financial crimes and 634 for narcotics-related financial crimes) and obtained 1,879 convictions. Of those convicted, 1,732 were actually incarcerated.

II. Custom Home Builder Not Entitled to Ordinary Loss on Deemed Sale of Lots.

In Ferguson vs. Commissioner, TC Memo 2019-40), Mr. Ferguson was a custom home builder operating through an S corporation. Mr. Ferguson got into a dispute with some of his customers regarding a new development project. In settlement of the lawsuit, Mr. Ferguson’s S corporation transferred lots to the homeowners. The S corporation claimed an ordinary loss deduction on the deemed sale of three of the lots.

The IRS disallowed the ordinary loss on the basis that the lots were not capital assets as defined in Section 1221(a). The main factor that worked against Mr. Ferguson was his claiming capital gain treatment on six other lots that were transferred to other plaintiffs.

III.       Rental Property Activities Were Not a Trade or Business.

In Keefe v. Commissioner, 126 AFTR 2d 2020-5331, Mr. and Mrs. Keefe purchased a historical mansion in Newport, Rhode Island for $1.35 million and then spent significant sums to renovate it. Mrs. Keefe spent over 70 hours per week overseeing the renovation. While the restoration was in progress, Mr. and Mrs. Keefe met with a rental agent to discuss renting out the mansion once it was restored. Ultimately, the house was never rented. Between June 2005 and July 2009, the value of the property dropped by almost $3 million. The property was sold for $6.15 million in July 2009.

On their original 2009 tax return, Mr. and Mrs. Keefe reported the transaction as the sale of a capital asset. They then amended their 2009 return and reported the sale of the mansion as the sale of a business property resulting in an ordinary loss.

The Tax Court held Mr. and Mrs. Keefe did not operate their rental activity on a continuous, regular and substantial basis so the property was not real property used in a trade or business. A number of courts have held rental real estate is a trade or business only if the taxpayer-lessor engages in regular and continuous activities in relation to renting out the property. Alvary v. United States, 302 F.2d 790, 796 (2d Cir. 1962); Pinchot v. Commissioner, 113 F.2d 718, 719 (2d Cir. 1940); Grier v. United States, 120 F. Supp. 395 (D. Conn. 1954).

The court concluded Mr. and Mrs. Keefe did not engage in regular and continuous rental activities because they never commenced any rental activity in a meaningful or substantial way.  They never advertised the mansion for rent. They never signed any lease with a potential tenant nor did they furnish the property for rent after the renovations were completed. In fact, Mr. and Mrs. Keefe spent a significant amount of time from 2004 to 2009 trying to sell the property rather than to rent it. In addition, Mr. and Mrs. Keefe were not already engaged in any type of rental trade or business before purchasing and renovating the Rhode Island mansion.

The Court of Appeals affirmed the Tax Court’s holding that the mansion was a capital asset. Also, the Court of Appeals upheld the IRS imposition of the Section 6662 substantial understatement penalty. Apparently, the only penalty defense the Keefes raised during the trial was the substantial authority defense. They evidently did not raise the good faith or reasonable basis defense at either the Tax Court or the Court of Appeals.

IV. Terminated Employee Can Exclude Portion of Lawsuit Recovery under Section 104.

In Beckett v. Commissioner, T.C. Summary Opinion, 2020-19, Ms. Beckett was employed as a certified nursing assistant until her termination in January 2020. She suffered from epileptic seizures while at her workplace. Some seizures were so severe she hit her head hard enough to require stitches. Other times, she bit her tongue. At least once she went to the emergency room.

After her termination, Ms. Beckett sued her employer for employment discrimination under the Americans with Disabilities Act (the “ADA”) claiming she was wrongfully terminated because of her epilepsy and her employer’s failure to make reasonable accommodations as required under the ADA. Ultimately, the parties settled and Ms. Beckett received a payment of $28,000. The settlement agreement provided $19,000 was to compensate Ms. Beckett for her claims of emotional distress, pain and suffering, physical distress and damages. The court ruled a portion of this $19,000 payment (one-third) was exempt under Section 104(a)(2) because the settlement agreement stated the compensatory damages were paid, in part, for “physical distress and damages” and Ms. Beckett credibly testified she suffered head and other physical injuries directly caused by her employer’s refusal to make reasonable accommodations.

V. Employer-Provided Loan to Purchase Real Estate Was Ineligible for the Section 108 Cancellation of Principal Residence Debt Exclusion.

In Weiderman v. Commissioner, TC Memo 2020-109, Mrs. Weiderman’s employer provided her a $500,000 loan to purchase a home near her employer. The loan was evidenced by a promissory note but was unsecured. After Mrs. Weiderman’s employer terminated her employment, it made a demand for repayment of the promissory note. Ultimately, Mrs. Weiderman and her employer reached a settlement, and a portion of the loan was forgiven.

The Tax Court held the forgiven debt did not qualify for the Section 108(a)(1)(E) exclusion from cancellation of debt income for qualified principal residence indebtedness that is discharged.  The court noted qualified principal residence indebtedness is defined as acquisition indebtedness within the meaning of Section 163(h)(3)(B). Under that section, acquisition indebtedness is defined as indebtedness that is used to acquire or improve a qualified residence of the taxpayer and is secured by that residence. Because the $500,000 loan was unsecured, Mrs. Weiderman did not qualify for the principal residence debt exclusion.

The court also upheld the Section 6662 substantial understatement penalty because Mrs. Weiderman did not have reasonable cause for her underpayments under Section 6664(c)(1). Mrs. Weiderman contended she relied upon her accountant in preparing her tax return, which should excuse the Section 6662 penalty.  The court noted while a taxpayer’s reliance on an accountant to prepare accurate returns may indicate an absence of fraud, the “reliance upon my accountant” defense will relieve penalties only if the accountant has been supplied with all the information necessary to prepare the returns. Mr. and Mrs. Weiderman provided very little background information to their accountant. The Weidermans did not rely only on the judgment of their accountant, but instead had decided on their own to exclude the cancelled debt from their gross income.

VI. Tax Court Rules a Cutting Horse Activity had a For Profit Motive So Losses were not Limited under Section 183 Hobby Loss Rules.

In Den Besten, T.C. Memo 2019-154, the Tax Court ruled Mr. Besten had a for profit motive in his cutting horse activity based on the following favorable factors:

  1. Mr. Besten conducted the activity in a businesslike manner even though he had only an informal business plan;
  2. He kept good records of his activities, which allowed him to make quick business decisions.  He occasionally changed his methods of operation to enhance profitability;
  3. He often advertised;
  4. Over the years, he developed expertise in training and selling registered cutting horses;
  5. He spent a great deal of time in his cutting horse activities;
  6. He was successful in other business activities he operated at the same time he was operating his cutting horse activity;
  7. The profits from his unrelated businesses would not have allowed him to sustain losses from his cutting horse business without a profit motive; and
  8. There was a lack of personal enjoyment in the activity because most of his horses were cared for and trained by hired professionals at his farm.

The court found there were other factors that indicated a lack of profit motive, such as a long history of losses and the low probability of the fair market value of the assets appreciating and exceeding cumulative operating losses. The court ruled the factors indicating a profit activity outweighed the factors against such a determination.

Keith A. Wood is an attorney with Carruthers & Roth, P.A. in Greensboro.

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