Federal Income Tax Update
By This is the first of three installments of this article.
I. Audit Statistics: What Are Your Chances of Being Audited?
The 2021 Internal Revenue Service Data Book contains audit statistics for 2011 through 2019. Below are audit statistics for 2019 returns:
A. Audit Rates for Individual Income Tax Returns. During FY 2021, only 0.2% of individual income tax returns filed in 2019 were audited (about the same as for 2018 returns).
Total individual returns audited: 0.2%
(1) With no positive income 8%
(2) $100,000 to $500,000 1%
(3) $500,000 to $1 Million 3%
(4) $1 Million to $5 Million 6%
(5) $5 Million to $10 Million 1%
(6) $10 Million or More 2%
B. Audit Rates for Partnerships and S Corporations. During FY 2021, for partnership and S corporations, the audit rate for 2019 returns was 0.1%.
C. Audit Rates for C Corporations. C corporation returns filed for 2019 had an audit rate of 2.9% during FY 2021.
Total C corporation returns audited: 2.9%
(1) Assets less than $5 Million 4%
(2) Assets $5 Million to $10 Million 5%
(3) Assets $10 Million to $50 Million 1%
D. Schedule C Returns. Not surprisingly, audit rates for Schedule C returns are much higher than for other individual returns. Schedule Cs filed for 2018 showing receipts of $100,000-$200,000 had a 2.4% audit rate. Schedule C returns filed for 2018 showing income over $200,000 had a 1.9% audit rate.
E. Offers in Compromise and Criminal Case Referrals.
1. Offers in Compromise. For FY 2021, the IRS received about 49,000 offers in compromise but accepted only about 15,000 of them.
2. Criminal Case Referrals. The IRS initiated 2,581 criminal investigations during FY 2021. The IRS referred 1,982 cases for criminal prosecution (575 for legal source tax crimes, 761 for illegal source financial crimes, and 646 for narcotics-related financial crimes) and obtained 1,263 convictions. Of those convictions, 993 were incarcerated.
II. No Section 104 Exclusion for Wrongful Termination Recovery. Dern v. Commissioner, TC Memo 2022-90.
Mr. Dern was employed as a sale representative. In 2015, he was hospitalized for acute gastrointestinal bleeding and a resulting heart attack. His illness and hospitalization, however, were unrelated to his work for his employer. In early 2016, Mr. Dern’s employer terminated his employment. A termination letter stated, “your prolonged health conditions have unfortunately had a significant impact on your ability to effectively represent the Company and perform the duties of a sales representative.” Mr. Dern sued his former employer under several theories, including disability discrimination. The parties settled all claims. The employer paid Mr. Dern $550,000 “to compensate Mr. Dern for alleged personal injuries, costs, penalties, and all other damages and claims.” The settlement agreement further provided it was “for and on account of [Mr. Dern’s] claims alleging compensatory damages, emotional injuries, penalties and punitive damages.”
The Tax Court agreed with the IRS that, under the settlement agreement, the payment was not on account of Mr. Dern’s physical injuries or physical sickness. The settlement agreement used the phrase “personal injuries” in stating the settlement payment was to “compensate [Mr. Dern] for alleged personal injuries.” However, the agreement did not specifically refer to physical injuries. Mr. Dern argued Section 104(a)(2) was applicable because it was Mr. Dern’s physical illnesses that caused his employer to terminate him. However, under Lindsey v. Commissioner, 422 F3d 684 (8th Cir. 2005), there must be a direct causal link between an illness and a settlement payment. Mr. Dern could easily prove he was physically ill, but he did not provide evidence his employer caused or exasperated his illness. Because the employer did not compensate Mr. Dern for any physical injury or physical sickness, the court held the settlement payments were not excludable under Section 104(a)(2).
III. Recovery for Legal Malpractice Recovery in Medical Malpractice Case is Taxable. Blum v. Commissioner, 129 AFTR 2d 2022-1170 (9th Cir. 2022).
Ms. Blum sued her personal injury lawyer for malpractice relating to her personal injury medical malpractice lawsuit against a hospital. Ms. Blum sued her lawyer for failing to recover damages for her physical injuries caused by the hospital’s negligence. Nevertheless, the court held her legal malpractice recovery taxable rather than excludable under Section 104. The settlement agreement stated the settlement payment was not for Ms. Blum’s underlying physical injuries but instead damages for legal malpractice by her former lawyer. The settlement agreement went even further in stating Ms. Blum did not sustain any physical injuries as a result of her former attorney’s alleged negligence. The parties executed the settlement agreement “for the purpose of compromising and settling the [malpractice] dispute.”
IV. Capital Loss Rather than Ordinary Loss Recognized on Property Sales. Musselwhite v. Commissioner, TC Memo 2022-57.
Mr. Musselwhite received his undergraduate business degree from Wake Forest University and his law degree from Campbell University. After law school, he became a personal injury lawyer in Lumberton, North Carolina. Over the years, Mr. Musselwhite became involved in several real estate ventures. He started his first venture in 1986 when he, his father, uncle, and brother purchased 100 acres of undeveloped land in Lumberton, which they developed into a 90-lot subdivision called Wycliffe East. This development project lasted 13 years, and ultimately all 90 lots were sold. Mr. Musselwhite and his brother then participated in another real estate venture, also in Lumberton. They formed Carolina Group Partnership (“CGP”), which purchased 100 acres of undeveloped land that was later developed in phases into a residential subdivision.
Mr. Musselwhite later became interested in real estate investments in the Wrightsville Beach/Wilmington, North Carolina area. He became involved with David Stephenson, who was a successful businessman with a real estate development company in Lumberton. In 2005, Mr. Musselwhite and Mr. Stephenson formed DS&EM Investments. It filed an annual report in 2005 indicating its business was “real estate investment.” From 2006 to 2012, all Secretary of State LLC annual reports continued to reflect the nature of the LLC’s business was real estate investment. DS&EM initially purchased five investment condominiums on Wrightsville Beach and immediately sold two of them. It also acquired undeveloped lots in Lumberton and the Brunswick County Sea Watch Subdivision, as well as a house in Wilmington. The undeveloped lots were purchased for investment purposes. Mr. Musselwhite also owned portions of several parks. In the summer of 2006, Adam Lisk, a North Carolina real estate developer, contacted DS&EM proposing a possible business arrangement. Mr. Lisk offered Mr. Musselwhite an opportunity to invest in a subdivision Mr. Lisk was developing consisting of nine undeveloped wooded lots. Mr. Lisk would purchase the Wilmington house, and DS&EM would purchase four undeveloped wooded lots in the Cypress Lakes Subdivision in Brunswick County that Mr. Lisk owned. Mr. Lisk and DS&EM entered into a written agreement memorializing their plans for the development of the nine wooded lots. DS&EM purchased the four lots from Mr. Lisk for $1 million. Mr. Lisk purchased the Wilmington house from DS&EM for over $2 million.
In 2007, the real estate market in Brunswick County began to deteriorate. Ultimately, a dispute between Mr. Lisk and DS&EM arose. To resolve the dispute, Mr. Lisk agreed to transfer his five lots to DS&EM so DS&EM would own all of the nine lots in the subdivision. By the end of 2008, Mr. Lisk had made some improvements to the nine-lot subdivision, such as tree removal, creation of a road, grading for storm water drainage, and securing some permitting for the subdivision. However, after 2008, no further improvements were made to the lots. From December 2008 until September 2011, the lots were offered for sale. Ultimately, Mr. Musselwhite and Mr. Stephenson decided to divide the DS&EM properties. In July 2012, DS&EM distributed the four lots to Mr. Musselwhite. Mr. Musselwhite immediately hired a local real estate broker to market the lots. On November 14, 2012, Mr. Musselwhite sold all four lots for a total price of $17,500, resulting in a loss of over $1 million on the project.
Mr. Musselwhite hired a CPA in Lumberton to prepare the DS&EM tax returns for 2005 through 2012. The returns reported (1) DS&EM’s principal business activity was “investment,” and (2) its principal product or service was “property.” The Forms 1065 reflected DS&EM had no inventories but instead held investment real estate. For the first time in 2011, the tax returns reported the four lots were held as inventory. When the 2011 tax return was filed, Mr. Musselwhite and DS&EM were well aware the fair market value of the nine lots was less than DS&EM’s income tax basis in those lots. Mr. Musselwhite’s CPA testified he believed the lots were always held by DS&EM as inventory. However, DS&EM did not file amended tax returns for the prior years reporting the lots’ purported status as inventory. Also, during prior years, Mr. Musselwhite’s personal income tax returns reflected some capital gains, but mostly pass-through income from various partnerships and S corporations as well as from his law firm practice. However, none of his returns reported any meaningful income from the activities of DS&EM.
After auditing Mr. Musselwhite’s tax return for 2012, the IRS disallowed his reported $1 million Schedule C loss from the sale of the four lots due to it being a capital loss. The court noted the 4th Circuit Court of Appeals in Garver (1989) held several factors are relevant in determining losses as capital or ordinary. Among the factors are (1) the purpose for which the property was acquired; (2) the purpose for which it was held; (3) improvements made to the property by the taxpayer; (4) the frequency, number, and continuity of sales; (5) the extent and substantiality of the transaction; (6) the nature and extent of the taxpayer’s business; (7) the extent of advertising or lack thereof; and (8) the listing of the property for sale directly or through a broker.
Mr. Musselwhite acquired the four lots via a distribution from DS&EM as part of an agreement with Mr. Stephenson to wind up its affairs. Mr. Musselwhite never had any intent to develop the lots when he acquired them. He never made any improvements to the lots. Also, DS&EM purchased and held the lots for investment as it did with all of its real estate. The annual reports for DS&EM and all of its tax returns from 2005 through 2012 reflected the lots as held for real estate investment purposes. Even if DS&EM had originally acquired the four lots in 2006 for development, all evidence indicated the LLC had abandoned any development plans by the end of 2008. Further, from 2008 through 2012, DS&EM did nothing to improve the lots or market them for sale. The court noted, while Mr. Musselwhite and his family had been involved in various real estate development projects in the 1980s and 1990s, DS&EM had reported sales of property or producing capital gain or loss. Moreover, Mr. Musselwhite’s everyday business was not real estate development but instead his personal injury law practice. From 2011 to 2013, Mr. Musselwhite’s income from his law firm ranged from $700,000 to $1.2 million.
The court found Mr. Musselwhite and Mr. Stephenson formed and operated DS&EM as a vehicle to invest in real estate. All their federal tax returns and Secretary of State annual reports bore that out. Although Mr. Musselwhite made efforts to market and sell the four lots, that alone was insufficient to demonstrate Mr. Musselwhite’s overall relationship with the four lots was anything more than merely participating in DS&EM real estate investment activities. Although the court ultimately concluded Mr. Musselwhite was entitled to only a capital loss on the sales of those four lots, no penalties were assessed. The IRS had stipulated before the trial Mr. Musselwhite would not be liable for any accuracy-related penalties.
V. Ordinary Income, rather than Capital Gain, on Transfer of Patent to Controlled Corporation. Filler v. Commissioner, 130 AFTR 2d 2022-5093 (2022).
Dr. Filler is a licensed attorney and a neurosurgeon. Over the years, Dr. Filler developed numerous patents. He brought more than 20 patent infringement lawsuits. In 2014, Dr. Filler claimed an NOL of almost $2 million. He alleged the State of California had infringed on his patent, thereby destroying the value of his stock in NeuroGrafix, Inc. (“NGI”), which owned the patent. Dr. Filler never sued California for patent infringement but instead claimed an involuntary conversion of NGI’s patent. Because no court ever found patent infringement by California, the Tax Court did not allow the claimed $2 million ordinary loss. Instead, Dr. Filler could, at most, claim a capital loss. He transferred his patent to NGI for a royalty arrangement when he owned 75% of the stock of NGI. Section 1235(a) treats as capital gain any consideration received for the transfer of substantially all of the rights of a patent. However, Section 1235(a) does not apply to transfers between related persons, including a corporation and an individual who owns more than 25% of the corporation’s shares. That caused all the royalties to be ordinary income.
VI. Merger Termination Fee Generates Capital Loss, CCA 202224010.
The taxpayer attempted to acquire a company. After the taxpayer and the target agreed to terminate the merger agreement, the taxpayer paid a fee to the target to terminate the agreement. The IRS Chief Counsel was asked whether the termination fee should produce a capital loss under Section 1234A or a deductible business expense under Section 162. Section 1234A provides any gain or loss attributable to the cancellation, lapse, expiration, or other termination of a right or obligation as to property that is (or an acquisition of which would be) a capital asset in the hands of the taxpayer is treated as a gain or loss from the sale of the capital asset. In the CCA, an event extinguished the taxpayer’s contractual obligation to perform under the merger agreement. Thus, the termination fee could only be deducted as a capital loss under Section 1234A rather than a Section 162 business expense.
VII. Deduction for Travel Expenses When Away from Home. Harwood, TC Memo 2028‑8.
Mr. Harwood lived in Yakima, Washington and worked on different construction projects in Washington and Oregon. The court allowed Mr. Harwood to deduct travel expenses while he was away from home on temporary job assignments. Under Section 162(a)(2), a taxpayer is allowed to deduct reasonable and necessary travel expenses, such as meals and lodging, while away from home. Courts have struggled with the definition of “away from home” in applying Section 162(a)(2). That requires a determination of the taxpayer’s tax home. If a taxpayer is away on a temporary job assignment, the taxpayer is deemed to be away from home while away from his or her primary place of work. That allows the taxpayer to deduct travel expenses. If the taxpayer is on a job assignment that is expected to last for less than a year, the job assignment is deemed to be temporary. However, when a job assignment has an indefinite period during which the taxpayer must be away from home, the location of the taxpayer’s new job assignment becomes the taxpayer’s new tax home. In that case, the taxpayer cannot deduct travel expenses.
In Hardwood, the court determined whether Mr. Harwood had a tax home by referring to the three factors in Revenue Ruling 73-529. In applying the ruling, courts have considered whether the taxpayer (a) incurs duplicate living expenses while traveling and maintaining the home, (b) has personal and historical connections to the home, and (c) has a business justification for maintaining the home. See Geiman, T.C. Memo. 2021-80. Based on factors set forth in the ruling and applicable case law, the court ruled Mr. Harwood’s residence in Yakima, Washington was his tax home. Mr. Harwood was able to establish he had significant personal and historical ties to Yakima. He had a business justification for staying in Yakima because he was a member of the local union. By maintaining his residence in Yakima and staying close to his union, Mr. Harwood could access jobs within the union’s territory.