Federal Income Tax Update

By Keith A. Wood

1. Tax Court Again Rules Emotional Distress is Not Physical Illness.

   In Tressler v. Commissioner, T.C. Summ. Op. 2021-33, the Tax Court held emotional distress damages are not excluded from income unless those emotional damages are attributable to a direct physical injury. Ms. Tressler brought a lawsuit against her former employer for failing to prevent a physical assault by another employee. Ms. Tressler alleged the assault caused her emotional distress, which caused even more physical injuries. The court held the emotional distress damages were not excludable from income under Section 104(a)(2) because the settlement agreement failed to state the payments Ms. Tressler received were related to physical injuries rather than her claims for emotional distress.

2. IRS Announces Refusal to Follow the Tax Court Decision in Schieber’s Holding that Pension Interest is not Part of the Insolvency Calculation Under Section 108.

   Previously, in Schieber, T.C. Memo. 2017-32, the Tax Court stated, as laid out in Carlson v. Commissioner, 116 TC 87 (2001), for purposes of determining whether something is an asset for Section 108(d)(3) purposes, the relevant test is whether the asset gives the taxpayer the ability to pay an immediate tax on income from the cancelled debt. Therefore, a pension plan asset balance should not be deemed an asset of the taxpayer for purposes of applying the insolvency test where the taxpayer cannot borrow against or assign the pension asset nor convert the balance to a lump sum amount.

   In its Action on Decision, IRB 2021-15 (April 12, 2021), the IRS advised it would not follow Schieber in excluding pension plan assets from assets under Section 108(d)(3) merely on the grounds the pension plan assets cannot be converted to a lump-sum cash amount or cannot be sold, assigned or borrowed against.

3. No Charitable Deduction for Home Donated as Salvage.

   In Mann v. U.S., 127 AFTR2d 2021-447, the Fourth Circuit denied a couple’s charitable deduction for the donation of salvaged materials from their home’s demolition. The court affirmed the owner’s interest in the structure, without the recording of a deed of transfer of the home itself, was not severed from the underlying land. A transfer agreement with the charity receiving the items was ruled insufficient to support a transfer of an interest in the structure itself.

   Mr. and Mrs. Mann decided to tear down their house and construct a new one on the property. The Manns entered into a transfer agreement with Second Chance, a charitable organization, which provided the Manns would retain ownership of the underlying land but would donate the house to Second Chance. Under Maryland law, to transfer the house separately from the underlying land, the Manns were required to sever the house from the land by recording the transfer of the house with the local county. However, the Manns did not record a deed of transfer for the house from the underlying land. The court held since, under Maryland law, the Manns still retained record ownership of the house and were liable for property taxes, they had not conveyed their entire interest in the property.

4. Losses Disallowed on Demolition of Home Destroyed by Fire.

   In Parker v. Commissioner, T.C. Memo. 2021-111, Mr. and Mrs. Parker claimed a Section 165 deduction for loss on the demolition of their property that had burned down in a prior year. The Tax Court disallowed the deduction. Section 280B provides, in the case of the demolition of any structure, no deductions are allowed for any expense incurred in connection with the demolition or any loss sustained on account of such demolition. Instead, those amounts are added to the taxpayer’s basis in the land on which the demolished structure was located.

5. Team-Roping Activities Were Deemed a Hobby.

   In Gallegos v. Commissioner, T.C. Memo. 2021-25, Mr. Gallegos and his wife built an extremely successful insurance business. Later, Mr. Gallegos decided to start competing in a sport called team-roping. Over the course of three years, Mr. Gallegos lost over $150,000 in pursuing his dream of being a team-roping champion. The court held Mr. Gallegos’s activities did not rise to a trade or business but instead were a hobby.

   Several factors indicated Mr. Gallegos operated his team-roping activities as a hobby. First, Mr. and Mrs. Gallegos kept very inaccurate records of their team-roping activities and expenses. They had no formal business plan and did not maintain a separate bank account or records. Also, they had no formal budget.

6. In Another Case an Actress was Deemed to have Engaged in a Trade or Business and not a Hobby.

   In Gaston v. Commissioner, T.C. Memo. 2021-1071, after 45 years of working as a Mary Kay sales agent, Ms. Gaston retired from Mary Kay to pursue her dream of becoming an actress. Over several years, Ms. Gaston incurred significant losses pursuing acting. Nevertheless, the Tax Court determined Ms. Gaston’s acting activities were not a hobby but instead constituted a for-profit endeavor because she had engaged in the activities with the honest objective of earning a profit.

   When analyzing whether taxpayers have entered into acting activities with an intent to profit, courts have considered industry-specific factors such as whether they: (1) belong to an acting network or union, (2) take classes or otherwise formally develop their skills, (3) develop industry contacts, (4) seek or secure multiple auditions or roles, (5) advertise their services, (6) prepare headshots or a portfolio, (7) retain an agency or assistant to help secure roles, and (8) maintain their efforts over time given the nature of the industry. See Richards v. Commissioner, T.C. Memo. 1999-163.

   Ms. Gaston secured roles in feature-length films; spent 35-45 hours per week researching, applying or auditioning for other roles; trained to enhance her skills through acting and voice lessons; retained an assistant and an agent to help her obtain new roles; and otherwise carried on her activities in a businesslike manner. She also engaged various casting services, retained an agent and a business management company, secured professional headshots, advertised her skills, and took acting and voice lessons. The court noted as a result of her efforts, Ms. Gaston landed some roles in movies and commercials.

7. Taxpayers’ For-Profit Motive for Miniature Donkey Breeding Activities.

   In Huff v. Commissioner, T.C. Memo 2021-140, William and Cathy Huff wanted to supplement their income by breeding and selling miniature donkeys. Mr. Huff was a successful asset manager. Mrs. Huff was a successful attorney. Mr. and Mrs. Huff purchased 31.35 acres in New Jersey, subject to a conservation easement that permitted most equestrian and agricultural uses for their donkey breeding activities. In 2004, the Huffs formed Ecotone, an LLC of which they were the sole members. The LLC operating agreement stated Ecotone was organized for, among other things, agricultural and equestrian or equine purposes including breeding and raising animals.

   Although the Huffs’ had losses from their activities, the Tax Court held they had a for-profit motive. The Huffs had a business plan for their activity, kept separate books and records, and otherwise conducted the activity in a businesslike manner. They operated their business through an LLC. Also, Mr. and Mrs. Huff enlisted the help of professionals who advised them about their industry, spent significant time on their activity, and engaged experts to assist them. The court also noted because the Huffs’ losses were far less than their other income, it was not a case of using losses to shelter other income.

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