Federal Income Tax Update

Keith, a white man with brown hair, wears wire-rimmed glasses, a white shirt and black jacket.By Keith A. Wood

I. 2023 Audit Statistics; Chances of Being Audited.

The 2023 Internal Revenue Service Data Book released in April 2024 contains audit statistics for years 2013 through 2021, as of the fiscal year ended September 30, 2023 (FY 2023). For years before 2020, the statute of limitations had generally expired as of September 30, 2023. However, for 2020 and later returns, the statute of limitations has yet to expire, so additional returns for those years may be audited.

For 2013 through 2021, audit rates dropped significantly. For example, individual tax returns had an audit rate of 0.6% for 2013 returns versus 0.2% for 2021. For individuals with income between $1 million and $5 million, the audit rate dropped from 3% for 2013 returns to 0.5% for 2021 returns.

The overall audit rate for C corporations dropped from 1.2% for 2013 returns to 0.3% for 2021 returns. For partnerships and S corporations, the audit rate for 2013 returns was 0.3% compared to 0.1% for 2021 returns.

In FY 2023, 22.7% of audits were field audits. The others were correspondence audits.

Below are the FY 2023 audit statistics for 2021 returns:

A. Audit Rates for Individual Returns. During FY 2023, only 0.2% of individual income tax returns filed for 2021 were audited (and the rate was the same for 2020 returns).

Total 2021 Individual Returns Audited in FY 2023:             0.2%

1) No positive income                     3%
2) $100,000 to $200,000                 1%
3) $500,000 to $1 million                3%
4) $1 million to $5 million               5%
5) $5 million to $10 million             4%
6) $10 million or more                     9%

B. Audit Rates For Partnerships and S Corporations: For partnership and S corporations, the FY 2023 audit rate for 2021 returns was 0.1% (and was the same for 2020 returns).

C. Audit Rates for C Corporations. C corporation returns filed for 2021 had an audit rate of 0.3% during FY 2023 (down from .6% for 2020 returns).

Total 2021 C Corporation Returns Audited in Fiscal Year 2023:                         0.3%

1) Assets $1 million to $5 million                                 0.4%
2) Assets $5 million to $20 million                               6.5%
3) Assets $20 million or more                                      15.8%

D. Offers in Compromise and Criminal Case Referrals. For FY 2023, the IRS received around 30,000 offers in compromise and accepted about 12,700. The IRS initiated 2,676 criminal investigations for FY 2023 and completed 2,584 cases. The IRS referred 1,838 cases for criminal prosecution (484 for legal source tax crimes, 874 for illegal source financial crimes, and 480 for narcotics-related financial crimes) and obtained 1,508 convictions. For convictions, 1,167 were incarcerated.

II. Bankruptcy Court Rules S Status is a Corporate Asset that Shareholders Cannot Terminate while S Corporation is in Bankruptcy; In Re Vital Pharmaceuticals, 22-178424 (Bankr. S.D. FLA 2023).

Vital Pharmaceuticals was an S Corporation that sought Chapter 11 bankruptcy protection. Mr. John Owoc was its sole shareholder. Vital entered into an agreement to sell its assets for $370 million, which would have generated a substantial tax liability to Mr. Owoc. Mr. Owoc desired to revoke Vital’s S election prior to the closing of the sale. Three weeks before the sale was scheduled to close, Mr. Owoc filed a motion asking the court to confirm Vital’s S election was not property of the estate bankruptcy, and the court’s automatic stay did not bar him from revoking Vital’s S election. Mr. Owoc requested the court to lift its automatic stay so he could terminate the S corporation status by transferring Vital stock in a way that would cause Vital to become ineligible to be an S corporation. Mr. Owoc contended Vital’s S election was not property of the estate, and therefore the automatic stay should not apply to acts that would result in its termination.

The Bankruptcy Court, however, refused to lift the stay. Rejecting the Third Circuit’s reasoning in Majestic Star Casino, 111 AFTR 2d 2013-742 (2013), the court ruled S corporation status is the property of the S corporation-debtor’s bankruptcy estate and is protected by the automatic stay. S status provided a benefit to the debtor-corporation by allowing it to avoid corporate level income tax. The court determined the power to terminate an S election rests with the corporation, and not with its shareholder. That a shareholder can take action that results in the termination of a corporation’s S status is irrelevant to whether the S election is property of the estate. The court stated while owners of an S corporation can take action that will result in the termination of the S election (such as by selling shares to an ineligible shareholder), it is “only the corporation that can revoke its S election,” even though it cannot do so without the consent of its shareholders. An S election therefore is property of the estate.

The court also reasoned although a corporation’s right to its S election is contingent on shareholders not taking action that could cause the termination of the election, S status gives a corporation the right to avoid paying taxes. Therefore, lifting the automatic stay would allow the officers and directors of Vital to breach their fiduciary duties to Vital by revoking its S election.

III. Yacht Rental Activity was Per Se Passive because Zero Rental Days do not Establish Average Period of Customer Use; Rogerson vs. Commissioner, 2023 U.S. App. 2023 WL 8271976.

The Ninth Circuit Court of Appeals upheld the Tax Court’s decision and ruled the taxpayer’s activities were non-passive and thus generated non-passive income that could not be offset by losses from his passive activities. During 2014 to 2016, Mr. Rogerson owned several corporations that were engaged in various aspects of the aerospace industry. Between 2005 and 2013, all of the separate corporations were wholly-owned subsidiaries of an S corporation holding company. From 2005 through 2013, Mr. Rogerson filed his income tax returns treating the holding company’s activities as non-passive. In 2014, Mr. Rogerson restructured ownership of the holding company so he directly owned the former subsidiaries of the holding company. One of the corporations (RAEG) earned substantial profits in 2014, 2015 and 2016.

In addition to owning the S corporations, Mr. Rogerson owned two yachts he planned to charter. However, neither yacht was charted out during 2014, 2015 and 2016, during which substantial losses were generated. On his 2014, 2015 and 2016 tax returns, Mr. Rogerson reported his yacht losses as non-passive and treated his income from RAEG as passive income. Mr. Rogerson assumed even if the IRS recharacterized the yacht activities from non-passive to passive, he would be able to use the passive from the yacht activity to offset his passive income from RAEG. The IRS, however, determined Mr. Rogerson’s activities as to RAEG were non-passive, and the yacht charter activities were passive.

The Tax Court and the Ninth Circuit agreed with the IRS that Mr. Rogerson’s activities for RAEG were regular, continuous and substantial as contemplated by Section 469(h). For purposes of Section 469(h)(1), a taxpayer is treated as materially participating in an activity if he materially participated in the activity for any five out of the ten years immediately preceding the taxable year. Reg. Section 1.469-5T(5). The Tax Court decided the activities of RAEG satisfied the five of the last ten years material participation test, in part because of Mr. Rogerson’s tax treatment of the combined S corporation holding company structure as non-passive in tax years before 2014. In upholding the decision of the Tax Court, the Ninth Circuit found the Tax Court had sufficient evidence before it to conclude Mr. Rogerson materially participated in RAEG under Section 469(h)(1) even though Mr. Rogerson argued his activities for RAEG “did not require much of his time.” The court stated Section 469(h) does not impose a minimal hours requirement for the taxpayer to materially participate in an activity, but only that the participation is regular, continuous and substantial.

The Court of Appeals agreed with the Tax Court’s conclusion that the yachting activities were per se passive rental activities. Of the six exceptions to the definition of a per se passive rental activity, only two could be relevant to the court’s analysis: the seven days or less test and the thirty days or less test combined with the provision of significant personal services provided by the taxpayer. Reg. 1.469-1T(e)(3)(ii)(8)(A) and (B). Mr. Rogerson claimed he qualified under both of those exceptions. The court, however, ruled Mr. Rogerson did not meet either test because there was no customer use in any of the years. Mr. Rogerson testified none of the charters were available for more than seven-day charters, and no one would have rented a charter for more than thirty days. Notwithstanding his testimony, the absence of any actual customer use of the yachts precluded a determination of the actual average period of customer use. The Ninth Circuit, therefore, held the Tax Court applied the correct standard, and “actual activity, not intention, is relevant to the applicability” of the seven days or less and the thirty days or less tests. The Tax Court, however, had earlier refused to uphold the IRS assessment of the Section 6666(a)(2) 20% negligence penalty because Mr. Rogerson’s CPA provided Mr. Rogerson with advice regarding the proper reporting of his activities.

IV. Tenancy by the Entirety Property does not Escape the Tax Lien; Morgan v. Bruton, 2024 U.S. App. LEXIS 9266 (4th Cir. 2024).

Ronald Morgan owned tenants by the entirety real property in North Carolina with his wife. In July 2021, Mr. Morgan filed for Chapter 7 bankruptcy and listed his tenants by the entirety single family home on his asset schedule. Mr. Morgan showed he owed a debt to the IRS that was strictly his debt and for which Mrs. Morgan was not liable. When Mr. Morgan filed for Chapter 7 bankruptcy protection, the IRS had not yet filed a federal tax lien to perfect its lien. In his bankruptcy filing, Mr. Morgan took the position the single family home, held as tenants by the entirety, was exempt from the bankruptcy estate under 11 U.S.C. 522(b)(3)(B). That section allows the debtor to keep his entirety interest outside the bankruptcy estate, thus protecting the property from creditors, but only “to the extent that such interest . . . is exempt from process under applicable non-bankruptcy law.” 11 U.S.C. 522(b)(3)(B).

Under North Carolina law, tenants by the entirety real property is generally exempt from claims of creditors. Dealer Supply Co. v. Greene, 422 S.E.2d 350, (N.C. App. 1992) (“In North Carolina, it is well established that an individual creditor of either a husband or a wife has no right to levy upon property held by the couple as tenants by the entirety.”); accord L & M Gas Co. v. Leggett, 161 S.E.2d 23, (N.C. 1968); Grabenhofer v. Garrett, 131 S.E.2d 675, (N.C. 1963). The bankruptcy trustee, however, asserted the tenants by the entirety home was not exempt notwithstanding that under general North Carolina law, tenants by the entirety property is exempt. The North Carolina exemption does not apply to tax obligations owed to the United States under the Supreme Court decision in Craft vs. US, 535 US 274 (2002). In U.S. vs. Craft, the U.S. Supreme Court ruled a federal tax lien under Section 6321 could attach to a husband’s entirety interest even though only the husband owed debts to the IRS. The court found each tenant possesses individual rights in the tenants by the entirety real property that constitutes rights to property for purposes of a federal tax lien.

V. No Physical Injury Damage Exclusion where Damages Were in Settlement of Constitutional Claims; Estate of Finnigan vs. Commissioner TC Memo 2024-42.

A group of plaintiffs brought Constitutional action claims against the Pulaski County Department of Child Services claiming violations of plaintiffs’ Constitutional rights under the First, Fourth, Sixth and Fourteenth Amendments. A jury awarded $31.5 million in compensatory damages. After the defendants appealed, the parties entered into a $25 million settlement.

The plaintiffs argued they suffered from post-traumatic stress disorder (PTSD) as a result of the defendant’s actions and thereby excluded the $25 million from income under the Section 104(a)(2) exclusion for physical injury recoveries. The Tax Court ruled, for the award to be excludable under Section 104(a)(2), there had to be a “direct causal link between the action giving rise to the damages and the physical injury or physical illness.” In all of the proceedings prior to the settlement agreement, there had been little mention of PTSD by the plaintiffs. PTSD was not even mentioned in the plaintiffs’ complaint or in the form jury instructions. The jury did not indicate any portion was for PTSD or for any physical injury or sickness. Further, the settlement agreement made no mention of PTSD or physical injury. It even stated the plaintiffs’ agreement to report the income and pay tax on the full settlement.

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