IRS Practice and Procedure News Briefs for August 2017

REPAID UNEMPLOYMENT BENEFITS – Yoklic v. Commissioner, TC Memo. 2017-143 (2017)

Why This Case is Important: This case provides a good explanation of the claim-of-right doctrine, which requires taxpayers to report and pay taxes on income they receive even if they may have to repay that income at a later date.

Facts: In Yoklic, the taxpayer filed a claim for unemployment benefits in April 2012 with the Arizona Department of Employment Security (DES). Initially, DES found him eligible to receive benefits and paid to him a total of $3,360. In the fall of 2012, DES issued several determination letters informing the taxpayer that he actually was not eligible to receive these benefits, such that he had been overpaid by $3,360, which amount he was required to refund to DES. While the taxpayer had until November 26, 2012 to appeal that determination before it was finalized, he never exercised that right. He repaid the full debt to DES the following year. DES sent the taxpayer and the IRS a Form 1099-G for 2012 reporting the $3,360 in unemployment compensation it had paid to him. Because he knew he would have to repay this amount, he did not include it on his 2012 income tax return and did not pay tax on it. The IRS issued a notice of deficiency in the amount of $840; the taxes it claimed were due with respect to the unemployment benefits. The taxpayer filed a petition with the U.S. Tax Court contesting this notice.

Law and Analysis: Under Section 85(a) and (b) of the Internal Revenue Code, unemployment compensation is taxable income. Section 451 of the Code requires cash basis taxpayers (such as the taxpayer in this case) to report on their annual income tax return all taxable income received in a given year. The taxpayer argued that he was not required to report the unemployment income in 2012 because it was later repaid. The IRS argued that he received the income under a “claim of right,” meaning that even though the taxpayer knew that he may have to repay the income, he received it without any restrictions on his use of it. Under the claim-of-right doctrine, if a taxpayer receives income under a claim of right, he must report it as taxable income in the year he received it. The only exception to this is where, in the year the taxpayer received the income, he “recognizes” an obligation to repay the income and “makes provisions for repayment.” In this case, because the taxpayer did not repay DES until 2013, he cannot be said to have made provisions for repayment in 2012. That being the case, the claim-of-right doctrine applied and the taxpayer was required to report the unemployment benefits on his 2012 return. The Court found in favor of the IRS.

EXISTENCE OF A TRADE OR BUSINESS – Owens v. C.I.R., TC Memo 2017-157 (2017)

Why this Case is Important: With respect to certain expenses, it is extremely advantageous for taxpayers to deduct them as business, rather than personal expenses. This case is a good example of that type of situation and provides good explanation of the analysis the IRS and Tax Court use to determine whether a taxpayer is involved in a trade or business.

Facts: In Owens, the taxpayer was the president and majority shareholder of Owens Financial Group (OFG), a mortgage lender. The taxpayer also had been making personal loans for over 30 years. He estimated that he had made around 300 personal loans. Often, these loans were to borrowers who were too risky for OFG. In 2003, OFG loaned $7.5 million to a customer that required over $10 million of financing. Because OFG would not loan the full amount, the taxpayer personally loaned the customer an additional $2.75 million. The loans were separately document and were made on different terms. The taxpayer also made subsequent personal loans to that customer. The customer later took on new debt, and used that to payoff OFG, but not the loans from taxpayer. In 2008, the customer’s business failed and it filed bankruptcy. Upon the liquidation of the customer’s assets, the taxpayer received no payment against its loans to the customer. On the advice of his tax preparer, the taxpayer took a $9.5 million bad debt deduction on Schedule C to his 2008 personal income tax return. The IRS disallowed the deduction and issued a notice of deficiency proposing a tax debt of over $3 million. The taxpayer contested this notice by filing a petition with the U.S. Tax Court.

Law and Conclusion: Section 166 of the Internal Revenue Code and related regulations permit taxpayers to deduct bona fide business debts that become worthless to the extent that the debt was created or acquired in connection with the taxpayer’s trade or business. The IRS argued that the taxpayer, personally, was not in the trade or business of mortgage lending, and therefore was not entitled to a bad debt deduction. Instead, it asserted that the bad debt could be deducted as a short-term capital loss, which would be limited to $3,000 per year in excess of any net capital gains. For a taxpayer’s lending activity to be considered a trade or business, he must have been involved in the activity with continuity and regularity with the primary purpose of earning income or making a profit.” Courts have developed a non-exhaustive list of facts and circumstances to consider in deciding whether a taxpayer is in the business of lending money, including: (1) the total number of loans made; (2) the time period over which the loans were made; (3) the adequacy and nature of the taxpayer’s records; (4) whether the loan activities were kept separate from the taxpayer’s other activities; (5) whether the taxpayer sought out the lending business; (6) the amount of time and effort expended in the lending activity; and (7) the relationship between the taxpayer and his debtors. After reviewing these factors in light of the taxpayer’s lending history and other circumstances, the Court found that the taxpayer was in the money lending business found in his favor, allowing the bad debt deduction.

ACA TAX CREDITS – Nelson v. C.I.R., Docket No. 12491-16 (U.S. Tax. Ct. 2017)

Why This Case is Important: Many taxpayers may assume that all health insurance plans, regardless of how they are purchased, are equal for purposes of premium assistance tax credit eligibility. As this case demonstrates, that is not the case.

Facts: In Nelson, the taxpayer was a self-employed California resident. In 2014, he purchased health insurance directly from Kaiser Permanente. He did not purchase this insurance through a “Health Insurance Marketplace” established by the state of California. On his 2014 income tax return, the taxpayer claimed a $3,392 premium tax credit related to the cost of his health insurance premiums. The IRS disallowed this credit based on the taxpayer not having enrolled in coverage through the Health Insurance Marketplace and sent a notice of deficiency to the taxpayer in the amount of the disallowed credit. The taxpayer contested this disallowance by filing a petition with the U.S. Tax Court.

Law and Analysis: Section 36B of the Internal Revenue Code entitles certain taxpayers to take a “premium assistance” credit against their income tax for any given year with respect to their health insurance premium payments. For a taxpayer to be eligible for this credit, he or she must be covered by a qualified health plan “offered in the individual market within a State,” that he or she purchased “through an Exchange established by the State under the Affordable Care Act.” In this case, the taxpayer purchased insurance directly through his insurer, rather than through Covered California, the exchange established by California. The taxpayer argued that guidance issued by the IRS with respect to what constituted a “marketplace” was unclear, and that because he purchased his insurance in the general insurance market, he should be entitled to the credit. However, because the relevant statute is clear on the requirements for eligibility for the premium assistance credit, the Court found in favor of the IRS.

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