IRS Practice and Procedures News Briefs for March 2017

DEPENDENCY EXEMPTIONS – Walker v. Commissioner, T.C. Summ. Op. 2017-8 (2017)

Why This Case is Important: Taxpayers may assume that they are only entitled to tax dependency exemption deductions for their own children. As this case demonstrates, that is not always the case.

Facts: In Walker, the taxpayer resided fulltime with his girlfriend and her son in 2013 and 2014. He was not the son’s biological or adopted father, but did provide all of the child’s financial support. On his 2013 and 2014 returns, the taxpayer used a “head of household” filing status and claimed a dependency exemption deduction, child tax credit, and earned income credit based on his assertion that the child was his dependent for tax purposes. The IRS examined these returns, changed his filing status to “single,” and disallowed the dependency exemption, along with other changes. As a result of these changes, the IRS determined tax deficiencies for the two years of over $15,000. The taxpayer petitioned the Tax Court for review of these determinations.

Law and Analysis: Section 151 of the Internal Revenue Code permits taxpayers to take an annual exemption deduction for every “dependent.” Section 152 defines a dependent as either a “qualifying child” or a “qualifying relative.” To be a qualifying child, one requirement is that the child be the taxpayer’s child, descendant, sibling, or stepsibling. In this case, the child was not the taxpayer’s qualifying child, and could only be his qualifying relative. To be a qualifying relative, among other requirements, a child or other individual must have a certain familial relationship with the taxpayer or must have the same principal abode as the taxpayer, and the taxpayer must provide over one-half of the child’s financial support. In this case, the child met the requirements to be the taxpayer’s qualifying relative. Therefore, the Court found that the taxpayer was entitled to tax a dependency exemption deduction with respect to the child. Because the child was the taxpayer’s tax dependent and the taxpayer was not married, the Court also found that the taxpayer was permitted to use a head of household filing status.

ALIMONY DEDUCTION – Quintal v. Commissioner, T.C. Memo. 2017-3 (2017)

Why this Case is Important: This case demonstrates the importance of carefully drafting marital separation agreements to ensure that alimony payments are tax deductible.

Facts: In Quintal, the taxpayer and his former wife had three children before divorcing in 2010. The parties entered into a marital separation agreement that was incorporated into the divorce judgment. Several last-minute negotiations to that agreement were memorialized in handwritten changes to Exhibits B and J of the agreement. Exhibit B to the agreement, as revised, required the taxpayer to pay his former wife $900 per week in unallocated support, with such payments terminating on the earlier of her death or remarriage. The revisions to that section stated that the parties intended the payments to be deductible by the taxpayer and includable in his former wife’s taxable income. Revisions to Exhibit J to the agreement, dealing with child support payments, referred to the taxpayer’s payment obligations under Exhibit B as his support obligations. The Exhibit further stated that the taxpayer’s child support obligations were to terminate upon the children’s emancipation and that all payments required by Exhibit J were non-deductible to the taxpayer and excludable from his former wife’s taxable income. On each of his 2011, 2012, and 2013 federal income tax returns, the taxpayer deducted $46,800 in alimony payments. His former wife did not include any payments in her taxable income. The IRS disallowed these deductions and assessed tax and penalties against the taxpayer of over $54,000. The taxpayer petitioned the Tax Court for review of these disallowances.

Law and Conclusion: Under Sections 215(a) and 71(b) of the Internal Revenue Code, payments constitute deductible alimony if they are: (1) received by a former spouse under a divorce or separation agreement; (2) not excluded from the recipient’s taxable income by way of such agreement; (3) not paid to and from individuals living in the same household; and (4) not required to be paid after the death of the recipient. Section 71(c) provides that any payment that constitutes child support is excluded from the taxable income of the recipient spouse and therefore does not meet the requirements to be deducted as alimony. This Section also provides that, if any payment obligation pursuant to a divorce decree “will be reduced” on the happening of a contingency related to a child of the payor, that amount is treated as child support. The IRS argued that, with the parties’ last-minute revisions to Exhibit J to the agreement, they agreed that all payments required under the Exhibit (which by cross-referenced incorporated the payments required by Exhibit B) would be excluded from the wife’s taxable income, in violation of the second above-referenced requirement. Further, because those payments were to terminate on the children’s emancipation, the IRS argued that they should be considered non-deductible child support payments. The Court agreed that, while the parties may have intended some or all of the payments to be deductible alimony, due to the sloppy drafting, all payments required under Exhibit B were subject to the revised language of Exhibit J and therefore did not meet the requirements to be deductible alimony. Therefore, the Court found in favor of the IRS.

SUBSTANCE-OVER-FORM – Summa Holdings, Inc. v. Commissioner, No. 16-172 (6th Cir. 2017)

Why This Case is Important: This case is interesting because it involves taxpayers who, by the IRS’s own admission, strictly complied with the requirements of the Internal Revenue Code in funding Roth IRAs. Nonetheless, the IRS attempted to recharacterize the contributions using a substance-over-form argument.

Facts: Summa Holdings involved members of the Benenson family. In 2008, these individuals’ incomes exceeded certain thresholds established in the Internal Revenue Code, precluding them from making contributions to their Roth IRAs. They used complex tax planning to circumvent this prohibition. Because the Internal Revenue Code allowed Roth IRAs to own shares of “domestic international sales corporations” (DISCs), the individuals formed a DISC, with their Roth IRAs being the DISCs only shareholders. They then established a corporate structure by which their other corporation, Summa Holdings, paid commissions to an intermediary corporation owned by the DISC. The intermediary distributed these funds to the DISC, which then paid the distributions to the IRAs as dividends. Using this structure, the taxpayers were able to pay almost $1.5 million in to the IRAs in 2008, despite the restriction on contributions. The IRS examined this structure and recharacterized the commissions paid by Summa Holdings as dividends to the individuals themselves, and treated the individuals as having contributed these dividends into the Roth IRAs. Because they were not permitted to make contributions into the IRAs, the IRS assessed a 6% excise tax on the contributions. The taxpayers challenged this recharacterization in Tax Court and the Court found in favor of the IRS. The taxpayers then appealed that finding to the Sixth Circuit Court of Appeals.

Law and Analysis: Under the substance-over-form doctrine, the substance of a transaction, and not necessarily its form, determines its tax consequences. This doctrine gives the IRS the ability to challenge the tax benefits of a transaction by looking to the transaction’s economic realities rather than to the particular form used by the parties. In this case, the IRS argued that the taxpayers only used the complicated structure to circumvent the limitations on contributions into their Roth IRAs. Because, in substance, the taxpayers were making excessive contributions into their IRAs, the IRS argued that the form they employed should not be respected. The Court focused on the fact that the form used by the taxpayers was expressly permitted by the Internal Revenue Code, an issue that the IRS conceded. The Court held that where that is the case, the IRS does not have the right to ignore the form in the interest of maximizing tax liabilities. Instead, the Court held that the IRS was bound by the taxpayers’ form and overruled the Tax Court in finding for the taxpayers.

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