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Vermont Bar Association

Seminar Materials

2017 Solo & Small Firm Conference

Federal Tax Issues Facing

Solos and Small Firms

May 18 & 19, 2017

Basin Harbor Club

Vergennes, VT

Speaker:

Joseph Ronan, Esq.

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Everybody’s a Tax LawyerVERMONT BAR ASSOCIATIONSOLO & SMALL FIRM CONFERENCEMAY 2017

Speaker

Joseph E. Ronan Jr.

Ronan Law Group, PLLC

P.O. Box 1188, Norwich VT 05055

802-649-7314

35+ years experience in tax/executive compensation/benefits

Adjunct @ Villanova Law School

J.D., LL.M. (in Taxation)– NYU; B.A. – Haverford College

Inspirational Quotes

Albert EinsteinThe hardest thing in the world to understand is the income tax.

Dr. Laurence J. PeterAmerica is a land of taxation that was founded to avoid taxation.

Will RogersThe difference between death and taxes is death doesn't get worse every time Congress meets.

Jean-Baptiste ColbertThe art of taxation consists in so plucking the goose as to obtain the largest amount of feathers with the least amount of hissing.

Basic tax, as everyone knows, is the only genuinely funny subject in law school. — Martin D. Ginsburg [Psychiatrist to tax accountant:] We both treat the same neurosis: what to declare and what to hide. —

Patrice Leconte and Jerome Tonnerre (Intimate Strangers)

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Everybody’s a Tax Lawyer

Whether you like it or not!

Everybody's a dreamer and everybody's a star,And everybody's in movies, it doesn't matter who you are. Kinks, “Celluloid Heroes”

Tax issues are everywhere, under, over, on every rock.

But first….

What’s the difference between an introvert tax lawyer and an extrovert tax lawyer?

But first…

The extrovert looks at the other guy’s feet.

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But first….

A tax attorney defended a case of tax evasion for an affluent client. He devoted over a year to the case, familiarizing himself with every loophole and angle of current legislation, and made a brilliant argument before the court. His client was called out of town when the jury returned with its verdict, a sweeping victory for his client on every count. Flushed with victory, the lawyer exuberantly sent an email to his client, “Justice has triumphed!”

But first….

The client immediately emailed back, “Appeal at once!”

Don’t Fear the Reaper….

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Don’t Fear the Reaper…..

Two Tax-Gatherers probably 1540s, Workshop of Marinus van Reymerswale



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GDP: $19,302.8 blnGO:$33,757.6 bln

United States FederalState and Local Government Revenue

US CA >Pop: 325.4

million

-5yr -1yr Fiscal Year 2017 in $ trillion +1yr +4yr

state,localUnitedStatesNoPieChart

Don’t Fear the Reaper…..

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Trump Disruption

ACA Repeal--- American Health Care Act, as passed by House: Individual mandate: � Tax penalty for not having minimum essential coverage is eliminated

effective January 1, 2016

� Late enrollment penalty (30% of otherwise applicable premium) applies for individuals buying non-group coverage who have not maintained continuous creditable coverage.

Trump Disruption

HSAs: Modify certain rules for HSAs, changes take effect January 1, 2018: - Increase annual tax free contribution limit to equal the limit on out-of-pocket

cost sharing under qualified high deductible health plans ($6,550 for self only coverage, $13,100 for family coverage in 2017, indexed for inflation).

Additional catch up contribution of up to $1,000 may be made by persons over age 55. Both spouses can make catch up contributions to the same HSA.

Amounts withdrawn for qualified medical expenses are not subject to income tax. Qualified medical expense definition expanded to include over-the-counter medications and expenses incurred up to 60 days prior to date HSA was established

Tax penalty for HSA withdrawals used for non-qualified expenses is reduced from 20% to 10%.

Trump Disruption

Tax penalty for large employers that do not provide health benefits is reduced to zero, retroactive to January 1, 2016

Cadillac tax on high-cost employer-sponsored group health plans is suspended for tax years 2020 through 2025, no revenues shall be collected during this period

Repeals the HI payroll tax on high earners (0.9%) and tax on unearned income (3.8%), beginning after December 31, 2022.

http://files.kff.org/attachment/Proposals-to-Replace-the-Affordable-Care-Act-Summary-of-the-American-Health-Care-Act

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Trump Disruption

Cutting the corporate tax rate from 35 percent to 15 percent Cutting the tax rate on “pass-through” businesses to 15 percent--- costs $2T Switching from a worldwide to a territorial system for corporations Eliminate “border adjustment” idea Reducing the number of tax brackets from 7 to 3 (10, 25, and 35 percent) Eliminating itemized deductions—such as the state/local tax deduction- but keep

mortgage interest, charitable? Standard deduction roughly doubled. Expanding child care benefits Eliminate AMT and estate taxes Deficit issues! Loophole closing--- real estate issues

Tax Issues Facing Solos and Small Firms

Choice of Entity S Corp, C Corp, LLC taxed as Partnership, LLC tax as disregarded entity (solo)

If you are not an employee, SECA and estimated taxes apply

Retirement planning/benefits: generally, self-employed can save for retirement on same basis as employees; partners/self-employed lose access to pretax healthcare Recent studies suggest that saving 15% a year is about right

Nice Thought…..

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But don’t do this….

Fail to pay VT taxes: § 13. Good Standing with Respect to Taxes. An attorney is in good standing with

respect to any and all taxes due to the State of Vermont if the attorney: (a) has paid all taxes due to the State of Vermont and has filed all returns; (b) has entered into an agreement with the Commissioner of Taxes for becoming current on an unpaid tax obligation; (c) has appealed the alleged obligation; (d) has requested the Commissioner of Taxes to abate the unpaid tax claim for good cause; or (e) has filed a court challenge to the claim.

See In re Obregon, 2016 VT 32 (2016).

Don’t Do This

Fail to File/Fail to Pay Federal Taxes: Failure to File/Failure to Pay: 26 USC 7203 (criminal penalty); “serious crime”

under state law– compare U.S. v. Wray, 433 F.3d 376 (4th Cir. 2005) (conviction for willful failure to pay income taxes not clearly within “serious crime” definition under Federal rules) with, e.g., In re Tenzer, 726 NYS2d 711 (2d Dept. 2001) (NY law addresses this; one year suspension).

Fraud/Evasion: Suspension (e.g., 3 years)

Disbarment– In re Levine, 776 NYS2d 299 (2d Dept. 2004) (conviction on 10 counts of filing false tax refund claims; cognizable under NY law as offering a false instrument of filing, also a felony; disbarment)

Really Don’t Do This

Withhold “trust fund” taxes and fail to pay them over: Income tax

Social Security tax Medicare tax

Sec. 6672(a) provides that “any person required to collect, truthfully account for, and pay over any tax imposed by” the Internal Revenue Code who willfully fails to do so, will, “in addition to other penalties provided by law, be liable to a penalty equal to the total amount of the tax … not collected … and paid over.”

Responsible person = anyone with functional responsibility for tax payment process

Knowledge that taxes must be withheld + failure to pay = willful = potential criminal liability http://cases.justia.com/federal/appellate-courts/ca6/15-2396/15-2396-2017-05-15.pdf?ts=1494865848 Be careful with outsourcing payroll: http://www.thetaxadviser.com/issues/2015/oct/cpas-may-be-

responsible-for-client-payroll-tax-penalties.html

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Very Close Call

We share the IRS’s concern that Congress intended for § 6672 “to protect the government against losses,” Gephart, 818 F.2d at 473, but we must balance this goal against the unfairness of imposing too strict a rule of liability. Here, the government has successfully argued that Byrne and Kuswere negligent. But, based on our review of the record, we are convinced that Byrne and Kus have met their burden in demonstrating that their negligence in believing that Eagle Trim’s trust-fund taxes were being paid for the third and fourth quarters of 2000 did not rise to the level of recklessness. Byrne v. U.S., 6th Cir., May 15, 2017.

Circular 230

What’s that?

https://www.irs.gov/pub/irs-utl/revised_circular_230_6_-_2014.pdf---governs practice before the IRS/Treasury

Wait--- I don’t practice before the IRS/Treasury--- I’m just a [family law attorney][litigator][real estate attorney][singer in a rock ‘n’ roll band]!

But you are subject to Circular 230 if you give tax advice and you may be a return preparer and not know it. PTIN requirement

More Circular 230

https://www.irsvideos.gov/Circular230OverviewWebinar/player/Powerpoint_Presentation.pdf

https://www.irs.gov/pub/irs-utl/guidance_regarding_professional_obligations_under_circular_230.pdf

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Return Preparer

If you are a return preparer, you may give advice as to a tax position on the return only if: “Substantial authority” (40% or more); or

“Reasonable basis” (20% or more) + disclosure

A Couple of Circular 230 Notes

Get rid of the Circular 230 footer! You can’t negotiate checks from the Treasury! You may not endorse,

negotiate, electronically transfer, or direct the deposit of any government check relating to a Federal tax liability issued to a client. This prohibits any person subject to Treasury Circular No. 230 from directing or accepting payment from the government to the taxpayer into an account owned or controlled by that person. This provision does not apply to whistleblower payments. Treasury Circular No. 230 §10.31.

Contingent fees in federal tax matters: You can’t charge a contingent fee to prepare and file original tax returns but you can enter into contingent fee arrangements for refunds. See http://www.cpapracticeadvisor.com/news/12005748/irs-concedes-defeat-on-circular-230-contingent-fees

Amended Returns

Substantive Issues

Family Law: Divorce Taxation “Tax-Free” Division of Property– Section 1041 and DROs/QDROs

Alimony

Tax Treatment of Settlements and Awards

Wills and Estates

Can be high stakes and easy to mess up!

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Division of Property Incident to Divorce

Section 1041: General rule: no taxable gain or loss is recognized on a transfer of property from a spouse to, or in trust for, the other spouse or former spouse if the transfer to the other or former spouse is incident to a divorce.

But this isn’t elective!

Old Rule: U.S. v. Davis (U.S. S. Ct.): taxable transaction

Collateral tax results: When property is subject to the rules of Code Section 1041(a), the property is treated

as if it had been acquired by the transferee by gift. The transferee’s basis in the transferred property carries over from the transferor - i.e. the transferee takes the transferor’s basis in the property immediately prior to the transfer. Code Section 1041(b)(2).

Basis Rules on Property Transfer

Important note: This means that the transferee takes something like “historical cost” (as adjusted) as his/her basis, not FMV--- generates potential BIG/BIL.

Thus, $1of appreciated property transfer value may not equal, e.g., $1 of bank account value or car value (must tax effect)

Tricky issues about payments to spouse/liabilities/circumstances under which transferor recognizes gain

Holding period “tacks”--- i.e., transferor’s H/P applies to transferee

“Incident To” Divorce

Section 1041 applies to transfers between spouses– no divorce needed. If there is a divorce or separation, things gets more complex--- if these conditions aren’t met,

there’s a “rebuttable presumption” that the transfer is not incident to a divorce 1. The transfer occurs not more than one year after the date on which the marriage ceases

(whether or not made pursuant to a divorce or separation instrument, and regardless of whether the marriage ends by divorce, annulment, or as the result of the violation of state law), Code Section 1041(c)(1); or

2. The transfer is related to the cessation of the marriage. Code Section 1041(c)(2). A property transfer is treated as related to the cessation of the marriage if both of the following conditions apply, namely: a. The transfer is made pursuant to a divorce or separation instrument described in Code Section 71(b)(2), (including a modification or amendment of such decree or instrument) [Note: a transfer occurring within one year of the date of cessation of the marriage need not be made pursuant to a divorce or separation instrument. Code Section 1041(c)(1)] and b. The transfer occurs not more than six years after the date of cessation of the marriage. Reg. 1.1041-1T(b), Q&A 7. PLR 9306015. The Regulations include in the term “cessation of the marriage” events such as annulments and voided marriages. Reg. 1.1041-1T(b), Q&A 8. 3. If these conditions are not met, i.e. the transfer is not made pursuant to a

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Specific Situations

1. Recapture of Depreciation, Investment Tax Credits. The transfer of property incident to divorce will not result in the recognition of depreciation or investment tax credit recapture, (even if the property is Section 1245 or Section 1250 property), since no gain or loss, including depreciation recapture, is triggered by Code Section 1041, since the transfer is treated in the same manner as a disposition by gift. PLR 8719007.

2. Installment Obligations. Except in the case of a transfer to a trust, the transfer of an installment obligation will not be treated as a disposition of the obligation, and will not cause acceleration of gain to the transferor spouse. Code Section 453B(g). The same tax treatment as would have applied to the transferor spouse will be applied to the transferee spouse. Code Section 453B(g)(2).

3. United States Savings Bonds. The transfer of Series E and EE United States Savings Bonds will be taxable to the transferor spouse to the extent of untaxed accrued interest inherent in the bonds at the time of the transfer. An assignment of income theory is applied here. Code Section 454; Rev. Rul. 87-112, 1987-2 C.B. 207. The transferee spouse will take a basis in the transferred bonds equal to the transferor spouse’s basis plus the amount of income recognized by the transferor. Reg. 1.454-1(a). Note that Code Section 1041 is not applicable here since Section 1041 shields gain from recognition, not income.

Specific Situations

4. S Corporation Shares. Where S corporation stock is transferred pursuant to a divorce, any suspended losses incurred by the transferor are transferred to the transferee. Code Section 1366(d)(2)(B).

5. Passive Activity Property. Where the transferor spouse transfers his or her entire interest in a passive activity to a transferee spouse incident to divorce, the transfer will not trigger a deduction for suspended losses by the transferor spouse. Instead, Code Section 469(j)(6) provides that in the case of a disposition of any interest in a passive activity by gift, the basis of such interest immediately before the transfer is to be increased by the amount of any passive activity losses allocable to such interest with respect to which a deduction has not been allowed, thereby indirectly permitting the transferee spouse to use the losses as a result of an increase in basis.

6. Life Insurance Policies. Transfer of a life insurance policy pursuant to divorce, even though made for consideration, does not trigger the transfer for value rule of Code Section 101(a)(2), since Code Section 1041 gives the transferee spouse a carryover basis in the property and negates the operation of the transfer for value rule.

Retirement Plan Assets-- IRAs

Interests in IRAs. Transfers of interests in an IRA to a spouse or former spouse are treated as nontaxable transfers provided that the transfer is pursuant to a decree of divorce or separate maintenance or a written instrument incident to such a decree. Code Section 71(b)(2)(A). Note that a transfer in accordance with a written separation agreement is not sufficient to achieve a nontaxable transfer of an IRA. FSA 199935005; PLR 9344027. Once transferred under a divorce or separation agreement, the participant’s interest in the IRA is treated as owned by and taxable to the transferee spouse. Code Section 408(d)(6); Reg. 1.408-4(g)(1). Where a spouse takes a distribution from an IRA and pays it to the other spouse pursuant to a divorce, such a transfer has been held to not constitute the transfer of an “interest” in the IRA, so that the withdrawal is taxable to the IRA owner. Bunney v. Commissioner, 114 TC 259 (2000)(Must transfer an interest in an IRA, not the proceeds, to shift the tax burden); Czepielv. Commissioner, TC Memo 1999-289; aff’d 86 AFTR2d 2000-7304 (1st Cir. 2000).

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DROs/QDROs

Interests in Qualified Retirement Plans. As a general rule, the ERISA rules prohibit the transfer (“alienation”) of qualifiedretirement plans. However, in order to facilitate matrimonial settlements where qualified plans are involved, transfers of interests in qualified retirement plans may be made when they are in the form of a Qualified Domestic Relations Order (QDRO) that satisfies the requirements of ERISA. Code Sections 401(a)(13)(A) and 414(p). The transferee spouse is referred to as an “alternate payee” of the qualified plan. If the plan terms permit, a QDRO may provide for the payment of plan benefits that would be payable to the plan participant to an alternate payee at any time. A QDRO may be written to direct payments to an alternate payee prior to the time that the plan could make payments to a participant, Reg. 1.401(a)-13(g)(3), or at the earliest retirement age permitted under the plan. Code Section 414(p)(4).

a. A “qualified domestic relations order” includes a judgment, decree, or order, including an order approving a property settlement agreement, that relates to the provision of child support, alimony payments or marital property rights to an alternate payee, who may be a spouse, former spouse, child, or other dependent of the participant which is made pursuant to a state domestic relations or community property law. Code Sections 414(p)(8) and 414(p)(1)(B)(ii).

b. A QDRO must create or recognize the existence of an alternate payee’s right to, or assign to an alternate payee the right to receive all or a portion of the benefits payable to a participant. It must clearly and fully specify the amount or percentage of benefits to be paid to each alternate payee, or the formula by which such amount or percentage is to be determined, along with the number of payments or the period over which payments are to be made. If an order is not a QDRO, the distribution will generally be taxable to the employee, not to the alternate payee. Code Sections 414(p)(1)(A)(i) and (ii) and 414(p)(2)(A)-(C). Hawkins v. Commissioner, 86 F. 3d 982 (10th Cir. 1996).

Tax liability shifts to the alternate payee only if the payee is a spouse or former spouse. Code Section 402(e)(1)(A). Amountspaid pursuant to a QDRO to a child or other dependent will be taxed to the plan participant. Stahl v. Commissioner, TC Memo 2001-22.

DROs/QDROs

c. The transferee spouse can have the plan benefits described in a QDRO paid in a direct rollover to an IRA or to another qualified employer plan. The 10% penalty tax imposed on early plan distributions is not applied to a QDRO. Code Section 72(t)(2)(C).

d. Note that courts have been firm in finding that ERISA preempts state statutes, so that the ERISA rules, designating the QDRO as the only mechanism by which a former spouse can preserve his or her rights to qualified plan survivor benefits upon the plan participant’s death, are the exclusive recourse for a spouse’s protection. Egelhoff v. Egelhoff, 121 S. Ct. 1322 (2001). In short, if a matrimonial agreement does not contain a QDRO making specific reference to retirement plan benefits, the non-employee spouse will be denied recovery of any share of such benefits.

e. If a former spouse is the named beneficiary of a qualified plan when the participant dies, and the matrimonial agreement and divorce decree provided for the spouse’s waiver of the plan rights, but no QDRO was created, and no beneficiary change was filed, the naming of the spouse as the plan beneficiary controls the disposition of the plan proceeds, and the divorce decree is properly ignored. Kennedy v. Plan Adm’r for DuPont Savings & Inv. Plan

DRO on other topics

Nonqualified deferred compensation

Stock options

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Alimony

If you think the property transfer rules are bad…..

General rule: alimony is taxable to the recipient, not to the payor---income tax shift

Also not elective!

Alimony Background

Alimony income and the alimony deduction are reported on IRS Form 1040 for federal income tax purposes. State laws should be checked (particularly those states with an “independent” income tax system that does not “piggyback” the Federal system) to determine if alimony is deductible by the payor and includible as income by the payee.

Alimony is an “above the line deduction”, i.e. it is deductible whether or not the payor itemizes deductions. It is not a miscellaneous itemized deduction. Code Sections 62(a)(10); 67(a).

Alimony payments do not, however, generate a net operating loss deduction, since it is a nonbusiness expense. Monfore v. Commissioner, TC Memo 1988-197; Code Section 172(d)(4).

As a general rule, there is no requirement for the payor spouse to withhold income taxes on alimony payments. An exception to this general rule applies in the case of alimony payments to a nonresident alien, since such payments are deemed United States source income. Where withholding applies, the rate is 30%. Code Section 1441(a); Rev. Rul. 69-108, 1969-1 C.B. 192. It is possible that a tax treaty with the home country of the payee may negate the withholding requirement.

Alimony Background

5. Since alimony constitutes taxable income to the payee spouse, such spouse should be sure to include any alimony received in his or her tax calculation for purposes of determining liability for estimated taxes. Code Section 6654. Alimony is not considered income from self employment, so that social security and Medicare taxes are not applied to it.

6. Since alimony is treated as earned income, the divorced recipient spouse may separately create an IRA and contribute to the IRA (subject to the IRA contribution limitations) based on the amount of alimony received. Code Section 219(b)(4).

7. The payee spouse must provide his or her social security number to the payor spouse, and the payor spouse is required to indicate the name and social security number of the payee spouse on the first tax return on which the payor spouse claims an income tax deduction for alimony payments made. Code Section 215(c); Reg.1.215-1T, Q&A 1. There is a $50 penalty imposed on any party who fails to comply with these rules. Code Sections 6723 and 6724(d)(3)(C).

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Seven Alimony Criteria

1. The payment must be made in cash. Code Sections 71(b)(1); 215(b). a. Cash payments, including checks and money orders payable on demand,

qualify as alimony and separate maintenance payments. A lump sum payment may qualify as alimony. The payment must be received by or on behalf of the payee spouse.

b. Transfers of services or property, the execution of a promissory note, or other debt instrument, or allowing the payee to use property of the payor do not qualify as cash payments of alimony. Delivery of a third party’s debt instrument or an annuity contract do not constitute cash payments of alimony. Reg. 1.71-1T(b) Q&A 5.

c. Alimony may be found to have been constructively received by the recipient spouse when wages of the payor spouse are garnished and placed into a trust account for the recipient’s benefit. Burkes v. Commissioner, TC Memo 1998-61


2. The payment must be received by or on behalf of a spouse pursuant to a “qualifying instrument”, namely a divorce decree, decree of separate maintenance, or a written separation agreement. Code Section 71(b)(1)(A), (b)(2).

a. A divorce or separation instrument is a decree (aka a judgment) of divorce or separate maintenance or a written instrumentincident to such a decree; or a written separation agreement; or any other decree requiring a spouse to make payments for thesupport or maintenance of the other spouse (such as a temporary and pendente lite order of support) Code Section 71(b)(2)(A)-(C). Brooks v. Commissioner, TC Memo 1983-304.

b. The payment must be made under the instrument. When a payment is made prior to the execution of a divorce or separation instrument, it will not be treated as a payment made under the instrument. Payment should be made after execution of a divorce or separate maintenance decree or a written separation agreement. The decree must be “final”. Code Section 71(b)(2)(A). State law will determine when an order or decree is considered “final”. Jachym v. Commissioner, TC Memo 1984-182. Temporary support payments made and accepted (absent a formal order) while other issues are disputed and no agreement is final will not be characterized as“alimony”. Nemeth v. Commissioner, TC Memo 1982-646.

c. Cash payments to a third party on behalf of the payee spouse under the terms of a divorce or separation agreement can qualify as a cash payment to the spouse. For example, if the divorce or separation agreement requires that the payor spouse pay the payee spouse’s mortgage, rent, real estate taxes, (where the payee spouse owns the property), life insurance premiums (only where the payee spouse owns the policy) or tuition obligations, such payments will qualify as alimony or maintenance payments. Reg. 1.71-1T(b), Q&A 6. Where the payee spouse owns the residence, and the payor spouse pays the mortgage, property taxes, repairs and insurance,such payments will qualify as alimony if all of the Section 71 requirements are satisfied. This will enable the payor spouse to deduct the payments as alimony paid, and require the payee spouse to include the payments in income as alimony received. The payee spouse may then deduct the mortgage interest and real estate taxes paid on spouse’s behalf, provided the payee spouse itemizes deductions, and further provided that the interest constitutes qualified residential interest. Rev. Rul 62-39, 1962-1 CB 17.


#2 continued:

Cash payments made to a third party at the written request, consent, or ratification of a spouse qualify as alimony, provided the payments are in lieu of payments of alimony directly to the spouse; are intended by both spouses, per the written request, to be treated as alimony; and the written request is received from the spouse before the payor spouse files an income tax return for the year the payment is made. Reg. 1.71-1T(b),Q&A 7; PLR 8710089. For example, if the payee spouse has the payor make a contribution to a charity at the payee’s request, the payor may treat the payment as an alimony payment. In such a case, the payee spouse should be able to claim a charitable deduction for the payment.

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3. The parties do not designate that the payment is not alimony; i.e. the divorce or separation agreement does not designate the payment as nondeductible by the payor or excludable from the payee’s income. Code Section 71(b)(1)(B) allows the parties to affirmatively agree that an otherwise qualifying payment is not alimony or separate maintenance, and accordingly is not deductible by the payor or includible by the payee. A court may order that the payments are nondeductible/nontaxable.

Effectively, you can elect out but not in.


4. The divorced or legally separated spouses must reside in separate households when the payment is made. Code Section 71(b)(1)(C). A formerly shared home is considered one household, even if the parties are physically separated within the home. Persons will not be treated as members of the same household if one is preparing to leave the household and does leave no later than one month after the date of the payment. Reg. 1.71-1T(b), Q&A 9; Coltman v. Commissioner, 980 F. 2d 1134 (7th Cir. 1992).

This requirement only applies to divorced or legally separated spouses. If the spouses are not divorced or legally separated under a decree of divorce or separate maintenance, payments made pursuant to a written separation agreement or support order may still qualify as alimony even if the parties reside in the same household.


5. The payor is not liable to make any payment for any period after the death of the payee spouse, and there is no liability to make any payment (whether in cash or in property) as a substitute for such payments after the death of the payee spouse. Code Section 71(b)(1)(D); Stokes v. Commissioner, TC Memo 1994-456.

a. Alimony payments must end at the death of the payee spouse. A provision requiring payments to continue after the death of the payee will taint all payments, including those made both before and after death. A required payment to the payee’s estate will taint any other payments designated as alimony, since a payment to the payee’s estate is considered a payment after death. Reg. 1.71-1T(b) Q&A 13.

b. The divorce or separation instrument does not have to expressly state that the payments cease upon the death of the payee spouse if, for example, the liability for continued payments would end under state law. However, allowing the instrument to be silent on the issue of termination of the obligation at death may not be a good idea. Cases indicate that courts may interpret obligations as continuing beyond the lifetime of the payee, thus damaging the payor’s expected income tax treatment of alimony payments. Webb v. Commissioner, TC Memo 1990-540; Rosenthal v. Commissioner, TC Memo 1995-603. It is strongly recommended that in order to avoid any ambiguity, the applicable divorce instrument should contain a provision stating that all alimony payments terminate upon the death of the payee spouse.

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#5 continued---

c. An agreement may provide that payments are to continue to the payee spouse after the death of the payor spouse. The estate of the payor spouse is not entitled to an alimony income tax deduction for such payments. However, such post-death payments from the payor spouse’s estate are considered distributions to an estate beneficiary subject to the estate income tax distribution rules. Code Section 682(b). Accordingly, if the payor spouse’s estate has distributable net income, the estate can deduct the distribution, and the payee would be required to include the payment in income as a distribution of income received from the estate.

d. If the divorce agreement contains a provision requiring a reduction of alimony payments either in the event of the death of the payor spouse, or in the event of the remarriage of the payee spouse, such provisions will not preclude the deduction of ongoing reduced payments as alimony, nor will they jeopardize the original larger payments from alimony treatment.


6. The parties must file separate income tax returns. Code Section 71(e). The payor must include the payee’s social security number on his or her first tax return for the taxable year in which the payment is made. The payee is required to furnish this number to the payor. Code Section 215(c); Reg. 1.215-1T, Q&A 1. Alimony payments will not be recognized if the payor and payee file a joint return.

Married filing separately is ok!


7. The payment must not be a payment for child support. Code Section 71(c). Payments made under the terms of a divorce or separation agreement that are specifically designated or treated as made for the support of a child of the payor spouse are not alimony or separate maintenance payments. In such a case, the payment is not deductible by the payor, and not included in the income of the payee. Reg. 1.71-1T(b), Q&A 15.

Alimony payment decreases as child age out?

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Alimony “Recapture”

The alimony recapture rule exists to prevent taxpayers from “disguising” otherwise nondeductible property settlement payments as alimony payments by attempting to “front-load” and deduct property settlement payments that are purportedly characterized as alimony.


If the payor’s alimony payments decrease or terminate during the first three calendar years in which payments are made, the alimony recapture rule may be applicable.

a. If total alimony payments deducted in year one exceed the average annual payments made in years two and three by more than $15,000, the excess deduction is recaptured in the payor’s gross income in the third year.

b. If payments in the second year exceed payments in the third year by more than $15,000, the excess deduction is recaptured in the payor’s gross income in the third year.

The first calendar year in which the payor spouse makes alimony payments to the payee spouse is called the “first post-separation year”. The first calendar year following the first post-separation year is referred to as the second post-separation year, and the second calendar year following the first post-separation year is referred to as the third post-separation year. These rules will apply whether or not alimony payments are actually made in the second or third post-separation years. Code Section 71(f)(6). Recapture will apply with respect to excess amounts of alimony payments made in the first and the second post-separation years.


Only payments made in the first and second post-separation years are subject to recapture. Payments made in the third post-separation year and subsequent years are not subject to recapture.

The law provides a “safe harbor” threshold of $15,000 per year. Payments of alimony of up to $15,000 per year may be made without being subject to the recapture rules.

However, the recapture rules will apply in the third post-separation year if the alimony paid in the third year decreases by more than $15,000 from the second year, or the alimony paid in the second and third years decreases significantly from the alimony paid in the first year.

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Alimony “Recapture”--Exceptions

1. Payments in the three post-separation years are under $15,000 per year. 2. No recapture is required if either spouse dies before the end of the third post-separation year,

and the alimony payments cease as the result of such death. Code Section 71(f)(5)(A)(i), (ii). 3. No recapture is required if the payee spouse remarries before the end of the third post-

separation year, and the alimony payments cease as the result of such remarriage. Code Section 71(f)(5)(A)(i),(ii).

4. The recapture rules do not apply to support payments made pursuant to a court order for temporary or pendente lite support. Code Section 71(b)(2)(C).

5. The recapture rules do not apply to payments made pursuant to a continuing liability over the period of at least the first three postseparation years to pay a fixed portion of the income derived by the payor spouse from a business or rental property, or from compensation for employment or self-employment. Code Section 71(f)(5)(C). This rule enables the parties to agree on a fixed, pre-existing formula under which the actual payments may vary from year to year with the payor’s income consistent with the agreed-upon formula. Note, however, that in order for a variable payment agreement to be exempt from the excess alimony recapture rules, such agreement must be effective for at least three years.


So…. Equal payments for 3 years

Start lower and increase

Use $15,000 rule

Death/remarriage

Child Support

Payments that are specifically designated as child support or treated as specifically designated as child support under a divorce or separation instrument are not alimony, and are not includible in the recipient’s gross income. Code Section 71(c) excludes from the definition of alimony cash payments which constitute child support.

To avoid ambiguity, the divorce instrument should clearly and unambiguously identify (“fix”) the payment as child support. The presumption for an unallocated award is that it has not been “fixed” as a payment for child support. Simpson v. Commissioner, TC Memo 1999-251.

Payments made for child support are not deductible by the payor spouse and are not taxable income to either the payee spouse or to the child.

Payments “Fixed” as Child Support. A payment or portion of a payment is treated as specifically designated or “fixed” for child support if the divorce or separation instrument specifically designates an amount of money or a percentage of a payment as being made for the child of the payor. Code Section 71(c)(1). 1. The concept of a “fixed” payment refers to a clearly determinable payment for child support, rather than a specific amount. This rule allows the actual amount of a payment to vary from year to year without losing its essential qualification as a child support payment. Reg. 1.71-1T(c). An example of this rule would be a direction to pay educational or medical expenses for a child. While the amount of the payment may vary from year to year, the characterization of the expense clearly fits it within the child support classification. Sperling v. Commissioner, 726 F. 2d 948 (2nd Cir. 1984).

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Settlement or Judgment. The tax consequences of a payment made in connection with a lawsuit are the same whether the lawsuit is settled or proceeds to judgment.

“Origin of Claim” Analysis: in general, the origin of the claim presented in the lawsuit determines the tax consequences of the Award. A plaintiff’s tax treatment is determined by reference to the genesis and gravamen of the underlying claims. U.S. v. Gilmore, 372 U.S. 39 (1963); U.S. v Woodward, 397 U.S. 572 (1970); Keller St. Dev. Co. v. Comm’r, 688 F.2d 675 (9th Cir. 1982).


Lost Profits Versus Goodwill. Claims which arise in a business context often involve elements relating to both lost profits and damage to identifiable assets, such as goodwill. The burden is on the taxpayer to demonstrate the existence of an asset, as well as damage thereto, in order to avoid treatment of an Award as ordinary income. Rev. Rul. 75- 527, 1975-2 C.B. 30. Raytheon Corp. v. Comm’r, 144 F.2d 110 (1st Cir. 1944).

Return of Capital. To the extent that the amount received for damage to an identifiable asset does not exceed the taxpayer’s basis in the asset, the Award is treated as a nontaxable return of capital, which decreases the remaining basis in the asset. Rev. Rul. 81-277, 1981-2 C.B. 14; Daugherty v. Comm’r, 78 T.C. 623 (1982).

Awards in Excess of Basis. Existing case law is not clear on the issue of whether an Award in excess of basis with respect to a capital asset is taxable as ordinary income or as capital gain. Compare Fahey v. Comm’r, 16 T.C. 105 (1951) (no capital gain because no “sale or exchange”) with Durkee v. Comm’r, 181 F.2d 189 (6th Cir. 1950) (award for destruction of zero-basis goodwill taxable as capital gain even in the absence of a demonstrable sale or exchange). See also, Turzillo v. Comm., 346 F.2d 884 (6th Cir. 1965) (inquiry into “sale or “exchange” found “formalistic,” Award for breach of agreement to acquire shares held taxable as capital gains); Inco Electroenergy v. Comm’r, T.C.M. 1987-437 (1987) (capital gain where 1181093v2 2 Award in trademark litigation found to be compensation for damage to trademark and goodwill).

Tax Treatment of Awards and Settlements

Sale or Exchange: In Steel, T.C.M. 2002-113, the Tax Court emphasized the “sale or exchange” requirement in treating as ordinary income the settlement of an insurance claim assigned to the taxpayers by a corporation. The court also rejected the taxpayer’s argument that the distribution of the claim should be integrated with a sale of the distributing corporation’s stock occurring shortly thereafter. The distinction between capital gain and ordinary income has grown more significant after the passage of the Jobs and Growth Tax Relief Reconciliation Act of 2003 (“JGTRRA”) which reduced the maximum tax rate on capital gains for individuals to 15%.

Acquired Legal Claims. A different rule may apply to settlement of an acquired legal claim. Nahey v. Comm’r, 196 F.3d 866 (7th Cir. 1999) aff’g 111 T.C. 256 (1998). The taxpayer in Nahey acquired all the assets of a corporation, including a breach of contract claim against Xerox related to installation of a new computer system. Without addressing the “origin” of the claim against Xerox, both courts concluded that taxpayer necessarily realized ordinary income because the extinguishment of the claim did not amount to a sale or exchange. The Nahey rule also suggests that a plaintiff may recognize capital gain on any sale of a claim to a third party.

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Involuntary Conversion. In FSA 200217001, the IRS held that an Award for breach of contract and tortious interference was not an involuntary conversion for purposes of I.R.C. § 1033, finding that no theft occurred due to the lack of criminal activity.

Claims for Lost Tax Benefits. In Clark v. Comm’r, 40 B.T.A. 333 (1939), acq. 1957-2 C.B. 4, and Rev. Rul. 57- 47, 1957-1 C.B. 3 the Tax Court held (and the IRS ultimately agreed) that a payment made by a tax practitioner to reimburse a client who had overpaid taxes due to faulty advice was not includible in the taxpayer’s income. The holdings were premised on a variant of the tax benefit rule – i.e., recovery on a non-deductible expenditure (federal income taxes paid) should not produce income. In a series of private rulings, however, the IRS has tried to narrow the scope of Clark--where a third party reimburses a taxpayer for income taxes paid, the reimbursement will constitute income – unless the difference is the result of payment of more tax than the minimum that would have been due absent return preparation errors.

Limitation on Origin of the Claims Doctrine. Even if a claim arises out of an item, the receipt of which would have been tax-free to the plaintiff, the receipt of an Award may not be tax-free unless all requirements of the applicable Code Section are met. In PLR 200528023 settlement payments made by a corporation to the estates of various former employees of the corporation were found taxable. Unbeknownst to the employees, the corporation had purchased insurance on their lives with the corporation named as the beneficiary. The IRS held that the settlements received were taxable as a recovery of “converted funds” because they were received from the corporation, not the insurance company, and were less than the amount of the death benefit.

Personal Injuries

Confusing case law prior to 1996

Prior to August 21, 1996, IRC § 104(a)(2) did not contain the word “physical” with regard to personal injuries or sickness. Consequently, many taxpayers were allowed to exclude from income amounts received on account of personal non-physical injuries and sickness while others erroneously failed to report as income almost all types of awards/settlements under IRC § 104(a)(2). In 1996, IRC § 104(a)(2) was amended to exclude from gross income “the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness.” IRC § 104(a)(2).

Good IRS summary: https://www.irs.gov/pub/irs-utl/lawsuitesawardssettlements.pdf


Treatment of Settlements: “Origin of Claim” Analysis

Adverse parties allocation should be respected

But IRS can challenge if unrealistic. See LeFleur v. Commissioner, T.C. Memo. 1997-312

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Physical Injury

The Service has consistently held that compensatory damages, including lost wages, received on account of a personal physical injury are excludable from gross income with the exception of punitive damages. Rev. Rul. 85-97, 1985-2 C.B. 50, amplifying Rev. Rul. 61-1; see also Commissioner v. Schleier, 515 U.S. 323, 329-30 (1995), in which the Supreme Court used an example of an automobile accident to illustrate in this employment discrimination case how “on account of” in IRC § 104(a)(2) is construed. In the example, the Court held medical expenses (not previously deducted), pain and suffering, and lost wages received by an accident victim are excludable from income as “on account of personal injuries.” Schleier, 515 U.S. at 329.

Physical Injury

The House Committee Report to the 1996 Act states:

If an action has its origin in a physical injury or physical sickness, then all damages (other than punitive) that flow therefrom are treated as payments received on account of physical injury or physical sickness whether or not the recipient of the damages is the injured party. For example, damages (other than punitive) received by an individual on account of a claim for loss of consortium due to the physical injury or physical sickness of such individual‟s spouse are excludable from gross income.

Punitive damages never qualify!

On account of

In order for damage awards to be excluded from gross income they must have been received on account of personal physical injuries or physical sickness. Commissioner v. Schleier, 515 U.S. 323 (1995); see Murphy v. IRS, 493 F.3d 170 (2007)(D.C. Circuit sustained the district court‟s holding that damages awarded in an administrative action against a former employer under whistleblower environmental statutes, for “mental pain and anguish” and “injury to professional reputation,” were outside the Internal Revenue Code's “personal physical injuries or physical sickness” damages exclusion, even though the taxpayer no doubt had suffered from certain physical manifestations of the emotional distress on which the award was based); Stadnyk v. Commissioner, T.C. Memo. 2008-289; Ballmer v. Commissioner, T.C. Memo. 2007-295, and Hawkins v. Commissioner, T.C. Memo. 2007-286

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Emotional Distress

To be excludible, an emotional distress recovery must be on account of (attributed to) personal physical injuries or sickness unless the amount is for reimbursement of actual medical expenses related to emotional distress that was not previously deducted under IRC § 213. The flush language of IRC § 104(a) states, “For purposes of paragraph (2), emotional distress shall not be treated as a physical injury or physical sickness. The preceding sentence shall not apply to an amount of damages not in excess of the amount paid for medical care (described in subparagraph (A) or (B) of section 213(d)(1)) attributable to emotional distress”. According to a footnote in the Conference Committee Report to the 1996 Act 104 -188, the term "emotional distress" includes physical symptoms, such as insomnia, headaches, and stomach disorders, which may result from such emotional distress.

In Emerson v. Comr., T.C. Memo 2003-82, the Tax Court found that a tort recovery for various claims, including emotional distress, was not excludible under IRC § 104(a)(2) because the recovery was not received on account of personal physical injuries or physical sickness. Also, in Witcher v. Comr., T.C. Memo 2002-292, the Tax Court held that a tort recovery for various claims, including emotional distress and defamation, was not excludible because it was not received on account of personal physical injuries or physical sickness.

Wrongful Death

General Rule: Claims for wrongful death usually encompass compensatory damages for physical and mental injury, as well as punitive damages for reckless, malicious, or reprehensible conduct. As a result, both claims may generate settlement amounts. Any amounts determined to be compensatory for the personal physical injuries are excludable from gross income under IRC § 104(a)(2). Any amounts determined to be punitive are not excludable under IRC § 104(a)(2). This is true regardless of whether the punitive amounts are received prior or subsequent to the August 20, 1996, amendment. See O’Gilvie v. United States, 519 U.S. 79 (1996).

But….Courts have looked to the state statute under which the wrongful death claim was litigated to determine whether there could be compensatory and/or punitive damages awarded. This search may reveal a state statute which provides only for punitive damages in wrongful death claims. In these cases, IRC § 104(c) allows the exclusion of punitive damages for amounts received after 1996.

Employment-Related Claims

Employment-related lawsuits may arise from wrongful discharge or failure to honor contract obligations. Damages received to compensate for economic loss, for example, lost wages, business income, and benefits, are not excludable from gross income unless a personal physical injury caused such loss.

The taxpayer can exclude under IRC § 104(a)(2) only an amount of damages for actual out of pocket medical costs paid to treat any emotional distress if those medical costs had not been deducted on his or her tax return. See IRC §§ 111 and 213.

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Employment Discrimination

Discrimination suits usually are brought alleging infringements in the areas of age, race, gender, religion or disability. These types of cases can generate compensatory, contractual and punitive awards, none of which are excludable under IRC § 104(a)(2).

Revenue Ruling 96-65, 1996-2 C.B. 6 holds: Current section 104(a)(2) - (after August 20, 1996). Back pay received in satisfaction of a claim for denial of a promotion due to disparate treatment employment discrimination under Title VII is not excludable from gross income under section 104(a)(2) because it is completely independent of, and thus is not damages received on account of, personal physical injuries or physical sickness under that section. Similarly, amounts received for emotional distress in satisfaction of such a claim are not excludable from gross income under section 104(a)(2), except to the extent they are damages paid for medical care (as described in section 213(d)(1)(A) or (B)) attributable to emotional distress.

Everything Else

Libel, defamation, breach of contracts, etc.--- all taxable under section 104 since non-physical

Payroll Tax Treatment

Nontaxable amounts under section 104--- not wages, not subject to IT withholding/FICA

Back pay: wages, therefore subject to IT withholding/FICA

Front pay: IRS argues same treatment; some courts disagree

Settlement of ERISA matters: confused– IRS wants to argue the whole amount is subject to IT withholding/FICA but some courts split the amounts

Severance/dismissal pay--- wages subject to IT withholding/FICA

Liquidated damages and other non-wage payments--- not wages

Self-employment income– may be narrower

Amounts paid pursuant to fee shifting statute: http://www.mondaq.com/article.asp?article_id=264240&signup=true

Opt-in vs. Opt-out class actions

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Reporting the Award/Settlement Amount– Attorneys’ Fees

The full amount of the taxable award/settlement must be reported as gross income, even if some is paid directly to the attorney.

Commissioner v. Banks, 543 U.S. 426 (2005): the Court held that attorney fees, including those paid directly to the litigant‟s attorney on a contingent fee basis, are fully includible in the gross income of the litigant.

Deduction for Attorneys’ Fees

Generally, cash method TPs can deduct attorneys’ fees in year paid. But if award/settlement amount is nontaxable, no deduction. Except in rare cases, such as a compensatory recovery of self-employment

income (for example, commissions that are reported on Schedule C) or recovery of capital gain income, legal fees will be a Schedule A miscellaneous itemized deduction, subject to the 2 percent floor and AMT. (This, of course, assumes that the lawsuit proceeds have been taxed at gross in the taxpayer‟sincome.) Nevertheless, the Tax Court has ruled adversely to the Commissioner that a self-employed individual could deduct legal fees allocable to the recovery of punitive damages on Schedule C, rather than as a miscellaneous itemized deduction on Schedule A. Guill v Commissioner, 112 T.C. 325 (1999) (court held that the punitive damages recovered by the taxpayer were Schedule C income).

Above the Line Deduction

The American Jobs Creation Act of 2004 enacted IRC § 62(a)(20), thereby establishing an above-the-line deduction for attorney fees and court costs paid in connection with discrimination and certain other suits. In December 2006, the Tax Relief and Health Care Act of 2006 was enacted creating IRC §62(a)(21), an above the line-deduction for attorney fees and court costs associated with suits involving whistleblower claims.

In order for IRC § 62(a)(20) to apply, attorney fees and court costs must have been paid after October 22, 2004, with respect to a judgment or settlement occurring after such date. Additionally, the suit must involve -

� Unlawful discrimination, � Certain claims against the federal government, or

� A private cause of action under Medicare Secondary Payer statute

In order for IRC § 62(a)(21) to apply, the attorney fees or court costs must have been paid in connection with a whistleblower award for providing information regarding violations of tax laws as outlined in IRC § 7623(b), and the information must have been provided on or after December 20, 2006.

The deductions allowed under IRC §§ 62(a)(20) and 62(a)(21) are limited to the amount includible in the litigant‟s gross income for the taxable year in which the deduction is being claimed

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Tax Reporting

Wages--- report to recipient on Form W-2. Taxable Non-wage payments: Form 1099-MISC - Reporting Requirements

IRC §§ 6041(a) and 6045(f), with regard to payments to attorneys, generally requires all persons engaged in a trade or business and making payment in the course of such trade or business to another person of fixed or determinable gains, profits, and income of $600 or more in a calendar year to file an information return with the Service. IRC § 6041(d) provides that each person required to make the return described in IRC § 6041(a) shall furnish to each person for whom a return is required a payee statement.

Treas. Reg. § 1.6041-1(c) states that income is fixed when it is paid in amounts definitely predetermined. Income is determinable whenever there is a basis of calculation by which the amount to be paid may be ascertained. The payor is required to determine whether payments are taxable and need to be reported. The Instructions for Forms 1099, 1098, 5498 and W-2G provides instructions on the items to be reported.

In lawsuit settlements, the person with the obligation to report payments to the plaintiff will generally be the defendant or its insurer rather than the plaintiff‟s attorney. In addition, the defendant or its insurer will also generally be responsible for reporting payments to the plaintiff‟s attorney.

Tax Reporting

Box 3 of Form 1099-MISC is used to report other income that is not reportable in one of the other boxes on the form. Generally, all punitive damages (even if they relate to physical injury or physical sickness), any damages for non-physical injuries or sickness, liquidated damages received under the Age Discrimination in Employment Act of 1967, and any other taxable damages are required to be reported in Box 3. Generally, all compensatory damages for nonphysical injuries or sickness (for example, emotional distress) arising from employment discrimination or defamation are reportable in Box 3. However, if a taxpayer receives an award of back pay that constitutes wages, it generally would be reportable on Form W-2, not Form 1099-MISC.

The following damages (other than punitive damages) are not reportable in Box 3 of Form 1099MISC:

1. Damages received on account of personal physical injuries or physical sickness; 2. Damages that do not exceed the amount paid for medical care for emotional distress; or 3. Damages received on account of non-physical injuries (for example, emotional distress) under a written binding agreement, court decree, or mediation award in effect on or issued by September 13, 1995.

Damages received on account of emotional distress due to non-physical injury or sickness, including physical symptoms such as insomnia, headaches, and stomach disorders, are reportable unless described above. However, damages received on account of emotional distress due to physical injuries or physical sickness are not reportable.

The amount of damages reflected on the Form 1099-MISC is not reduced by attorney’s fees. For example, a defendant settles a plaintiff‟s claim for emotional distress from non-physical injuries by writing a $100,000 check naming the plaintiff and her attorney as joint payees. The attorney retains $40,000 in fees for services rendered and remits the remaining $60,000 to the plaintiff. The amount of damages reportable with respect to the plaintiff on Form 1099-MISC is $100,000

Tax Reporting– Attorney’s Fees

IRC §§ 6041(a), 6051, and 6045(f) and their respective Treasury Regulations are the operative sections that provide instructions with regard to information reporting of payments to attorneys. Generally, in the context of lawsuits, awards, and settlements, payments of $600 or more that are paid by a defendant to an attorney must be reported to the Service.

In most situations, a defendant, or a defendant‟s insurance company, will report the full amount of the payment to the attorney in Box 14 of the Form 1099-MISC. This indicates to the Service that the amount represents gross proceeds, and not necessarily taxable income, to the attorney.

However, there may be some circumstances where a defendant will be required to report the payments to the attorney in Box 7, to indicate to the Service that the payment represents income to the attorney. See Johnson v. LPL Financial Services, 517 F.Supp.2d. 1231, 1233 fn. 3 (S.D. Cal. 2007); see also Treas. Reg. § 1.6041-1(e).

The reporting requirement for payments made to an attorney apply regardless of whether the income is taxable to the plaintiff, and is in addition to the requirement to issue a Form 1099MISC to the plaintiff for the full taxable amount of the settlement, as discussed above.

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Reporting Attorney’s Fees

For example, an insurance company pays a plaintiff‟s attorney $100,000 to settle a plaintiff‟s claims for damages that are excludable from income of the plaintiff under IRC § 104(a)(2). The insurance company must report $100,000 in Box 14 of Form 1099-MISC to be issued to the plaintiff‟s attorney. No Form 1099-MISC is required for the plaintiff since the settlement is nontaxable.

The term “attorney” includes a law firm or other provider of legal services. Further, the exemption from reporting payments made to corporations no longer applies to payments for legal services. Therefore, attorney fees reported in Box 7 or gross proceeds reported in Box 14, as described above, paid to corporations providing legal services are reportable.

Treasury Regulation 1.6045-5 provides examples of the reporting requirements in various situations involving the payment of lawsuit and settlement amounts. The regulation also outlines the defendant‟s, as well as the attorney‟s, obligations in situations where other firms or referral attorneys are involved.

Examples

Example 1. One check--joint payees--taxable to claimant. Employee C, who sues employer P for back wages, is represented by attorney A. P settles the suit for $300,000. The $300,000 represents taxable wages to C under existing legal principles. P writes a settlement check payable jointly to C and A in the amount of $200,000, net of income and FICA tax withholding with respect to C. P delivers the check to A. A retains $100,000 of the payment as compensation for legal services and disburses the remaining $100,000 to C. P must file an information return with respect to A for $200,000 under paragraph (a)(1) of this section. P also must file an information return with respect to C under sections 6041 and 6051, in the amount of $300,000. See §§ 1.6041-1(f) and 1.6041-2.

Examples

Example 2. One check--joint payees--excludable to claimant. C, who sues corporation P for damages on account of personal physical injuries, is represented by attorney A. P settles the suit for a $300,000 damage payment that is excludable from C's gross income under section 104(a)(2). P writes a $300,000 settlement check payable jointly to C and A and delivers the check to A. A retains $120,000 of the payment as compensation for legal services and remits the remaining $180,000 to C. P must file an information return with respect to A for $300,000 under paragraph (a)(1) of this section. P does not file an information return with respect to tax-free damages paid to C.

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Examples

Example 3. Separate checks--taxable to claimant. C, an individual plaintiff in a suit for lost profits against corporation P, is represented by attorney A. P settles the suit for $300,000, all of which will be includible in C's gross income. A requests P to write two checks, one payable to A in the amount of $100,000 as compensation for legal services and the other payable to C in the amount of $200,000. P writes the checks in accordance with A's instructions and delivers both checks to A. P must file an information return with respect to A for $100,000 under paragraph (a)(1) of this section. Pursuant to § 1.6041-1(a) and (f), P must file an information return with respect to C for the $300,000.

Examples

Example 4. Check made payable to claimant, but delivered to nonpayeeattorney. Corporation P is a defendant in a suit for damages in which C, the plaintiff, has been represented by attorney A throughout the proceeding. P settles the suit for $300,000. Pursuant to a request by A, P writes the $300,000 settlement check payable solely to C and delivers it to A at A's office. P is not required to file an information return under paragraph (a)(1) of this section with respect to A, because there is no payment to an attorney within the meaning of paragraph (d)(4) of this section.

Examples

Example 5. Multiple attorneys listed as payees. Corporation P, a defendant, settles a lost profits suit brought by C for $300,000 by issuing a check naming C's attorneys, Y, A, and Z, as payees in that order. Y, A, and Z do not belong to the same law firm. P delivers the payment to A's office. A deposits the check proceeds into a trust account and makes payments by separate checks to Y of $30,000 and to Z of $15,000, as compensation for legal services, pursuant to authorization from C to pay these amounts. A also makes a payment by check of $155,000 to C. A retains $100,000 as compensation for legal services. P must file an information return for $300,000 with respect to A under paragraphs (a)(1) and (b)(1)(i) of this section. A, in turn, must file information returns with respect to Y of $30,000 and to Z of $15,000 under paragraphs (a)(1) and (b)(2) of this section because A is not required to file information returns under section 6041 with respect to A's payments to Y and Z because A's role in making the payments to Y and Z is merely ministerial. See § 1.6041–1(e)(1), (e)(2) and (e)(5) Example 7 for information reporting requirements with respect to A's payments to Y and Z. As described in Example 3, P must also file an information return with respect to C, pursuant to § 1.6041–1(a) and (f).

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Nice, simple summary

https://www.forbes.com/sites/robertwood/2015/07/06/10-things-to-know-about-taxes-on-legal-settlements/#3f9b11202f88

Wills and Estates

Watch out for estate and gift tax issues (not repealed yet)

http://www.schwab.com/public/schwab/nn/articles/The-Estate-Tax-and-Lifetime-Gifting --- current exemption ~$5.5m

Can be malpractice trap: https://mn.gov/law-library-stat/archive/ctappub/2017/OPa161810-050817.pdf

Home Office Deduction

Not all that easy to do! But: Americans claim more than $7 billion in home-office-expense deductions. In addition 11.6 million taxpayers deducted $63.2 billion in miscellaneous itemized deductions subject to the 2% floor. -

Requirements:

Regular and Exclusive Use. You must regularly use part of your home exclusively for conducting business. For example, if you use an extra room to run your business, you can take a home office deduction for that extra room.

Principal Place of Business: the office must be “the principal place of business.”

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Exclusive Use

On first blush, seems almost impossible to meet A taxpayer must have a specific part of the home—though not necessarily a complete room—

set aside and used regularly and exclusively for business purposes. The area is not limited to a single room; multiple rooms may qualify. If the taxpayer uses an area of the home for both business and personal use, no deduction is allowed.

In Weightman , TC Memo 1981-301, the IRS disallowed a home office deduction for a taxpayer who used part of his bedroom as a home office. Although the amount was disallowed based on the exclusive use rule, the Tax Court found that nothing in the law supported the idea that a home office must be an entire room or be physically separate from the remainder of the house.

The Tax Court confirmed that finding in Huang , TC Summary Opinion 2002-93, allowing the taxpayer a deduction for 75% of a room that was used exclusively for business, even though the entire room was not used for business purposes.

In Hughes , TC Memo 1981-140, the Tax Court ruled a home office could be located in what may be considered an unconventional place—a large walk-in closet—if all the rules were met for the space.

Employee Standard

The office must be for the convenience of the employer and not for the convenience of the taxpayer. This is the most difficult rule to overcome. The taxpayer also must not rent to the employer any part of the home that he or she uses to perform services as an employee of that employer.

Your business use must be for the convenience of your employer, and

You must not rent any part of your home to your employer and use the rented portion to perform services as an employee for that employer.

If the use of the home office is merely appropriate and helpful, you cannot deduct expenses for the business use of your home.

Employee Issue

In Cadwallader , TC Memo 1989-356, the Tax Court found that the university provided adequate office space to professor Cadwallader and denied the home office deduction. The Seventh Circuit upheld the Tax Court’s decision. If the university had failed to supply Cadwallader with adequate office facilities, that would imply it expected him to maintain a suitable office at home. If he had used such an office exclusively and on a regular basis for his scholarly research and writing, he would be entitled to the home office deduction under IRC section 280A. But since the university provided him with adequate facilities on campus, the fact that he had chosen to work at home instead did not entitle him to take a deduction. In this situation the home office was not maintained for the convenience of the employer but for the convenience of the employee.

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Methods

Simplified Option For taxable years starting on, or after, January 1, 2013 (filed beginning in 2014), you now

have a simpler option for computing the business use of your home (IRS Revenue Procedure 2013-13, January 15, 2013). The standard method has some calculation, allocation, and substantiation requirements that are complex and burdensome for small business owners. This new simplified option can significantly reduce recordkeeping burden by allowing a qualified taxpayer to multiply a prescribed rate by the allowable square footage of the office in lieu of determining actual expenses.

Regular Method Taxpayers using the regular method (required for tax years 2012 and prior), instead of the

optional method, must determine the actual expenses of their home office. These expenses may include mortgage interest, insurance, utilities, repairs, and depreciation. Generally, when using the regular method, deductions for a home office are based on the percentage of your home devoted to business use. So, if you use a whole room or part of a room for conducting your business, you need to figure out the percentage of your home devoted to your business activities.

Principal Place of Business

The1997 Tax Reduction Act (TRA) defines the phrase principal place of business as a place of business used for paperwork and management purposes and for other business activities if no other office space is available through the employer (section 280A(C)(1)). If a taxpayer has more than one business location for a single trade or business, no deduction is allowed unless the home is the principal place of business, based on the relative importance of the activities performed and the amount of time spent at each location. To qualify as the principal place of business, the area must be used exclusively and regularly for administrative or management activities of the trade or business. The taxpayer must have no other fixed location to conduct those activities.

See Soliman, https://www.law.cornell.edu/supct/html/91-998.ZS.html

Cell Phones, Cars etc.

Cell phones no longer “listed property”

Notice 2011-72: can be tax-free to employees without recordkeeping; personal use is de minimis fringe

http://www.pwc.com/us/en/washington-national-tax/newsletters/irs-hot-topics/assets/pwc-employer-provided-cell-phones.pdf

Cars: https://www.irs.gov/taxtopics/tc510.html

5/17/2017

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IRS Dirty Dozen Tax Scams

Phishing: Taxpayers need to be on guard against fake emails or websites looking to steal personal information. The IRS will never initiate contact with taxpayers via email about a bill or refund. Don’t click on one claiming to be from the IRS. Be wary of emails and websites that may be nothing more than scams to steal personal information. (IR-2017-15)

Phone Scams: Phone calls from criminals impersonating IRS agents remain an ongoing threat to taxpayers. The IRS has seen a surge of these phone scams in recent years as con artists threaten taxpayers with police arrest, deportation and license revocation, among other things. (IR-2017-19)

Identity Theft: Taxpayers need to watch out for identity theft especially around tax time. The IRS continues to aggressively pursue the criminals that file fraudulent returns using someone else’s Social Security number. Though the agency is making progress on this front, taxpayers still need to be extremely cautious and do everything they can to avoid being victimized. (IR-2017-22)

Return Preparer Fraud: Be on the lookout for unscrupulous return preparers. The vast majority of tax professionals provide honest high-quality service. There are some dishonest preparers who set up shop each filing season to perpetrate refund fraud, identity theft and other scams that hurt taxpayers. (IR-2017-23)

Fake Charities: Be on guard against groups masquerading as charitable organizations to attract donations from unsuspecting contributors. Be wary of charities with names similar to familiar or nationally known organizations. Contributors should take a few extra minutes to ensure their hard-earned money goes to legitimate and currently eligible charities. IRS.gov has the tools taxpayers need to check out the status of charitable organizations. (IR-2017-25)

Inflated Refund Claims: Taxpayers should be on the lookout for anyone promising inflated refunds. Be wary of anyone who asks taxpayers to sign a blank return, promises a big refund before looking at their records or charges fees based on a percentage of the refund. Fraudsters use flyers, advertisements, phony storefronts and word of mouth via community groups where trust is high to find victims. (IR-2017-26)

IRS Dirty Dozen

Excessive Claims for Business Credits: Avoid improperly claiming the fuel tax credit, a tax benefit generally not available to most taxpayers. The credit is usually limited to off-highway business use, including use in farming. Taxpayers should also avoid misuse of the research credit. Improper claims often involve failures to participate in or substantiate qualified research activities and/or satisfy the requirements related to qualified research expenses. (IR-2017-27)

Falsely Padding Deductions on Returns: Taxpayers should avoid the temptation to falsely inflate deductions or expenses on their returns to pay less than what they owe or potentially receive larger refunds. Think twice before overstating deductions such as charitable contributions and business expenses or improperly claiming credits such as the Earned Income Tax Credit or Child Tax Credit. (IR-2017-28)

Falsifying Income to Claim Credits: Don’t invent income to erroneously qualify for tax credits, such as the Earned Income Tax Credit. Taxpayers are sometimes talked into doing this by con artists. Taxpayers should file the most accurate return possible because they are legally responsible for what is on their return. This scam can lead to taxpayers facing large bills to pay back taxes, interest and penalties. In some cases, they may even face criminal prosecution. (IR-2017-29)

Abusive Tax Shelters: Don’t use abusive tax structures to avoid paying taxes. The IRS is committed to stopping complex tax avoidance schemes and the people who create and sell them. The vast majority of taxpayers pay their fair share, and everyone should be on the lookout for people peddling tax shelters that sound too good to be true. When in doubt, taxpayers should seek an independent opinion regarding complex products they are offered. (IR-2017-31)

Frivolous Tax Arguments: Don’t use frivolous tax arguments to avoid paying tax. Promoters of frivolous schemes encourage taxpayers to make unreasonable and outlandish claims even though they have been repeatedly thrown out of court. While taxpayers have the right to contest their tax liabilities in court, no one has the right to disobey the law or disregard their responsibility to pay taxes. The penalty for filing a frivolous tax return is $5,000. (IR-2017-33)

Offshore Tax Avoidance: The recent string of successful enforcement actions against offshore tax cheats and the financial organizations that help them shows that it’s a bad bet to hide money and income offshore. Taxpayers are best served by coming in voluntarily and getting caught up on their tax-filing responsibilities. The IRS offers the Offshore Voluntary Disclosure Program to enable people to catch up on their filing and tax obligations. (IR-2017-35)

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