This article does not summarize key rulings of 2022, but instead offers some key lessons and reminders from 2022 tax opinions as well as a few IRS rulings. If you want to read the ruling, see the citations and links. Takeaways from a few state tax rulings that have a lesson of relevance beyond the particular state are also included.
Income
If your client receives a 1099-MISC related to a settlement or a judgment, ask key questions of who, what, where, when, why and how to understand the tax consequences. In Dern, TC Memo 2022-90, The court sent a settlement to the plaintiff’s attorney who took their share before sending anything to the client and issued a 1099-MISC for the net amount the client received. Thus, the Form 1099 was incorrect because the entire settlement belonged to the plaintiff. Also, unless there is language in the settlement stating that the payment is for physical injury or sickness, the exclusion at IRC Section 104 does not apply. Finally, for some types of lawsuits, such as for certain discrimination actions, attorney fees and court costs are deductible for AGI (see IRC Section 62(a)(20)).
Funds received from a crowdfunding campaign to help someone with medical or tuition bills, likely are non-taxable gifts. However, it is important to get a list of donors from the crowdfunding platform. In FS-2022-20 (March 2022), the IRS observes that a contribution from one’s employer, generally, is taxable income. The Tax Court also reminded us that payments from an employer to an employee are not gifts, particularly when the amounts appear on a Form 1099 and the taxpayer can’t show by emails or other documentation that it was a gift (see Fields, TC Summary Opinion 2022-22 and IRC Section 102(c)).
Deductions and Losses
If your client produces an NOL, be sure to maintain detailed records to support its computation along with records showing how much your client used it in carryover years. In Amos, TC Memo 2022-109, the court stated, “A taxpayer who claims a net operating loss deduction bears the burden of establishing both the existence of the net operating loss and the amount that may be carried over to the year involved.” A tax return alone is not enough to prove an NOL deduction or carryover. Also see Treas. Reg. Section 1.172-1(c) and IRS Publication 536 and its worksheet.
Businesses that produce or sell cannabis, a federally controlled substance, can’t claim deductions and tax credits per IRC Section 280E. Cost of sales is allowable, though. In Lord, TC Memo 2022-13, the court agreed with the IRS that a producer of cannabis products could not use bonus depreciation in measuring cost of sales, even if allowed under IRC Section 263A for non-cannabis producers. Instead, the taxpayer must use regular depreciation methods in line with GAAP per regulations under IRC Section 471.
A taxpayer may only deduct ordinary and necessary business expenses once it is carrying on a business. Expenses of getting ready to carry on the business are likely to fall under IRC Section 195 requiring capitalization, with amortization over 15 years once the business begins. In Kellett, TC Memo 2022-62, the court reviewed how to know when a business begins even if it is not collecting receipts from customers.
The business involved operation of a website Kellett created. When he opened the site to the public, it was operating as he intended, and the court found that indicated business had begun and expenses were no longer required to be capitalized under IRC Section 195. Kellet also argued that some of his initial costs were software development deductible under IRC Section 174, so not subject to IRC Section 195. The court disagreed finding that there was no uncertainty involved in his website’s design so there were no R&D expenses. Kellet also posited that the software development costs were eligible for accounting treatment similar to IRC Section 174 (expensing for the years involved in this case), per Rev. Proc. 2000-50. The court argued that the IRS had no authority to draft such a rule and so ended that argument.
The Kellett case raises a few additional considerations. First, just because the taxpayer used open-source software to create the website doesn’t always mean there is no R&D activity as defined under Treas. Reg. 1.174-1; look at all the facts. The Tax Cuts and Jobs Act changed the operation of IRC Section 174 effective for tax years beginning after 2021. Today, R&D expenses are not deductible when incurred but the taxpayer must instead capitalize and amortize over five years using a half-year convention (15 years for foreign research). The TCJA change also added IRC Section 174(c)(3) providing that software development is a research or experimental expenditure. This is broader than Rev. Proc. 2000-50, which just allows an accounting treatment for software development costs similar to that for R&D. The TCJA change does not define software development, and perhaps information in Rev. Proc. 2000-50 can help until there’s new guidance.
Practice and Procedure
The IRS expects individuals to review their return before filing it. They also must give all the required information such as Forms 1099 to their return preparer. Finally, if they are operating a business, they must know about and follow proper recordkeeping. In Larochelle, TC Summary Opinion 2022-12, the Tax Court would not waive penalties the IRS assessed for failure to report income from a Form 1099-R for $238,000 that Larochelle said he did not receive because he moved. The court observed that the taxpayer was “a sophisticated businessperson” who was managing real estate partnerships and aware of the need to maintain financial records.
Reasonable cause to waive a penalty is difficult to prove. While illness might be reasonable cause for filing late, if the taxpayer was still working, even with reduced hours, the court is likely to view that as evidence of capacity to timely file a return (see Bennett, Tax Court Bench Opinion No. 7885-21 (2022)).
Tax advice from websites, even if a government agency operates it such as the Department of Defense (DoD), are not binding. In Schneiter, No. 21-1876C (Fed. Cls. 2022), a DoD employee used information on a DoD website about the tax treatment of moving expenses. But it was outdated information predating changes the Tax Cuts and Jobs Act of 2017 made. While the court was sympathetic to the employee’s grievance, it could not provide relief. This case presents two good reminders: (1) check whether you have any outdated tax information on your website, and (2) unless the website is presenting current primary authority, it is not reliable; there is a lot of tax misinformation on the web and social media and reminding clients of this regularly is a good idea.
Any type of an entity a U.S. citizen or resident created anywhere in the world may have U.S. tax filing obligations of some kind. In Rost, 44 F.4th 294 (5th Cir., 2022), the plaintiff suffered significant penalties for failure to file Forms 3520 and 3520-A for a trust set up in Liechtenstein. The court observed that the IRS has no obligation to draft rules to specifically identify every type of entity that has a filing obligation; general guidance is sufficient.
CCA 202225008 is a reminder that FBAR filing obligations are not just for individuals. Per this short ruling: “Entities created, organized, or formed under the laws of the United States have an FBAR filing requirement.” For more information, see IRS Practice Unit on FinCen Form 114—Report of Foreign Bank and Financial Accounts (FBAR) released in 2022 with background information and links to relevant authorities.
State Tax Cases of Interest Beyond the Particular State
Homeowners are likely to be entitled to a property tax reduction if the home is their principal residence. These property tax exemptions vary from state to state. In Campbell v. Michigan Dept. of Treasury, No. 161254 (2022), the state discovered that a Michigan homeowner also owned a home in Arizona with a principal residence exemption on it, which the state of Arizona had automatically given to the owner, assuming the home was a principal residence. Somehow learning of this, the Michigan Department of Treasury denied a homeowner exemption to the taxpayer. The taxpayer had Arizona remove the exemption for his home in that state to eventually resolve the matter.
Clients who own more than one home should check whether any property tax exemption is proper. This matter can have tax consequences beyond property taxes, including determining the state of domicile for income tax purposes.
Some states, such as California and Virginia, share information on state income tax filings with local governments for purposes of determining whether businesses are paying local business license taxes. Some businesses are not aware of all their possible tax obligations and a city or county business license tax is easily overlooked. In City of Charlottesville v. Regulus Books, LLC, No. 210414 (Virginia Supreme Court, 2022), the city contacted the business owner after learning of a Schedule C included with Klug’s Virginia income tax return and not finding any filing for a business license. Klug, sole owner of the LLC, is an author who has several published books. The court agreed with Klug that per the law involved, he was not liable for the business license tax because his work did not fit the ordinance’s exact language. This is another reminder for practitioners to be sure to look at the exact terms of the law to see whether a client needs a business license (and perhaps the client needs to consult with an attorney) since these ordinances differ from city to city and can be complex. City websites may have helpful information on due dates, forms, and links to the underlying ordinance.
Summary
Even when addressing longstanding tax provisions, several court case and IRS rulings each year often serve as helpful reminders of questions to ask of clients and cautions to exercise to avoid overlooking important nuances in the law or recordkeeping requirements. Hopefully, the points highlighted in this article from 2022 rulings provide useful reminders for effective compliance and planning.
