October 28, 2021

IRS Issues November 2021 Applicable Federal Rates; Sole Shareholder Is Liable for Corporation's Tax Debt; IRS Issues Monthly Corporate Yield Curve and Segment Rates; False Representations to Accounting Firm Can Be Admitted in Taxpayer's Trial ...

Year-End Tax Planning Season Begins Against a Backdrop of Legislative Uncertainty

As Congress engages in intense negotiations over an ever-changing rotation of tax provisions in a $1.85 trillion reconciliation bill, practitioners are busy working with clients to identify strategies they can use to minimize their 2021 tax liability.  Our year-end tax planning recaps the year's major changes affecting individual taxpayers and the implications of those changes for year-end tax moves.

Claim of Right Doctrine Doesn't Apply to Trustee's Voluntary Repurchase of Stock

The Seventh Circuit held that the sole beneficiaries of a grantor trust were not entitled to a refund of taxes they paid on a sale of stock held by the trust under the claim of right doctrine as codified in Code Sec. 1341 after the trustee determined in the following year that the sale was prohibited by the trust agreement and used the sale proceeds to buy back the same stock. The court found that the taxpayers failed to establish that the trust did not have an unrestricted right to the income from the stock sale since the beneficiaries did not demand the restoration of the stock or otherwise communicate an intent to pursue any of their rights for the breach of the trust agreement. Heiting v. U.S., 2021 PTC 333 (7th Cir. 2021).

IRS Provides Standards for LLCs to be Recognized as Tax Exempt Under Sec. 501(c)(3)

The IRS issued a notice setting forth the current standards that a limited liability company (LLC) must satisfy to receive a determination letter recognizing the LLC as tax-exempt under Code Sec. 501(a) and as an entity described in Code Sec. 501(c)(3). The IRS will issue a favorable determination letter to an LLC that submits a Form 1023, Application for Recognition of Exemption under Section 501(c)(3) of the Internal Revenue Code, after October 21, 2021, only if the LLC satisfies the requirements set forth in the notice in addition to the general requirements under Code Sec. 501(c)(3). Notice 2021-56.

Business Owner's Tax Background Supported Imposition of Fraud Penalty

The Ninth Circuit affirmed the Tax Court's imposition of a fraud penalty under Code Sec. 6663 on a taxpayer who underreported income for several years, provided no adequate records to substantiate the figures reported on his tax returns, concealed constructive dividend income, and failed to cooperate with an IRS agent's investigation. In addition, the court found that the taxpayer's background as a tax return preparer and his specialized knowledge and experience on corporate and business taxation provided even stronger circumstantial evidence of fraud. Chico v. Comm'r, 2021 PTC 326 (9th Cir. 2021).

Social Security Administration Announces a 5.9 Percent COLA

The Social Security Administration announced that social security and supplemental security income (SSI) benefits for approximately 70 million Americans will increase 5.9 percent in 2022. The amount of earning subject to social security tax will be $147,000 in 2022. Social Security 2022 Fact Sheet.

Debtor Must Pay Over Tax Refund Under Almost-Complete Bankruptcy Plan

A bankruptcy court held that a debtor was required under his Chapter 13 bankruptcy plan to turn over one half of his tax return refund, equaling $1,518, to the trustee even though a plan shortening provision stated that the plan would be complete when unsecured creditors received one percent of their claims and only $108 remained to be paid before that requirement was met. The court rejected the debtor's argument that he should be allowed to keep his refund and pay the $108 to the trustee, reasoning that the plan was still in effect and the plan shortening provision did not conflict with the provision requiring the payment of tax refunds to the trustee. In re Harrington, 2021 PTC 312 (Bankr. E.D. Wis. 2021).

 AFRs

IRS Issues November 2021 Applicable Federal Rates: In Rev. Rul. 2021-21, the IRS provides various prescribed rates for federal income tax purposes for November 2021, including the applicable federal interest rates, the adjusted applicable federal interest rates, the adjusted federal long-term rate, and the adjusted federal long-term tax-exempt rate. These rates are determined as prescribed by Code Sec. 1274.

Corporations

Sole Shareholder Is Liable for Corporation's Tax Debt: In U.S. v. Lothringer, 2021 PTC 329 (5th Cir. 2021), the Fifth Circuit affirmed a district court and held that the sole owner of a C corporation, which ran a used car lot, was personally liable for his corporation's failure to pay taxes because the corporation was his alter ego. The Fifth Circuit agreed that the district court was correct in applying Texas law and relying on a slew of undisputed facts, including that the taxpayer was the sole shareholder, officer, director, and owner of the C corporation; exercised complete dominion and control over the corporation; failed to observe certain corporate formalities; loaned substantial money to the corporation; and made payments from the corporate bank account to service personal loans.

Employee Benefits

IRS Issues Monthly Corporate Yield Curve and Segment Rates: In Notice 2021-60, the IRS sets forth updates on the corporate bond monthly yield curve, the corresponding spot segment rates for October 2021 used under Code Sec. 417(e)(3)(D). The notice also includes the 24-month average segment rates applicable for October 2021, and the 30-year Treasury rates, as reflected by the application of Code Sec. 430(h)(2)(C)(iv).

Employment Taxes

False Representations to Accounting Firm Can Be Admitted in Taxpayer's Trial: In U.S. v. Anglin, 2021 PTC 335 (W.D. Okla. 2021), a district court overruled the objection of a taxpayer, who controlled the finances of a corporation that owed payroll taxes, and held that the government could admit certain evidence in the taxpayer's trial on charges that she willfully failed to collect or truthfully account for and pay over payroll taxes due to the IRS. The government had argued that the taxpayer made false representations to an accounting firm regarding certain expenses of the corporation that owed the payroll taxes and those representations, the government said, were evidence of her willfulness, motive, knowledge, and intent regarding her authorization of payments other than the payroll taxes owed to the government.

Foreign Bank Account Reports

Taxpayer's Failure to File FBARs Was Only Willful for Two Out of Four Years: In U.S. v. Hughes, 2021 PTC 332 (N.D. Calif. 2021), a district court held that a businesswoman who owned foreign bank accounts willfully failed to file Foreign Bank Account Reports (FBARs) for 2012 and 2013 but the government did not meet its burden of showing that her failure to file FBARs for 2010 and 2011 was willful. The court concluded that, in the absence of any evidence that the taxpayer was aware of the FBAR filing requirement when she completed her returns for 2010 and 2011, or that she was presented with any information that should have put her on notice of that requirement, her failure to file FBARs in those years was negligent but not willful.

Procedure

IRS Provision Does Not Conflict with Fair Labor Standards Act Rules: In Walsh v. Wellfleet Communications, 2021 PTC 330 (9th Cir. 2021), the Ninth Circuit affirmed a district court and held that Code Sec. 3508 does not inform the definition of "employee" under the Fair Labor Standards Act (FLSA) because that provision is limited to federal taxation and Code Sec. 3508's tax implications for employees do not conflict with the FLSA's requirements for employers. The Ninth Circuit also affirmed the district court's holding that individuals who worked for a corporation, which was sued by the U.S. Department of Labor for violating FLSA rules, were employees under FLSA because they were dependent upon the corporation as a matter of economic reality.

IRS Issues SIFL Rates for Second Half of 2021: In Rev. Rul. 2021-19, the IRS issued the Standard Industry Fare Level (SIFL) rates for valuing noncommercial flights on employer-provided aircraft for flights taken from July 1, 2021, through December 31, 2021. The ruling contains three SIFL rates: (1) the Unadjusted SIFL Rate, (2) the SIFL Rate Adjusted for Payroll Support Program (PSP) Grants, and (3) the SIFL Rate Adjusted for PSP Grants and Promissory Notes.

Taxpayer Not Eligible for Overpayment Interest on Payment Labeled as a Deposit: In Hill v. Comm'r, T.C. Memo. 2021-121, the Tax Court held that it lacked jurisdiction to reopen a case to determine if a taxpayer was owed additional interest resulting from an overpayment the taxpayer said that he made to the IRS, even though the taxpayer labeled the amount at issue as a "deposit." The court agreed with the IRS that the amount the taxpayer sent to the IRS was not a payment of tax and thus the taxpayer was not entitled to overpayment interest.

 

Year-End Tax Planning Season Begins Against a Backdrop of Legislative Uncertainty

As Congress engages in intense negotiations over an ever-changing rotation of tax provisions in a $1.85 trillion reconciliation bill, practitioners are busy working with clients to identify strategies they can use to minimize their 2021 tax liability.  Our year-end tax planning recaps the year's major changes affecting individual taxpayers and the implications of those changes for year-end tax moves.

Introduction

As 2021 winds to a close, it's time to start thinking of any last-minute strategies that could benefit clients. This year's task is complicated not only by an unusually fluid and uncertain legislative backdrop, but also many Covid-related tax relief provisions that were enacted at the end of 2020 in the Consolidated Appropriations Act, 2021 (CAA 2021) and in March 2021 in the American Rescue Plan (ARP) Act of 2021.

CAA 2021 extended some key tax provisions, including a permanent reduction of the medical expense adjusted gross income threshold from 10 percent to 7.5 percent. The ARP responded to the ongoing pandemic by, among other things, providing a third round of economic impact payments and extending and enhancing the child tax credit, the earned income tax credit, the child and dependent care tax credit, and the premium tax credit.

On the current legislative front, a bipartisan infrastructure bill (featuring several significant tax provisions) that passed the Senate is being held up the House pending the results of negotiations among Democrats on a much larger tax and spending package. It remains to be seen what tax provisions will make it into the final bill and whether such a bill can win approval of tight Democratic majorities in both houses. As of press time, the most likely tax provisions include: (1) a 3 percent income tax surcharge on incomes in excess of $10 million (5 percent on incomes above $25 million); (2) broadening the 3.8 percent Net Investment Income Tax (NIIT) to apply to active trade or business income from pass-through entities of high-income taxpayers; (3) a 15 percent corporate minimum tax; (4) a 1 percent tax on corporate stock buybacks; and (5) a large increase in the IRS's enforcement budget. Proposed increases in individual, corporate, and capital gain tax rates appear to be off the table, as are new limits on the Code Sec. 199A deduction and a "billionaires income tax". The fate of a proposal to lift the $10,000 cap on the SALT deduction is unclear. Given the fluid nature of the negotiations and uncertainty about whether the bill will ultimately pass, practitioners may find it difficult to factor potential changes into year-end planning - at least until the shape of the final bill takes clear form.

A detailed discussion of 2021's major changes and planning opportunities under existing law follows.

Individual Tax Brackets Up Slightly

After being adjusted for inflation, individual tax brackets for 2021 have increased slightly. For 2021, the top tax rate of 37 percent applies to incomes over $523,600 (single and head of household), $628,300 (married filing jointly and surviving spouse), and $314,150 (married filing separately). However, high-income taxpayers are also subject to the 3.8 percent net investment income tax on the lesser of net investment income or the excess of modified adjusted gross income over the following threshold amounts: $250,000 for married filing jointly or qualifying widow(er), $125,000 for married filing separately, and $200,000 in all other cases. High-income taxpayers are also subject to the .9 percent additional Medicare tax on certain income that is more than the following threshold amounts: $200,000 for single filers and head of household, $250,000 for joint filers, and $125,000 for married-filing-separately. The types of income subject to this tax include Medicare wages, self-employment income and railroad retirement compensation. For taxpayers subject to one or both of these additional taxes, there are certain actions (discussed below) that can be taken to lower a taxpayer's adjusted gross income and mitigate the damage of these additional taxes. It's worth noting that these taxes are not deductible.

For married couples, employers do not take a spouse's self-employment income or wages into account when calculating the .9 percent additional Medicare tax withholding for an employee. If a married couple's income will exceed the $250,000 threshold in 2021, and they have not made enough tax payments to cover the additional .9 percent tax, a Form W-4 should be filed with the taxpayer's employer before year end to have an additional amount deducted from the client's wages. Otherwise, the couple may get hit with underpayment of tax penalties.

Standard Deduction versus Itemized Deductions

At the outset, it's important to determine if a client has enough deductions to itemize or if there are steps that can be taken which will give a taxpayer enough deductions to itemize. For 2021, the standard deduction amounts are: $12,550 (single); $18,800 (head of household); $25,100 (married filing jointly); and $12,550 (married filing separately). An additional standard deduction amount of $1,350 applies for taxpayers who are 65 or older or blind. This additional amount is increased to $1,700 if the individual is also unmarried and not a surviving spouse. If the taxpayer is 65 or older and blind, the deduction is doubled.

If a client's itemized deductions in 2021 will be close to his or her standard deduction amount, practitioners should evaluate whether alternating between bunching itemized deductions, such as charitable contributions or medical expenses, into 2021 and taking the standard deduction in 2022 (or vice versa) could provide a net-tax benefit over the two-year period.

Filing Status

Generally, a return filed as married filing separately is not beneficial for tax purposes. However, in some unique cases, such as when one party earns substantially less or when one party may be subject to IRS penalties for issues relating to that person's tax reporting, it may be advantageous to file as married filing separately. Additionally, if one spouse was not a full-year U.S. resident, an election is available to file a joint tax return where such joint filing status would otherwise not be available. Depending on each individual's taxable income, this could help the couple reduce their joint tax liability.

Income, Deductions, and Exclusions from Income Relating to Taxpayer's Residence

Home Office Expenses: The fact that the COVID-19 pandemic has caused more individuals to work from home means that more clients will be asking about the home-office deduction. For employees, expenses relating to working from home are not deductible. The Tax Cuts and Jobs Act of 2017 (TCJA) eliminated the deductibility of such expenses when it suspended the deduction for miscellaneous itemized expenses that was available before 2018. However, for self-employed individuals, tax deductions are still available. Because individuals are limited to a maximum $10,000 deduction for state income and property taxes, allocating a portion of these tax expenses to the portion of a taxpayer's home used for business, can increase deductions for these amounts that would otherwise be lost.

Mortgage Interest Deduction: For clients who sold a principal residence during the year and acquired a new principal residence, the mortgage interest deduction may be limited. For mortgages of more than $750,000 obtained after December 14, 2017, the deduction is limited to the portion of the interest allocable to $750,000 ($375,000 in the case of married taxpayers filing separately). For a mortgage on a principal residence acquired before December 15, 2017, the limitation applies to mortgages of $1,000,000 ($500,000 in the case of married taxpayers filing separately) or less. However, for clients operating a business from home, an allocable portion of the mortgage interest is not subject to these limitations.

Deductions for Interest on Home Equity Debt: Interest on home equity debt may be deductible where a client used that debt to buy, build, or substantially improve his or her home. For example, interest on a home equity loan used to build an addition is typically deductible, while interest on the same loan used to pay personal expenses, such as credit card debt, is not. Thus, it's important to document the portion of the debt for which an interest deduction is taken.

Gain or Loss on the Sale of a Home: If a client sold his or her home this year, up to $250,000 ($500,000 for married filing jointly) of the gain on the sale is excludible from income. However, this amount is reduced if part of the home was rented out or used for business purposes. Generally, a loss on the sale of a home is not deductible. But again, if a portion of the home was rented or was otherwise used for business, the loss attributable to that portion of the home is deductible.

Exclusion from Gross Income of Discharge of Qualified Principal Residence Indebtedness: Under Code Sec. 108(a)(1)(E), gross income does not include the discharge of indebtedness of a taxpayer if the debt discharged is qualified principal residence indebtedness and is discharged before January 1, 2026.

Treatment of Mortgage Insurance Premiums as Qualified Residence Interest: Under Code Sec. 163(h)(3)(E), taxpayers can treat amounts paid during 2021 for qualified mortgage insurance as qualified residence interest. The insurance must be in connection with acquisition debt for a qualified residence. This provision was previously scheduled to expire at the end of 2020 but instead was extended through 2021 by CAA 2021.

Exclusion from Gross Income of Cancelled Qualified Real Property Business Indebtedness

Under Code Sec. 108(a)(1)(D), taxpayers can exclude from gross income a discharge of qualified real property business indebtedness which applies to real property used in a trade or business, such as a home office, and is secured by such real property and meets certain other qualifications.

Charitable Contributions

Subject to certain limits, individuals who itemize their deductions may generally deduct charitable contributions to qualifying charitable organizations, although the usefulness of the charitable contribution deductions was reduced when the TCJA increased the standard deduction so it was greater than many individuals' itemized deductions. However, CAA 2021 extended through 2021 temporary changes to the charitable deduction rules that applied in 2020. Thus, individual taxpayers can claim an above-the-line deduction of up to $300 ($600 for married taxpayers filing jointly) for cash contributions to qualifying charitable organizations made during 2021. Contributions of noncash property, such as securities, do not qualify for this deduction. Note that an increased penalty of 50 percent applies for an overstatement of this deduction.

For individuals making charitable contributions that exceed their standard deduction, the deductible amount is limited based on the individual's adjusted gross income (AGI). These limits typically range from 20 percent to 60 percent of AGI and vary by the type of contribution and type of charitable organization. For example, a cash contribution made by an individual to a qualifying public charity is generally limited to 60 percent of the individual's AGI. Excess contributions may be carried forward for up to five tax years.

However, for 2021, CAA 2021 permits electing individuals to deduct up to 100 percent of their AGI for qualified contributions made during 2021. Qualified contributions are contributions made in cash to qualifying charitable organizations.

As with the new limited deduction for nonitemizers, cash contributions to most charitable organizations qualify, but cash contributions made either to supporting organizations or to establish or maintain a donor advised fund, do not. Nor do cash contributions to private foundations and most cash contributions to charitable remainder trusts

Donating appreciated assets, such as stock, to a charity can also help a client reap a bigger tax deduction. Generally, the higher the appreciated value of an asset, the bigger the potential value of the tax benefit. By donating appreciated assets, such as stock, a client can avoid the capital gains tax that would otherwise be due if the stock were sold and instead pick up a nice charitable contribution deduction. For example, if a client owns stock with a fair market value of $1,000 that was purchased for $250 and the client's capital gains tax rate is 15 percent, the capital gains tax on the sale would be $113 ($750 gain x 15%). By donating that stock instead of selling it, a client in the 24 percent tax bracket has an ordinary income deduction worth $240 ($1,000 FMV x 24% tax rate). So the client saves the $113 in capital gains tax that would otherwise be generated on the sale of the stock and that amount goes to the charity instead. Thus, the after-tax cost of the gift of appreciated stock is $647 ($1,000 - $240 - $113) compared to the after-tax cost of a $1,000 cash donation which would be $760 ($1,000 - $240). However, it's important to also keep in mind that tax deductions for contributions of appreciated long-term capital gain property may be limited to a certain percentage of adjusted gross income depending on the amount of the contribution and the type of property contributed.

Finally, if a client has an individual retirement account and is 70 1/2 years old and older, he or she can make a charitable contribution directly from the IRA. This is more advantageous than taking a distribution and making a donation to the charity that may or may not be deductible, depending on whether the taxpayer is itemizing deductions. By making the donation directly from an IRA to a charity, the client eliminates having the IRA distribution included in his or her income. This in turn reduces adjusted gross income (AGI) and, because various tax-related items, such as the medical expense deduction or the taxability of social security income or the 3.8 percent net investment income tax, are calculated based on AGI, the reduced AGI can potentially increase medical expense deductions, reduce the tax on social security income, and/or reduce any net investment income tax.

Medical Expenses, Health Savings Accounts, and Flexible Savings Accounts

Considering how many individuals were affected by the COVID-19 pandemic, especially those that required hospitalization, deductions relating to medical expenses will likely be a big issue on 2021 tax returns. For 2021, medical expenses are deductible as an itemized deduction to the extent they exceed 7.5 percent of adjusted gross income. As was previously mentioned, the threshold was set to increase to 10 percent for 2021 but was permanently reduced to 7.5 percent by CAA 2021.

To be deductible, medical care expenses must be primarily to alleviate or prevent a physical or mental disability or illness. Thus, the cost of vitamins or a vacation taken to relieve stress and anxiety don't count, but hospitalization and long-term care expenses, as well as other treatments relating to a COVID-19 diagnosis, do qualify.

Deductible medical expenses include amounts paid for health insurance premiums, out-of-pocket costs for medicine, and amounts paid for transportation to get medical care. Deductible medical expenses also include amounts paid for personal protective equipment (e.g., masks, hand sanitizer and sanitizing wipes), amounts paid for qualified long-term care services, and premiums paid for a qualified long-term care insurance contract. Qualified long-term care services are necessary diagnostic, preventive, therapeutic, curing, treating, mitigating, rehabilitative services, and maintenance and personal care services that are required by a chronically ill individual, and must be provided pursuant to a plan of care prescribed by a licensed health care practitioner. To be deductible as a medical expense, qualified long-term care insurance premiums must meet certain criteria (e.g., the contract must be guaranteed renewable) and the deduction for such premiums is limited to an amount that is based on the taxpayer's age before the close of the tax year.

Practitioners should consider whether it might be advantageous for a client, who has not already done so, to contribute to a health saving account (HSA) if he or she does not already have one. These tax-advantaged accounts can help an individual who has a high-deductible health plan (HDHPs) pay for medical expenses. Amounts contributed to an HSA are deductible in computing adjusted gross income. These contributions are deductible whether the client is itemizing deductions or not. Distributions from an HSA are tax free to the extent they are used to pay for qualified medical expenses (i.e., medical, dental, and vision expenses). For 2021, the annual contribution limits are $3,600 for an individual with self-only coverage and $7,200 for an individual with family coverage.

If a client works for an employer who offers a Flexible Spending Account (FSA), and the client has not already signed up for an FSA account, it's worth encouraging the client to do so. This will allow him or her to pay dependent care or medical and dental bills with pre-tax money. And the FSA can be used to pay qualified expenses even if the employer or employee haven't yet placed the funds in the account. While health FSA funds can be used to pay deductibles and copayments, they cannot be used for insurance premiums. The maximum amount that can be set aside in 2021 is $2,750. Additionally, while FSAs previously had a modified use-it-or-lose-it policy, meaning employees could carryover over a limited amount of unspent funds if the FSA plan allowed it, CAA 2021 temporarily allows a "full" carryover of unspent funds, if permitted under the FSA plan.

Tax-Free Disaster Relief Payments under Section 139

The Victims of Terrorism Tax Relief Act of 2001 enacted Code Sec. 139, a little-known or used provision under which employers can compensate employees tax-free for extra expenses incurred due to the COVID-19 pandemic. This could include expenses incurred to set up a home office or to rent a place in which to quarantine or even for medical care. Under Code Sec. 139(a), gross income does not include any amount received by an individual as a qualified disaster relief payment. The term "qualified disaster relief payment" means any amount paid to or for the benefit of an individual:

(1) to reimburse or pay reasonable and necessary personal, family, living, or funeral expenses incurred as a result of a qualified disaster;

(2) to reimburse or pay reasonable and necessary expenses incurred for the repair or rehabilitation of a personal residence or repair or replacement of its contents to the extent that the need for such repair, rehabilitation, or replacement, is attributable to a qualified disaster; or

(3) by a federal, state, or local government, or agency or instrumentality thereof, in connection with a qualified disaster in order to promote the general welfare.

In Rev. Rul. 2003-12, the IRS notes that Code Sec. 139 codifies (but does not supplant) the administrative general welfare exclusion with respect to certain disaster relief payments to individuals. According to the IRS, this exclusion from income applies only to the extent any expense compensated by such payment is not otherwise compensated for by insurance or otherwise. Additionally, qualified disaster relief payments do not include qualified wages paid by an employer, even those that are paid when an employee is not providing services.

The term "qualified disaster" includes a disaster determined by the President to warrant assistance by the federal government under the Robert T. Stafford Disaster Relief and Emergency Assistance Act. Since President Trump declared the COVID-19 pandemic a national emergency under the Robert T. Stafford Disaster Relief and Emergency Assistance Act, the provisions of Code Sec. 139 could apply to payments received by individuals from their employers to compensate the employee for additional expenses incurred as a result of the pandemic.

Education-Related Tax Items

There are several education-related tax deductions, credits, and exclusions from income that practitioners need to consider for clients who either attend, or have children who attend, eligible educational institutions.

Tax-Free Distributions from Qualified Tuition Programs: A Code Sec. 529 qualified tuition plan is a tax-advantaged investment vehicle designed to encourage saving for the future education expenses of the plan beneficiary. Tax-free distributions from a Code Sec. 529 qualified tuition program (QTP) of up to $10,000 are allowed for qualified higher education expenses. Qualified higher education expenses for this purpose include tuition expenses in connection with a designated beneficiary's enrollment or attendance at an elementary or secondary public, private, or religious school, i.e. kindergarten through grade 12. It also includes expenses for fees, books, supplies, and equipment required for the participation in certain apprenticeship programs and qualified education loan repayments in limited amounts. A special rule allows tax-free distributions to a sibling of a designated beneficiary (i.e., a brother, sister, stepbrother, or stepsister). As a result, a 529 account holder can make a student loan distribution to a sibling of the designated beneficiary without changing the designated beneficiary of the account. However, if the total QTP distributions to a designated beneficiary exceed the adjusted qualified higher education expenses of that beneficiary for the year, a portion of those distributions is taxable to the beneficiary. Code Sec. 529(c)(6) also provides that an additional 10 percent penalty tax generally applies to a taxable distribution from a QTP.

Deduction for Eligible Teacher Expenses: A deduction from gross income is available for eligible teacher expenses of up to $250 paid during 2021. If spouses are filing jointly and both were eligible educators, the maximum deduction on the joint return is $500. However, neither spouse can deduct more than $250 of his or her qualified expenses. Qualified expenses include unreimbursed expenses paid for personal protective equipment, disinfectant, and other supplies used for the prevention of the spread of COVID-19 in the classroom.

Exclusion from Income for Savings Bond Interest: If a client paid qualified higher education expenses during the tax year and also redeemed a qualified U.S. savings bond, the interest on the bond is excludible from income if the taxpayer's modified adjusted gross income level is below certain thresholds. Those thresholds are between $83,200 - $98,200 for single and head-of-household filers and $124,800 and $154,800 for married filing jointly or a surviving spouse.

Education Credits: A client who pays qualified education expenses, and has modified adjusted gross income below $80,000 or $160,000 (for joint filers) may be eligible for an American Opportunity Tax Credit of up to $2,500 per year for each eligible student. Above those income thresholds, a partial credit may be available. The amount of the credit for each student is computed as 100 percent of the first $2,000 of qualified education expenses paid for the student and 25 percent of the next $2,000 of such expenses paid. Additionally, a Lifetime Learning credit may be available in an amount equal to 20 percent of so much of the qualified tuition and related expenses paid during the tax year (for education furnished during any academic period beginning in such tax year) as does not exceed $10,000. However, the expenses taken into account for this credit cannot be the same as expenses taken into account for the American Opportunity Tax Credit. The credit is phased out for taxpayers with modified adjusted gross income between $80,000 and $90,000 ($160,000 and $180,000 for joint filers).

Exclusion from Income for Repayment of Student Loan Debt: Gross income does not include any amount which would otherwise be includible in gross income by reason of the discharge of a student loan occurring after December 31, 2020, and before January 1, 2026.

Alternative Minimum Tax

The TCJA decreased the odds of a taxpayer being hit with the alternative minimum tax (AMT) as it increased the AMT exemption and the AMT phase-out thresholds. However, it can still be an issue for higher-income clients. For 2021, the AMT exemption is $73,600 for a single filer, $114,600 for married filing jointly or surviving spouse, and $57,300 for married filing separately. The exemption begins to phase out by an amount equal to 25 percent of the amount by which alternative minimum taxable income exceeds $1,047,200 in the case of married individuals filing a joint return and surviving spouses and $523,600 in the case of unmarried individuals and married individuals filing separate returns. As a result, high-income taxpayers with household incomes above those thresholds, with large amounts of itemized deductions or significant AMT income from exercising stock options, could be at risk for the AMT.

If a taxpayer has a Schedule C business, allocating mortgage interest or property taxes to the taxpayer's Schedule C business will prevent those amounts from being added back and increasing the taxpayer's AMTI.

Qualified Business Income Deduction

Under the qualified business income (QBI) tax break in Code Sec. 199A, a 20 percent deduction is allowed against qualified business income from sole proprietorships, S corporations, partnerships, and LLCs taxed as partnerships. The deduction is available to both itemizers and non-itemizers. The rules that apply to individuals with taxable income at or below $164,900 ($329,800 for joint filers; $164,925 for married individuals filing separately) are simpler and more permissive than the ones that apply to individuals with taxable income above those thresholds. The deduction phases out entirely when taxable income exceeds $214,900 (single, head of household, and married filing separately) and $379,800 (joint filers).

The QBI deduction does not apply to a "specified service trade or business," which is defined as any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, including investing and investment management, trading, or dealing in securities, partnership interests, or commodities, and any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees. Engineering and architecture services are specifically excluded from the definition of a specified service trade or business.

Deductions for Excess Business Losses

Under Code Sec. 461(l), excess business losses of a noncorporate taxpayer are disallowed for tax years beginning after December 31, 2020, and before January 1, 2027. An excess business loss for the tax year is the excess of aggregate deductions attributable to a client's trades or businesses over the sum of aggregate gross income or gain plus a threshold amount. The threshold amount for 2021 is $262,000 or $524,000 for joint returns. Excess business losses that are disallowed are treated as a net operating loss carryover to the following tax year.

Life Events

For clients with divorces pending at the end of the year, practitioners may want to project the differences in a final tax bill based on filing a joint return or filing as married filing separately. For clients that divorced during the year, head of household filing status, with its increased standard deduction, is appropriate if the client has dependents living at home for more than half of the year and the client paid more than half of the upkeep of the home. For clients who will be changing their name as a result of a change in marital status (or for any other reason), the Social Security Administration (SSA) must be notified. Similarly, the SSA should be notified for a dependent whose name has been changed. A mismatch between the name shown on the tax return and the SSA records can cause problems in the processing of tax returns and may even delay tax refunds.

On the other hand, if a spouse died during 2021, the client can still use married filing jointly as the filing status. While the year of death is the last year for which a joint return can be filed with a deceased spouse, the client may be eligible to use the head-of-household filing status next year or the year after that if he or she is considered a "surviving spouse." A surviving spouse is one (1) whose spouse died during either of the two tax years immediately preceding the tax year; and (2) who maintains as a home a household which constitutes for the tax year the principal place of abode (as a member of such household) of a dependent who is a son, stepson, daughter, or stepdaughter of the taxpayer, and with respect to whom the clients is entitled to a dependency exemption deduction for the years in which such exemption deductions are available. Even if the client does not qualify as a surviving spouse, he or she may nevertheless qualify as a head of household if the applicable requirements are met.

2021 Recovery Rebate

The ARP added Code Sec. 6428B to provide a refundable tax credit (i.e., 2021 recovery rebate) in the amount of $1,400 per eligible individual. An eligible individual was any individual other than (1) a nonresident alien, (2) a dependent of another taxpayer, and (3) an estate or trust. Under Code Sec. 6428B(e)(1), the term "dependent" has the same meaning given the term by Code Sec. 152 and thus - unlike the first two rounds of payments - included a qualifying relative. The 2021 recovery rebate began phasing out starting at $75,000 of adjusted gross income (AGI) for an individual ($112,500 for heads of household and $150,000 in the case of a joint return or surviving spouse) and was completely phased out where an individual's AGI is $80,000 ($120,000 for heads of household and $160,000 in the case of a joint return or surviving spouse).

The 2021 recovery rebate is not includible in gross income. It does not reduce a client's refund or increase the amount tax owed if the taxpayer received more than he or she should have based on the taxpayer's adjusted gross income. It also does not affect income for purposes of determining eligibility for federal government assistance or benefit programs.

Child Tax Credit

The ARP significantly expanded the child tax credit (CTC) available to qualifying individuals by: (1) increasing the credit from $2,000 to $3,000 or, for children under 6, to $3,600; (2) increasing from 16 years old to 17 years old the age of a child for which the credit is available; and (3) increasing the refundable amount of the credit so that it equals the entire credit amount, rather than having the taxpayer calculate the refundable amount based on an earned income formula.

The refundable credit applies to a taxpayer (in the case of a joint return, either spouse) that has a principal place of abode in the United States for more than one-half of the tax year or is a bona fide resident of Puerto Rico for such tax year.

Special phase-out rules apply to the excess credit available for 2021 (i.e., either the $1,000 excess credit or, for children under 6, the $1,600 excess credit). Under these modified phase-out rules, the modified adjusted gross income threshold is reduced to $150,000 in the case of a joint return or surviving spouse, $112,500 in the case of a head of household, and $75,000 in any other case. This special phase-out reduction is limited to the lesser of the applicable credit increase amount (i.e., either $1,000 or $1,600) or 5 percent of the applicable phase-out threshold range.

Under Code Sec. 7527A, individuals with refundable child tax credits can receive advance payments equal to one-twelfth of the annual advance amount, thus potentially receiving up to $300 per month for children under 6 and $250 per month for children 6 years and older. These payments are made from July 2021 through December 2021. In essence, a taxpayer can receive one-half of the total child tax credit in the last six months of 2021 and the other half of the credit after filing his or her tax return.

Earned Income Credit

The ARP added Code Sec. 32(n), which expands the universe of individuals eligible for the earned income tax credit (EITC) in 2021 while also increasing the amount of the credit available.

For workers without qualifying children, the applicable minimum age to claim the EITC (i.e., the childless EITC) is reduced from 25 to 19 (except for certain full-time students) and the upper age limit for the childless EITC is eliminated. In addition, the childless EITC amount has been increased as a result of ARP (1) increasing the credit percentage and phase-out percentage from 7.65 to 15.3 percent, (2) increasing the income at which the maximum credit amount is reached from $4,220 to $9,820, and (3) increasing the income at which the phase out begins from $5,280 to $11,610 for non-joint filers. Under these parameters, the maximum EITC for 2021 for a childless individual is increased from $543 to $1,502. The ARP also repealed Code Sec. 32(c)(1)(F), which prohibited an otherwise EITC-eligible taxpayer with qualifying children from claiming the childless EITC if he or she could not claim the EITC with respect to qualifying children due to a failure to meet child identification requirements (such as having valid social security number for qualifying children).

The ARP also amended Code Sec. 32(d) to allow, for tax years beginning after December 31, 2020, a married but separated individual to be treated as not married for purposes of the EITC if a joint return is not filed. Thus, the EITC may be claimed by the individual on a separate return. This rule only applies if the taxpayer lives with a qualifying child for more than one-half of the tax year and either does not have the same principal place of abode as his or her spouse for the last six months of the year, or has a separation decree, instrument, or agreement and doesn't live with his or her spouse by the end of the tax year.

The ARP also increased the amount of disqualified investment income that an individual can have and still claim the EITC. For 2021, the EITC may not be claimed if an individual has disqualified investment income of more than $10,000 (up from $3,650 in 2020).

Finally, the ARP allows taxpayers in 2021, for purposes of computing the EITC, to substitute their 2019 earned income for their 2021 earned income, if 2021 earned income is less than 2019 earned income.

Dependent Care Assistance Tax Benefits

The ARP provided several changes to dependent care assistance programs (DCAPs). It added Code Sec. 21(g), which provides a number of favorable changes to tax benefits relating to dependent care assistance, including: (1) making the child and dependent care tax credit (CDCTC) refundable; (2) increasing the amount of expenses eligible for the CDCTC; (3) increasing the maximum rate of the CDCTC; (4) increasing the applicable percentage of expenses eligible for the CDCTC; and (5) increasing the exclusion from income for employer-provided dependent care assistance.

Generally, a taxpayer is allowed a nonrefundable CDCTC for up to 35 percent of the expenses paid to someone to care for a child or dependent so that the taxpayer can work or look for work. Under Code Sec. 21(g)(1), the dependent care credit is refundable for 2021 if the taxpayer has a principal place of abode in the United States for more than one-half of the tax year. In addition, Code Sec. 21(g)(2) increases the amount of child and dependent care expenses that are eligible for the credit to $8,000 for one qualifying individual and $16,000 for two or more qualifying individuals.

For 2021, Code Sec. 21(g)(3) increases the maximum credit rate from 35 to 50 percent and amends the phaseout thresholds so they begin at $125,000 instead of $15,000. At $125,000, the credit percentage begins to phase out, and plateaus at 20 percent. This 20-percent credit rate phases out for taxpayers whose adjusted gross income is in excess of $400,000, such that taxpayers with income in excess of $500,000 are not eligible for the credit.

The ARP also increased the exclusion for employer-provided dependent care assistance from $5,000 to $10,500 (from $2,500 to $5,250 in the case of a separate return filed by a married individual) for 2021.

Finally, in Notice 2021-15 and Notice 2021-26, the IRS clarified that DCAP benefits that would have been excluded from income if used during the tax year ending in 2020 or 2021, as applicable, remain eligible for exclusion from the participant's gross income and are disregarded for purposes of applying the limits for the subsequent tax years of the employee when they are carried over from a plan year ending in 2020 or 2021 or are permitted to be used pursuant to an extended claims period.

Premium Tax Credit

Code Sec. 36B provides a health insurance subsidy through a premium assistance credit for eligible individuals and families who purchase health insurance through the Health Insurance Marketplace, also known as the "Exchange." The provision is the result of the Patient Protection and Affordable Care Act (PPACA). The premium assistance credit is refundable and payable in advance directly to the insurer on the Exchange. Individuals with incomes exceeding 400 percent of the poverty level are normally not eligible for these subsidies. However, the ARP eliminated that cap for tax years beginning in 2021 or 2022 and allows anyone to qualify for the subsidy. In addition, the provision limits the percentage of a person's income paid for a health insurance under a PPACA plan to 8.5 percent of income. Thus, individuals who buy their own health insurance directly through the Exchange are eligible to receive increased tax credits to reduce their premiums.

In addition, the ARP provided a special rule under which a taxpayer who has received, or has been approved to receive, unemployment compensation for any week beginning during 2021 is treated as a taxpayer who is eligible for the premium assistance credit. Further, for such a taxpayer, any household income in excess of 133 percent of the poverty line is not taken into account in determining the premium tax credit.

Sick and Family Leave Equivalent Credits for Self-Employed Individuals

Certain self-employed individuals are eligible for refundable tax credits equal to the qualified sick leave equivalent amount and qualified family leave equivalent amount with respect for wages paid before October 1, 2021. The term ''eligible self-employed individual'' means an individual who regularly carries on any trade or business within the meaning of Code Sec. 1402 and would qualify to receive paid sick or family leave during the tax year under the Emergency Paid Sick Leave Act (EPSLA) and the Emergency Family and Medical Leave Expansion Act (EFMLEA) if the individual were an employee of an employer (other than himself or herself).

Compliance Tip: The qualified sick and family leave equivalent tax credits are calculated on Form 7202, Credits for Sick Leave and Family Leave for Certain Self-Employed Individuals. The total amount is then entered on Schedule 3 (Form 1040), line 12b.

In general, the term ''qualified sick leave equivalent amount'' means, with respect to any eligible self-employed individual, an amount equal to: (1) the number of days during the tax year (but not more than the applicable number of days) that the individual is unable to perform services in any trade or business referred to in Code Sec. 1402 for a reason with respect to which such individual would be entitled to receive sick leave multiplied by (2) the lesser of (i) $200 ($511 in the case of any day of paid sick time described in Pub. L. 116-127, Sec. 5102(a)(1), (2), or (3)) or (ii) 67 percent (100 percent in the case of any day of paid sick time described in Pub. L. 116-127, Sec. 5102(a)(1), (2), or (3)) of the average daily self-employment income of the individual for the tax year.

The term ''qualified family leave equivalent amount'' generally means, with respect to any eligible self-employed individual, an amount equal to the product of: (1) the number of days (not to exceed 50) during the tax year that the individual is unable to perform services in any trade or business referred to in Code Sec. 1402 for a reason with respect to which such individual is entitled to receive paid leave, multiplied by (2) the lesser of (i) 67 percent of the average daily self-employment income of the individual for the tax year, or (ii) $200.

For the period beginning on April 1, 2021, and ending on September 30, 2021, up to 10 additional days are provided for purposes of determining the qualified sick and family leave equivalent amounts. During this period, the EPSLA is applied as if it provided paid leave for an employee seeking or awaiting the results of a diagnostic test for, or a medical diagnosis of, COVID-19 and such employee has been exposed to COVID-19 or is unable to work pending the results of such test or diagnosis, or the employee is obtaining immunization related to COVID-19 or recovering from any injury, disability, illness, or condition related to such immunization. Any day taken into account in determining the qualified sick leave equivalent amount for the period beginning on April 1, 2021, and ending on September 30, 2021, cannot be taken into account in determining the qualified family leave equivalent amount for the same period.

The term ''average daily self-employment income'' means an amount equal to: (1) the net earnings from self-employment of the individual for the current tax year or, if elected, the prior tax year, divided by (2) 260. The term ''applicable number of days'' means the excess (if any) of 10 days over the number of days during the tax year (but not more than the applicable number of days) that the individual is unable to perform services in any trade or business referred to in Code Sec. 1402 for a reason with respect to which such individual would be entitled to receive sick leave during the tax year pursuant to EPSLA if the individual were an employee of an employer (other than himself or herself).

If an eligible self-employed individual received qualified sick leave wages from his or her employer, the individual's qualified sick leave equivalent amount is reduced (but not below zero) to the extent that the sum of the qualified sick leave equivalent amount and the qualified sick leave wages received exceeds $2,000 ($5,110 in the case of any day any portion of which is paid sick time described in Pub. L. 116-127, Sec. 5102(a)(1), (2), or (3).

Residential Energy Credits

Taxpayers may be eligible for residential energy credits for 2021 if they placed certain property in service during the year. The residential energy efficient property that qualifies for the credit under Code Sec. 25D equals the applicable percentage of the cost of certain qualified property installed on or used in connection with the taxpayer's home. Qualifying properties are (1) solar electric property, (2) solar water heaters, (3) fuel cell property, (4) small wind turbines, (5) geothermal heat pumps, and (6) qualified biomass fuel property expenditures paid or incurred in tax years beginning after December 31, 2020. The applicable percentages are: (1) 30 percent in the case of property placed in service after December 31, 2016, and before January 1, 2020; (2) 26 percent in the case of property placed in service after December 31, 2019, and before January 1, 2023; and (3) 22 percent in the case of property placed in service after December 31, 2022, and before January 1, 2024. This credit does not apply to property placed in service after December 31, 2023.

In addition, for property placed in service after 2010 and before 2022, Code Sec. 25C provides a nonbusiness energ

y property credit for (1) 10 percent of the cost of qualified energy efficiency improvements installed during the year, and (2) the amount of the residential energy property expenditures paid or incurred by the taxpayer during the year. Qualified energy efficiency improvements include the following qualifying products: (1) energy-efficient exterior windows, doors and skylights; (2) roofs (metal and asphalt) and roof products; and (3) insulation. Residential energy property expenditures generally include: (1) energy-efficient heating and air conditioning systems, and (2) water heaters (natural gas, propane, or oil).

There is a lifetime limit of $500 on the total amount of nonbusiness energy property credits that may be claimed. In addition, the amount of the credit taken with respect to windows cannot exceed $200. The following additional limitations also apply to the nonbusiness energy property credit: (1) $300 for any item of energy-efficient building property; (2) $150 for any furnace or hot water boiler; and (3) $50 for any advanced main air circulating fan.

The residential energy efficient property credit and the nonbusiness energy property credit are computed and reported on Form 5695, Residential Energy Credits.

Claim of Right Doctrine Doesn't Apply to Trustee's Voluntary Repurchase of Stock

The Seventh Circuit held that the sole beneficiaries of a grantor trust were not entitled to a refund of taxes they paid on a sale of stock held by the trust under the claim of right doctrine as codified in Code Sec. 1341 after the trustee determined in the following year that the sale was prohibited by the trust agreement and used the sale proceeds to buy back the same stock. The court found that the taxpayers failed to establish that the trust did not have an unrestricted right to the income from the stock sale since the beneficiaries did not demand the restoration of the stock or otherwise communicate an intent to pursue any of their rights for the breach of the trust agreement. Heiting v. U.S., 2021 PTC 333 (7th Cir. 2021).

Background

In January 2004, Kenneth and Ardyce Heiting created a revocable trust which was administered by the trustee BMO Harris Bank. Because the Heitings could revoke the trust agreement at any time during their lifetime, the trust was considered a grantor trust for federal tax purposes. As a grantor trust, the trust itself filed no tax returns, and the Heitings reported the trust's gains and losses on their own returns.

Under the terms of the trust, the trustee had broad authority as to the trust assets in general, but that power was explicitly limited with respect to two particular categories. With respect to Bank of Montreal Quebec common stock and Fidelity National Information Services, Inc. common stock (collectively, the "restricted stock"), the trustee had "no discretionary power, control or authority to take any action(s) with regard to any shares ... including, but not limited to, actions to purchase, sell, exchange, retain or option the Stock." In contrast to the nearly limitless power as to other stocks, with respect to the restricted stock the trustee thus lacked the authority to take any actions, including any sale or purchase of that stock, absent the Heitings' express authorization.

Despite that restriction, the trustee in October 2015 sold the restricted stock held in the trust and incurred a taxable gain on the sale which totaled $5,643,067. The Heitings accordingly included that gain in their gross income on their 2015 personal tax return and paid taxes on it. The trustee subsequently realized that the sale of the restricted stock was prohibited by the trust agreement, and, in January 2016, the trustee purchased the same number of shares of that restricted stock with the sale proceeds from the earlier transaction.

Following the purchase of the restricted stock in 2016, the Heitings sought to invoke the claim of right doctrine as codified in Code Sec. 1341 to claim a deduction on their 2016 return for the amount included in income in 2015. Under the claim of right doctrine, a taxpayer must report income in the year in which it was received, even if the taxpayer could be required to return the income at a later time. However, the taxpayer would then be entitled to a deduction in the year of that repayment. To alleviate inequities in the application of the claim of right doctrine, Congress subsequently enacted Code Sec. 1341, which added, as an alternative to the deduction in the repayment year, the option of the taxpayers recomputing their taxes for the year of receipt of the income. In order to qualify for relief under Code Sec. 1341, taxpayers must show that (1) an item was included in gross income for a prior tax year because it appeared that the taxpayer had an unrestricted right to such item; (2) a deduction is allowable for the tax year because "it was established" after the close of the prior tax year that the taxpayer did not have an unrestricted right to the item; and (3) the amount of such deduction exceeds $3,000.

The IRS rejected the Heitings' claim for a refund after determining that under Code Sec. 1341(b)(2), such relief was inapplicable to the sale or other disposition of the stock in trade of the taxpayer. The Heitings then filed a complaint in a district court and the IRS filed a motion to dismiss, but it abandoned its reliance on the stock-in-trade provision to support the denial. The district court dismissed the Heitings' complaint after finding that they were entitled to relief under Code Sec. 1341 only if they were legally obligated to return the proceeds of the restricted stock sale, and their complaint alleged no such obligation.

The Heitings appealed to the Seventh Circuit. They contended that the issue was the tax obligations of the trust, not of themselves as individuals, so the proper focus was on whether the trust had an unrestricted right to the income in the initial and subsequent tax years. The trustee's sale and subsequent repurchase of the restricted stock, the Heitings argued, fell within the language of Code Sec. 1341(a) as a taxable transaction that was "reversed" in the year after the sale by a trustee that was legally obligated to do so. As authority for their assertion of the trustee's legal obligation, the Heitings pointed to a Wisconsin law which authorizes lawsuits against trustees and sets forth the remedies for a breach of trust.

Analysis

The Seventh Circuit agreed with the district court that the Heitings could not show they were legally obligated to restore the income from the 2015 stock sale. The court therefore affirmed the district court's dismissal of their complaint.

First, the Seventh Circuit rejected Heitings' characterization of the 2016 stock purchase as a "reversal" of the 2015 sale. The court reasoned that, given that the price of stock fluctuates over time, a sale of stock in one time period cannot be simply reversed by purchasing the stock back at a different time. But the court said that regardless of the characterization of the transactions, the insurmountable problem for the Heitings wasn't that the transactions were unequal in nature but that they could not show that the trust had a legal obligation to restore the items of income - the restricted stock - as is required under Code Sec. 1341(a)(2). The court found that in Batchelor-Robjohns v. U.S., 2015 PTC 179 (11th Cir. 2015) and other decisions, the language requiring that "it was established" that the taxpayer did not have an unrestricted right to the item has been interpreted as requiring a legal obligation to restore the item of income; a voluntary choice to repay is not enough. According to the court, an involuntary legal obligation to restore the item of income can be shown by a court judgment requiring the repayment, but a good faith settlement of a claim can also suffice.

The court found that in this case, the Heitings failed to allege that "it was established" that the trust did not have an unrestricted right to the item of income. Rather, the Heitings alleged only that the sale was contrary to the trust agreement, which in the court's view was at most a potential restriction originating at the time of the transaction in 2015. But the court emphasized that the Heitings, as the sole beneficiaries of the trust, never demanded the restoration of the stock or otherwise communicated an intent to pursue any of their rights for the breach of the trust agreement. The existence of a potential claim against the income was not, in the view of the court, enough to "establish" that the trust lacked an unrestricted right to the income. The court said that the violation of the terms of the trust agreement was a dormant restriction, dependent upon the future application of law, that was insufficient to indicate that a right to the item of income was not an unrestricted one.

The court also rejected the Heitings' reliance on the Wisconsin statute as establishing a legal obligation to reverse the sale. According to the court, the statute does not mandate as a remedy the action taken in this case - the repurchase of the stock, but rather provides a list of potential remedies for a breach of trust, including seeking damages from the trustee or suspending or removing the trustee. The court further noted that the terms of the trust agreement in fact prohibited the trustee's 2016 repurchase of the restricted stock just as it had prohibited the sale of that stock in 2015. Thus, the Wisconsin statute failed to establish that the trustee had a legal obligation to purchase the restricted stock in 2016. However, the court explained that the statutory authority was unhelpful for an even more fundamental reason, which was that the Heitings as beneficiaries never sought relief at all from the trustee nor did they allege an intent or even a threat to do so. The court said that the mere possibility that they could have done so, as authorized by the Wisconsin statute, was insufficient to establish that the trust lacked an unrestricted right to the proceeds of the sale of the restricted stock.

IRS Provides Standards for LLCs to be Recognized as Tax Exempt Under Sec. 501(c)(3)

The IRS issued a notice setting forth the current standards that a limited liability company (LLC) must satisfy to receive a determination letter recognizing the LLC as tax-exempt under Code Sec. 501(a) and as an entity described in Code Sec. 501(c)(3). The IRS will issue a favorable determination letter to an LLC that submits a Form 1023, Application for Recognition of Exemption under Section 501(c)(3) of the Internal Revenue Code, after October 21, 2021, only if the LLC satisfies the requirements set forth in the notice in addition to the general requirements under Code Sec. 501(c)(3). Notice 2021-56.

Background

Code Sec. 501(a) generally provides that an organization described in Code Sec. 501(c) is exempt from federal income tax. Code Sec. 501(c)(3) refers, in part, to corporations, and any community chest, fund, or foundation organized and operated exclusively for certain purposes (i.e., "charitable purposes" or "exempt purposes"), where no part of the net earnings of such entity inures to the benefit of any private shareholder or individual. Code Sec. 7701(a)(3) generally provides that the term "corporation" includes associations. To be an eligible Code Sec. 501(c)(3) organization, an organization must be both organized and operated exclusively for one or more of the purposes specified in Code Sec. 501(c)(3). If an organization fails to meet either the organizational test or the operational test, it is not exempt.

Reg. Sec. 1.501(c)(3)-1(b), which sets forth the organizational test, was issued in 1959, before the enactment of the first limited liability company (LLC) statute in the United States. As a result, the regulations under Code Sec. 501(c)(3) do not specifically address LLCs and the IRS has not issued any formal guidance addressing the requirements for recognition of LLCs as organizations described in Code Sec. 501(c)(3). Historically, the standards that the IRS has applied for purposes of issuing determination letters have generally included a requirement that all the members of an LLC must themselves be Code Sec. 501(c)(3) organizations, governmental units, or wholly-owned instrumentalities of a state or political subdivision thereof.

Notice 2021-56

Last week, the IRS issued Notice 2021-56, in which it construes Code Sec. 501(c)(3) and Reg. Sec. 1.501(c)(3)-1 to permit the IRS to issue a favorable determination letter to an LLC that submits Form 1023, Application for Recognition of Exemption under Section 501(c)(3) of the Internal Revenue Code, after October 21, 2021, only if the LLC satisfies the requirements set forth in Sections 3.02 and 3.03 of Notice 2021-56 in addition to the general requirements under Code Sec. 501(c)(3). According to the IRS, the requirements in Sections 3.02 and 3.03 of Notice 2021-56 are intended to ensure that the LLC is organized and operated exclusively for exempt purposes, including that its assets are dedicated to an exempt purpose and do not inure to private interests. Notice 2021-56 does not affect the status of organizations currently recognized as described in Code Sec. 501(c)(3).

Under Section 3.02 of Notice 2021-56, the IRS generally will issue a determination letter recognizing an LLC as exempt from tax and as being an entity described in Code Sec. 501(c)(3) only if both the LLC's articles of organization and its operating agreement each include:

(1) provisions requiring that each member of the LLC be either (i) an organization described in Code Sec. 501(c)(3) and exempt from tax under Code Sec. 501(a), or (ii) a governmental unit described in Code Sec. 170(c)(1) (or wholly-owned instrumentality of such a governmental unit);

(2) express charitable purposes and charitable dissolution provisions in compliance with Reg. Sec. 1.501(c)(3)-1(b)(1) and (4);

(3) the express chapter 42 compliance provisions described in Code Sec. 508(e)(1), if the LLC is a private foundation; and

(4) an acceptable contingency plan (such as suspension of its membership rights until a member regains recognition of its Code Sec. 501(c)(3) status) in the event that one or more members cease to be Code Sec. 501(c)(3) organizations or governmental units (or wholly-owned instrumentalities thereof).

Under Section 3.03 of Notice 2021-56, the LLC must represent that all provisions in its articles of organization and operating agreement are consistent with applicable state LLC law and are legally enforceable. In addition, Section 3.04 of Notice 2021-56 provides that, if an LLC is formed under a state LLC law that prohibits the addition of provisions to articles of organization other than certain specific provisions required by the state LLC law, the requirements of Section 3.02 of Notice 2021-56 will be deemed satisfied if the LLC's operating agreement includes the provisions set forth in Section 3.02 and if the articles of organization and operating agreement do not include any inconsistent provisions.

In Section 4 of Notice 2021-56, the IRS requests public comments on these standards as well as specific issues relating to tax-exempt status for LLCs to assist the IRS in determining whether additional guidance is needed concerning the standards that an LLC must satisfy to be exempt from tax by reason of being described in Code Sec. 501(c).

Business Owner's Tax Background Supported Imposition of Fraud Penalty

The Ninth Circuit affirmed the Tax Court's imposition of a fraud penalty under Code Sec. 6663 on a taxpayer who underreported income for several years, provided no adequate records to substantiate the figures reported on his tax returns, concealed constructive dividend income, and failed to cooperate with an IRS agent's investigation. In addition, the court found that the taxpayer's background as a tax return preparer and his specialized knowledge and experience on corporate and business taxation provided even stronger circumstantial evidence of fraud. Chico v. Comm'r, 2021 PTC 326 (9th Cir. 2021).

Background

Raymond Chico worked as a land surveyor for about 20 years. When outdoor work was light, he began preparing tax returns for several of his acquaintances. Eventually Chico established Ray's Tax Service as a side business. The IRS issued him a Preparer Tax Identification Number, and he was registered from 2003 through 2016 with the California Tax Education Counsel (CTEC) to prepare and file tax returns. His continuing education courses in federal income taxation included courses in business return preparation. At his busiest Chico prepared about 73 tax returns per year; during the years at issue he prepared about 40 tax returns per year.

In 2007, Chico was diagnosed with cancer, and he began chemotherapy treatments. Because of the severe side effects, he had to stop working as a land surveyor. To alleviate the side effects he began to use marijuana cigarettes. Once his cancer went into remission, he became an entrepreneur. During 2010 through 2012, he engaged in several business activities: (1) rental of portions of his and his wife's marital home to third parties; (2) Doobtubes, which marketed and sold marijuana cigarette containers; (3) Lakewood Patient Resource Center Inc., a marijuana dispensary; and (4) the aforementioned Ray's Tax Services. Chico prepared his and his wife's joint Forms 1040. Two Schedules C with respect to Doobtubes and Ray's Tax Service were attached to each year's Form 1040, as was a Schedule E, Supplemental Income and Loss, with respect to the Chicos' rental income.

The IRS selected the Chicos' 2010-2012 Forms 1040 for examination. Revenue Agent Ryan Scott began his audit by issuing an information document request (IDR) to the Chicos and their then attorney, Jerome Hanley. The IDR sought copies of tax documents, bank and other financial institution account information, and records regarding all of Chico's businesses. Although Chico provided some documents to Hanley, Scott never received any response to the IDR. After examining the information he had, Scott discovered that the Chicos held 13 bank accounts. After issuing summonses to the banks, Scott reconstructed the Chicos' income using the bank deposits method. Scott then sent summonses to Hanley and the Chicos for additional records and information. None of the requested information was provided. After additional requests to meet with the Chicos failed to elicit any response, the government began a summons enforcement action in a district court. The Chicos then agreed to meet with Scott. At this meeting the Chicos answered some of Scott's questions but declined to answer others, invoking their Fifth Amendment rights.

In a notice of deficiency, the IRS determined that the Chicos had underreported income with respect to (1) rental income received from the rental of portions of their marital home, (2) Doobtubes' gross receipts, and (3) dividends and passthrough income from Lakewood. Scott also determined that the Chicos were not entitled to deductions in the amounts claimed with respect to the rental of portions of their marital home and Doobtubes. The IRS also asserted that Chico was liable for the fraud penalty under Code Sec. 6663. Under Code Sec. 6663(a), if any part of an underpayment of tax required to be shown on a return is due to fraud, there is an addition to tax of 75 percent of the portion of the underpayment that is attributable to fraud. To establish fraud, the IRS must prove for each year that: (1) an underpayment of tax exists, and (2) the taxpayer had fraudulent intent, i.e., that the taxpayer intended to evade taxes known to be owing by conduct intended to conceal, mislead, or otherwise prevent the collection of taxes. Fraudulent intent may be established using circumstantial evidence, or "badges of fraud," including the consistent understatement of income, inadequate records, failure to file tax returns, implausible or inconsistent explanations for behavior, concealment of income or assets, and failure to cooperate with tax authorities.

Analysis

The Chicos took their case to the Tax Court. In Chico v. Comm'r, T.C. Memo. 2019-125, the Tax Court upheld most of the deficiencies and the fraud penalties. The court found that the IRS was justified in reconstructing the Doobtubes' income through the bank deposits method since Chico failed to respond to Scott's request for information. Chico testified that he maintained adequate books and records using QuickBooks, but he never presented any such documents to the IRS or to the Tax Court. At trial, Chico asserted that Scott's bank deposits analysis failed to take into account a $353,000 inheritance that he received immediately before the years at issue. Chico asserted that portions of this inheritance were periodically transferred from the couple's Charles Schwab account to their bank accounts. However, the court found that Scott had correctly classified these transfers as credits for nontaxable inflow transactions and excluded them from the Chicos' taxable income.

The court also disallowed Doobtubes' claimed cost of goods sold for 2011 and 2012 because Chico provided no information regarding the company's beginning and ending inventories for either year. The Tax Court also found that Chico received constructive dividends from Lakewood in 2011 and 2012 in the form of direct cash transfers and payments of Chico's personal expenses. The court noted that Scott discovered Chico's interest in Lakewood in the course of performing his bank deposits analysis and the Chicos failed to respond to Scott's requests for information regarding Lakewood or to his requests that they file tax returns on the corporation's behalf. The Tax Court agreed with the IRS's determination that the Chicos underreported their rental income for 2010-2012. The court found that the Chicos failed to respond to Scott's request for information or otherwise to cooperate with his examination. Although Chico testified that the difference between the Chicos' reported income and the IRS's determination was due to the tenants' payments toward shared utilities expenses, they produced no evidence to substantiate the amounts of any such shared expenses or to show whether the rental agreements included or excluded utilities in the agreed-upon rental amounts.

In upholding the fraud penalty, the Tax Court found that Chico's fraudulent intent could be inferred from the badges of fraud that were present in this case. The court noted that the Chicos consistently and substantially understated their income over the three years at issue by understating their gross receipts by more than $180,000. The court found that the Chicos' records were inadequate and that Chico failed to file corporate tax returns for Lakewood despite being a 50 percent owner and the chief financial officer. The court reasoned that although Chico reported a portion of his dividend income from Lakewood, he did so in such a manner as to avoid disclosing the true nature and source of the dividends while omitting significant amounts of constructive dividends. Further, the court found that the Chicos were uncooperative during Scott's examination in that they failed to provide documentation or respond to questions until the IRS began a summons enforcement action. The court also noted that Chico was a tax professional who had familiarity with corporate filing procedures. The court said that Chico's business experience and knowledge of the tax laws constituted circumstantial evidence that he was aware of his tax reporting obligations and that in consistently underreporting his income, he did so with fraudulent intent. The Chicos appealed the Tax Court's imposition of a fraud penalty to the Ninth Circuit.

The Ninth Circuit affirmed the Tax Court and held that it did not clearly err in its finding of fraud. According to the Ninth Circuit, the record supported the Tax Court's findings that the Chicos: (1) understated their income by more than $275,000 over three years; (2) produced no adequate records to substantiate the amounts reported on their tax returns; (3) failed to file tax returns for Lakewood even after being asked to do so by Scott; (4) implausibly attributed their underreported income to nontaxable investments from an inheritance when Scott accurately characterized the majority of such transfers as nontaxable; (5) concealed income received from Lakewood by failing to report constructive dividends; and (6) failed to cooperate with Scott's investigation by ignoring his early requests for interviews and blaming their attorney for failing to produce adequate records. The Ninth Circuit noted that the Tax Court also considered these badges of fraud in the context of Chico's specialized knowledge and experience on corporate and business taxation as a tax preparer himself to find even stronger circumstantial evidence of fraud. According to the Ninth Circuit, there was no clear error in the Tax Court's finding that the total weight of these badges provided clear and convincing evidence of the Chicos' specific intent to avoid a tax known to be owing.

Social Security Administration Announces a 5.9 Percent COLA

The Social Security Administration announced that social security and supplemental security income (SSI) benefits for approximately 70 million Americans will increase 5.9 percent in 2022. The amount of earning subject to social security tax will be $147,000 in 2022. Social Security 2022 Fact Sheet.

On October 13, the Social Security Administration (SSA) issued a press release announcing that, in January 2022, a 5.9 percent cost-of-living adjustment (COLA) will take effect with respect to benefits payable to more than 64 million social security beneficiaries. Increased payments to approximately 8 million supplemental security income (SSI) beneficiaries will begin on December 30, 2021. The Social Security Act ties the annual COLA to the increase in the Consumer Price Index as determined by the Department of Labor's Bureau of Labor Statistics.

The Social Security's Old-Age, Survivors, and Disability Insurance (OASDI) program limits the amount of earnings subject to tax for a given year. The same annual limit also applies when those earnings are used in a benefit computation. This limit changes each year with changes in the national average wage index. This annual limit is referred to as the contribution and benefit base.

The SSA announced that, for 2022, the maximum amount of an individual's earnings subject to social security tax is $147,000. The OASDI tax rate for wages paid in 2022 is set by statute at 6.2 percent for employees and employers, each. Thus, an individual with wages equal to or larger than $147,000 will contribute $9,114 to the OASDI program in 2022, and his or her employer will contribute the same amount. The OASDI tax rate for self-employment income in 2022 is 12.4 percent.

Debtor Must Pay Over Tax Refund Under Almost-Complete Bankruptcy Plan

A bankruptcy court held that a debtor was required under his Chapter 13 bankruptcy plan to turn over one half of his tax return refund, equaling $1,518, to the trustee even though a plan shortening provision stated that the plan would be complete when unsecured creditors received one percent of their claims and only $108 remained to be paid before that requirement was met. The court rejected the debtor's argument that he should be allowed to keep his refund and pay the $108 to the trustee, reasoning that the plan was still in effect and the plan shortening provision did not conflict with the provision requiring the payment of tax refunds to the trustee. In re Harrington, 2021 PTC 312 (Bankr. E.D. Wis. 2021).

Cedric Harrington was near the completion of his Chapter 13 bankruptcy plan. Section 1(B) of the plan required Harrington to turn over to the trustee half of all net federal and state income tax refunds received during the term of the plan. Section 2 of the plan identified the plan term as 60 months. Under the plan, Harrington was required to make bi-weekly payments of $268 to the trustee. However, Section 10 of the plan, which allowed for the inclusion of special provisions that overrode any contrary terms contained in preceding sections of the plan, contained a "plan shortening" provision which stated that (1) general unsecured non-priority claims were entitled to be paid "not less than" one percent of their respective total claims, and (2) the plan would be complete once unsecured creditors received one percent of their claims. When he filed for bankruptcy, Harrington used a model plan form which contained a standard provision that allowed him to choose whether he wished to keep his tax refunds or surrender one-half of the refunds received during the plan to the trustee. Harrington opted for the latter.

The trustee filed a motion to dismiss Harrington's Chapter 13 case based on Harrington's failure to make plan payments - specifically, his failure to pay into the plan one-half of his tax refund for the 2020 tax year. Harrington argued that because he needed to pay only $108 into the plan for the unsecured creditors to receive a one percent distribution, and one-half of his 2020 tax refund was $1,581, the plan would be complete on its own terms as of the date he paid $108. Therefore, according to Harrington, it would be a waste of time to pay in the refund only to have his tax refund, minus the $108, returned to him. The trustee responded that submission of the tax refund was a required plan term and was supplemental to the percentage owed to unsecured creditors. The trustee referred to two previous rulings where the court ruled in favor of the trustee on a challenge to payment of late-in-plan tax refunds: In re Win, Case No. 16-31085 (oral ruling issued on Sept. 8, 2020); and In re Nasino, Case No. 16-30555 (oral ruling issued on Aug. 11, 2020). In both of these cases, the debtor's confirmed Chapter 13 plan included the requirement that the debtor pay in half of any tax refunds received during the term of the plan, as well as the same plan "shortening" language at issue in this case.

In In re Win, the trustee had moved to dismiss the debtor's case based on his failure to pay the trustee half of his 2019 tax refunds. The debtor responded that he was not required to do so because the plan had been completed at 36 months due to the plan-shortening language - even though the debtor was still making plan payments to the trustee to pay in (belatedly) half of his 2016, 2017, and 2018 tax refunds. The court rejected the debtor's argument and required the debtor to pay one-half of his 2019 tax refund to the trustee for distribution to creditors because the debtor had not yet completed his plan. The court relied in part on its holding in In re Nasino. In that case, the debtor had objected to the trustee's final report and account, arguing that the trustee had erred in using a portion of the debtor's 2019 tax refunds to distribute more than a one percent dividend to unsecured creditors (approximately 22 percent) because, according to the special provisions, the plan should have been completed once the 36-month mark was reached and general unsecured creditors were paid one percent on their claims. The debtor asked the court to order the trustee to refund the extra 21 percent paid to general unsecured creditors. The trustee responded that nothing in the plan's special provision expressly contradicted the requirement to pay to the trustee half of all net tax refunds received during the plan term. The court acknowledged that the provision addressing tax refunds and the plan shortening provision may have conflicted and reasoned that any ambiguity should be resolved against the debtor as the drafter of the plan. The court therefore held in favor of the trustee and denied the debtor's request.

In Harrington's case, the bankruptcy court found that the trustee's reading of the plan was the correct one. The court reasoned that, since Harrington still had to pay $108 into the plan before the unsecured creditors would receive one percent of their claims, the plan was therefore not yet complete. Therefore, Harrington's 2020 tax refunds fell within the scope of Section 1(B) of the plan as tax refunds received "during the term of the plan." The court further noted that the plan called for a distribution to unsecured creditors of "not less than" one percent. In the court's view, the "not less" requirement imposed a floor as opposed to a ceiling, and therefore the plan shortening provision did not conflict with the provision requiring the payment of tax refunds to the trustee. The court followed the approach taken in In re Win and denied the trustee's motion to dismiss, subject to the condition that Harrington comply with the plan term that required him to turn over half of his 2020 tax refund to the trustee.