Tax Cases

Supreme Court Upholds Tax on Medical Residents

by Joshua on January 11, 2011

In an unanimous decision, the Supreme Court upheld the requirement that medical residents pay Social Security taxes. As we noted in our prior posts on this topic, full-time students that work in addition to attending school are generally exempt from paying such taxes. However, in the Court’s opinion written by Chief Justice Roberts, the interpretation by the Internal Revenue Service of the law requiring residents to pay such tax was a reasonable one. The Court did not agree with Mayo Clinic’s argument that like full-time students, medical residents attend lectures and perform lab work in the course of learning and thus should not be responsible for paying the Social Security tax. The stakes in this case range from upwards of $700 Million payable by approximately 100,000 medical residents across the country.

Court Opinion

Wall Street Journal, Tax on Medical Residents Upheld by Court

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On Friday, a New Jersey state tax court ruled on appeal that a filing by three Trump casinos for overpaid utility taxes was barred by the four-year statute of limitations. The appeal was to recover nearly $3 million in overpaid taxes which were charged in error by Atlantic City Electric between 1998 and 2001. The appeals court dismissed Trump’s attorneys argument that the statute of limitations should have been extended because the tax was not clear on the bill. The court held that the error could have been discovered earlier.

Court Opinion

Businessweek, Trump casinos lose appeal on $2.7 million tax overpayment

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In the case of Estate of James F. Sheppard v. Schleis, Judge Abrahamson, writing the opinion for the Wisconsin Supreme Court held that payment of the federal estate tax is the burden of the Estate under 26 U.S.C. § 2002, which provides that an estate pays the estate tax on nonprobate property. Further, the Court held because P.O.D (Payable on Death) accounts do not fall under an exception to the general rule that the estate pays federal estate tax generated by nonprobate assets, the estate, not heirs, were required to pay the federal estate tax. Finally, the Court held that the Estate must pay the Wisconsin Estate taxes generated by the P.O.D. accounts.

A P.O.D. account is an account that designates a beneficiary at death and has become a common estate planning technique in avoiding probate.

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In State of Indiana Ex Rel. Indiana State Bar Association v. United Financial Systems Corporation, the Supreme Court of Indiana held that United Financial Systems Corporation (UFSC), an insurance marketing agency, engaged in the unauthorized practice of law by marketing and selling estate planning services, including wills and trusts.

The opinion states UFSC’s business practices were as follows:

UFSC targeted and then mailed prospective clients (generally retirees) information on how to avoid probate. For those who responded, as well as some existing UFSC clients, a UFSC sales representative (either an Estate Planning Assistant or a Health Planning Assistant) met with the client and gained access to his or her financial information, which the company seperatedly used later in an effort by its Financial Planning Assistants to sell insurance products. The presentation made by the Estate Planning Assistant or Health Planning Assistant to the prosective client touted UFSC’s team of tax strategists, financial consultants, independent atttorneys, and Medicaid and estate planning assistants. In reality, UFSC had no tax strategists.

The Estate Planning Assistant or Health Planning Assistant received a commission on the sale of estate planning products. However, the Estate Planning Assistant or Health Planning Assistant were not licensed attorneys and were not directly supervised by an attorney.

Once a sale was made and partial payment secured, the forms containing the client’s information were sent to UFSC’s in-house counsel who then provided the information to a panel attorney that UFSC had contracted with. UFSC argued that its business model was structured in a manner that sufficiently involved the exercise of independent professional judgment of attorneys. However the Court was persuaded by a number of factors that, in its opinion, called into question the attorneys’ ability and motivation to provided independent professional judgment in counseling clients regarding their estate planning needs. The factors included: The disparity of fees earned between the Estate Planning Assistants and Health Planning Assistants ($750 – $900) and the panel attorneys ($225); the estate plan was sold to the client prior to attorney involvement; emphasis of sales and revenue over objective, disinterested legal advice; minimal independent consultation with clients and heavy reliance on communications between the client and company’s salesperson; use of standardized estate planning documents and forms that had been prepared in advance and provided by UFSC; and explanation to the client of the relevance and purposes of the documents being executed was typically delegated to the Financial Planning Assistants. The Court stated that none of these factors was dispositive.

The Court granted an injunction prohibiting such conduct as wells as granted certain statutory attorneys fees to the Indiana Bar Association. Further, the Court granted disgorgement of fees.

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On Monday, the Tax Court in Lam v. Commissioner, T.C. Memo. 2010-82 (Apr. 19, 2010) rejected a taxpayer’s use of the “Geithner defense” (called this because during his confirmation hearings, Tim Geithner blamed some of his tax issues on problems with tax-preparation software) and held that blaming TurboTax for errors on her return did not excuse her from penalties.

The Court stated:

At trial Ms. Lam repeatedly argued that petitioners consistently filled out their tax returns using TurboTax and that she consistently confused capital gains and losses with ordinary income and expenses. Although the Court concludes the errors in petitioners’ tax preparation were made in good faith, petitioners have not established that they behaved in a manner consistent with that of a prudent person. Before the trial petitioners stipulated that they did not consult a tax professional or visit the IRS’ Web site for instructions on filing the Schedule C.

At trial Ms. Lam did not attempt to show a reasonable cause for petitioners’ underpayment of taxes. Instead she analogized her situation to that of the Secretary of the Treasury, Timothy Geithner. Citing a Wikipedia article, Ms. Lam essentially argues that, like Secretary Geithner, she used Turbo Tax, resulting in mistakes on her taxes.

Ms. Lam was not represented by counsel at this proceeding. Enjoy the video.

See also Wall Street Journal Blog

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In Scott v. Commissioner, T.C. Summ. Op. 2010-47, 2010 WL 1507571 (April 15, 2010), the Tax Court, in a summary opinion, held that a flight attendant is entitled to a deduction for tax return preparation fees and some unreimbursed employee business expenses. The business expenses included union dues, uniforms, and meals. The Tax Court did deny deductions for certain travel expenses while away from home and other personal expenses. For example, the Tax Court denied a deduction for parking fees, tolls, and transportation expenses that did not involve overnight travel or commuting to and from work.

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In Fisher v. U.S., the United States District Court for the Southern District of Indiana held that gifts a couple made to their children of limited liability company (LLC) interests in an LLC did not qualify for the gift tax exclusion under section 2503(b)(1) because the interests were not present interests in property due to certain restrictions on the children’s rights relating to the property.

The court concluded that conditions such as a right of first refusal provision granting the LLC the right to purchase a prospective transferor’s interest at price equal to the amount of the prospective transferee’s offer restricted the children’s ability to presently realize a substantial economic benefit.

The taxpayers argued that the children possessed the unrestricted right to receive distributions from the LLC’s proceeds. However, the court determined that because any potential distribution was subject to a number of contingencies, all within the discretion of the LLC’s General Manager, such distributions lacked a substantial present economic benefit.

Further, the taxpayers argued that the children possessed the unrestricted right to enjoy the principal asset in the LLC which was a beach front property. The court held that the LLC Operating Agreement did not indicate that the right was transferred to the children when they became members. Also, the court stated that the right to possess, use and enjoy property, without more, is not a right to a substantial present economic benefit.

Therefore, the court held that the transfers of the LLC interests to the children were future interests in property and not subject to the gift tax exclusion.

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Sixth Circuit: Settlement Proceeds Taxable

by Joshua on March 4, 2010

The Sixth Circuit in Stadnyk v. Commissioner affirmed the Tax Court’s holding that a couple was liable for income tax on settlement proceeds received by the wife, finding that the proceeds qualified as gross income and were not excludable under section 104(a)(2) because the claims underlying her lawsuit were not related to a physical injury.

The claims arose out of a purchase of a used 1990 Geo Storm from an auto dealership. The couple purchased the car making two payments using two separate checks. After the couple drove the car off the lot, the car broke down approximately seven miles from the dealership. The repairs required for the car amounted to $479.78. The couple purchased the car for $3,430.00.  Mrs. Stadnyk contacted her bank to stop payment on one of the checks indicating a dissatisfied purchased. However, the bank incorrectly stamped the check “NSF” for insufficient funds and returned it to the auto dealership. The dealership filed a criminal complaint against the wife who was subsequently arrested at her home in the presence of her husband, daughter, and a family friend. After being handcuffed and transferred to county jail she was released on bail in the early morning. She testified that she did not suffer any physical injury as a result of her arrest or detention.

After filing a complaint against the dealership owner, the dealership, and the bank, Mrs. Stadynk entered into a mediation agreement with the bank under which she received $49,000 and a written apology. However, the agreement did not state the purpose for which the payment was paid. During trial she testified that her attorney, the attorney for the bank, and the mediator advised that her settlement proceeds would not be subject to income tax. Therefore, the Stadnyks did not report the settlement proceeds on their tax return although the bank issued a 1099-Misc reporting the payment. The commissioner issued a notice of deficiency and assessed an accuracy related penalty.

First, the Sixth Circuit held that the settlement payments were gross income under section 61. Mrs. Stadnyk argued that the settlement award was not income under section 61 because she was merely made whole and not enriched by the compensatory damages. However, the Sixth Circuit stated that the Supreme Court has repeatedly upheld the broad concept of gross income under section 61. Further, the court stated that if damage awards received on account of personal injury were not income, there would be no need for the exclusion set forth in section 104(a)(2), which exempts damages received on account of personal physical injuries or physical sickness from income taxation.

Second, the court held that the settlement amount was not excluded from income under section 104(a)(2). Under the first prong of the section 104(a)(2) analysis, the court determined that Mrs. Stadnyk’s claims against the bank giving rise to her recovery were based on tort or tort type rights. After reviewing the complaint, the court determined that alleging tort claims such as malicious prosecution, abuse of process, false imprisonment, defamation, and outrageous conduct, was sufficient to meet the first prong of the analysis.

However, under the second prong of the analysis, the court held that Mrs.Stadnyk did not sustain the damages on account of personal physical injuries or sickness and thus the settlement proceeds were not excludable under section 104(a)(2). The court stated that Mrs. Stadnyk had testified that she did not suffer any physical injury as a result of her arrest and detention and under Kentucky law, physical injury is not a required element of a false imprisonment claim. Thus, although Mrs. Stadnyk may have been physically restrained for an extended period of time, no physical injuries were sustained. Therefore, the court affirmed the tax court’s holding and found that Stadnyk’s owed income taxes on the damages award received pursuant to the settlement with the bank.

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In Magdalin v. Commissioner, the First Circuit Court of Appeals affirmed a decision from the United States Tax Court holding that expenses incurred in connection with fathering two children using in vitro fertilization were nondeductible. The petitioner is the father of twin boys which were born through natural processes and without the use of in vitro fertilization. After the twins’ birth, the petitioner became the father of two more children. Those children were born using the in vitro process with two different women. The petitioner deducted $34,050 for 2004 and $28,230 in 2005 for medical expenses relating to the in vitro procedures.

The court, affirming the tax court, held that the expenses were nondeductible because the expenses were not incurred to treat an underlying medical condition suffered by the taxpayer. The taxpayer stipulated that he had two children which had been produced through natural process in conjunction with a woman who was his wife at the time. Further, the procedures were not conducted for the purpose of affecting the taxpayer’s own structure or function of his own body. Rather, it was the women who were the gestational carriers whose bodies were affected.

A question left unanswered by the tax court was whether legal fees and fees paid on behalf of the gestational carriers would have been deductible in the presecence of an underlying medical condition. However, in a footnote, the tax court did address Priv. Ltr. Rul.2003-18-017 (Jan. 9, 2003) which addressed the deductibility of egg donor fees including legal fees. The court stated that under section 6110(k)(3), PLR’s lack precedential status but “do reveal the interpretation put upon the statute by the agency charged with the responsibility of administering the revenue laws.” Further, the court IRS stated that although IRS publications are not authoritative sources of tax law, Publication 502, Medical and Dental Expenses (2008),  provides that procedures such as in vitro fertilization are deductible under section 213 if such expenses are incurred “to overcome an inability to have children.”

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The tax world has been buzzing about the recent tax court decision O’Donnabhain v. Commissioner, 134 T.C. No. 4 (February 2, 2010), which held that gender identity disorder (GID) is a disease within the meaning of section 213 and that an individual’s expenses for sex reassignment surgery and hormone replacement treatment are deductible medical expenses. However, the Tax Court held that expenses for breast augmentation are not deductible because they are cosmetic under section 213(d)(9).

The Petitioner in the case, Rhiannon G. O’Donnabhain was born genetically as a male, but after a diagnosis that she was suffering from severe GID, she began feminizing hormone treatment therapy. Thereafter, she lived as a female and had surgery to feminize facial features, as well as have sex reassignment  and breast augmentation surgeries. On her 2001 tax return O’Donnabhain deducted approximately $21,000, the cost of her hormone therapy, sex reassignment surgery, and breast augmentation. The IRS disallowed the medical expenses arguing that she did not suffered from a disease and that the treatments were cosmetic and thus were excluded as an expense under section 213.

The Tax Court found that most of the expenses incurred by O’Donnabhain were deductible, emphasizing that the expenses incurred were for the treatment of the disease GID. However, the court held that the expenses incurred from the breast augmentation procedure were not deductible because the augmentation simply improved the appearance and was not for treatment of GID, thus excluded from the deduction under section 213.

Although the Tax Court held that the breast augmentation surgery expenses were not deductible under section 213, an argument (albeit perhaps far-fetched) could be made that the expense are deductible as a trade or business expenses under section 162. Section 162(a) states that “there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” I am not certain what Ms. O’Donnabhain’s trade or business is currently, however, one could argue that breast augmentation surgery would be a necessary expense incurred in carrying on a trade or businesses, in light of her other surgeries.

Because future cases will likely turn on the facts and circumstances (and who has the best experts), this case may not represent the black letter law on this issue.

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