FEDERAL INCOME TAX UPDATE
By This is the first of two installments of this article. The second installment will soon be posted on the Tax Section blog.
I. Damages for Emotional Distress Not Excludable from Taxable Income Unless Directly Associated with Physical Injury.
A. Background.
Section 104(a)(2) provides an exclusion from gross income for damages received by a taxpayer for personal injury or physical sickness. Generally, emotional distress is not physical injury or physical sickness. Taxpayers, therefore, must report as gross income damages they receive for emotional distress unless they are reimbursements for medical care to treat the emotional distress. IRC § 104(a). Damages for emotional distress are excluded from gross income only when the emotional distress is attributable to a physical injury or a physical sickness.
B. Doyle, TC Memo 2019-8.
Doyle was terminated from his employment after he raised concern with his employer’s president that the company was involved in illegal anti-competition schemes. After he was terminated, Mr. Doyle began experiencing physical ailments such as nausea, vomiting, headaches, and backaches. Ultimately, after a confidential settlement with his employer, Mr. Doyle was paid $350,000 “as settlement for unpaid wages” and $200,000 “as settlement for alleged emotional distress and damages”. The Tax Court held the damages for the emotional distress were not excludable from gross income under Section 104(c)(2). The underlying wrong committed by Mr. Doyle’s former employer was based on employment or contact matters and had nothing to do with physical injury.
II. Custom Home Builder Not Entitled to Ordinary Loss on Deemed Sale of Lots. Ferguson vs. Commissioner, TC Memo 2019-40.
Mr. Ferguson was a custom home builder operating through an S corporation. Mr. Ferguson had a dispute with some of his customers regarding a new development project. In settlement of the lawsuit, Mr. Ferguson’s S corporation transferred lots to the homeowners. The S corporation claimed an ordinary loss deduction on the deemed sale of three of the lots by the S corporation. The court disallowed the ordinary losses on the grounds that Mr. Ferguson was unable to prove the lots were not capital assets as defined in Section 1221(a). The main factor that worked against Mr. Ferguson was he claimed capital gain treatment on six other lots that were transferred to other plaintiffs.
III. Golf Course Operations Were “For Profit” Notwithstanding Long History of Significant Losses. WP Realty LP vs. Commissioner, TC Memo 2019–120.
Corbin Robertson was a 99% limited partner of WP Realty Limited Partnership and the sole owner of Olympia Enterprises, Inc., the general partner of WP Realty. WP Realty operated a golf course that had years of significant losses totaling millions of dollars. During the years at issue, Mr. Robertson was CEO and chairman of the board of the directors of two publicly traded companies. His adjusted gross income for 2011 through 2014 was close to $175 million. Mr. Robertson also was a very active real estate investor and developer. The IRS took the position the primary purpose of the golf course was not to earn a profit. Based on the following factors, the court determined the golf course activities were conducted for-profit:
- The partnership kept accurate books and records.
- The partnership had a business plan outlining capital improvements to contribute to the golf club’s growth.
- The partnership took steps to make the club more marketable.
- The golf course was operated in a businesslike manner. Over time the partnership took significant steps to increase its club membership, such as making major capital improvements.
- The partnership relied on experts and hired and consulted with experienced professionals in the golf industry.
- The partnership hired professionals to manage the golf course. The golf course club hired executive chefs to prepare meals.
- Mr. Robertson had been exceedingly successful in many other similar ventures.
The court stated the only factors that weighed against Mr. Robertson were the long history of losses, and anticipated appreciation of club assets were not expected to overcome those losses. However, considering the other factors, the court concluded the golf course activities were operated with a for-profit motive. The court noted, however, if the losses continued now that the partnership had initiated a new membership goal and finished major improvements, the partnership “may again find its profit motive before this court.”
IV. Horse Breeding Activity Determined Not For Profit. Donoghue, TC Memo 2019–71.
A married couple incurred significant losses from their horse breeding activity. The Donoghues owned horses but boarded them at farms and stables owned by others. Mr. Donoghue was employed full-time, and Mrs. Donoghue was disabled. From 1985 to 2012, the horse breeding activity incurred over $1 million of expenses but realized only about $34,000 of income. The activity never turned a profit in any of those 27 years.
The Tax Court agreed with the IRS that the Donoghues did not operate their horse breeding activity for profit during 2010 – 2012. The court viewed the following factors against Mr. and Mrs. Donoghue:
- Manner of conducting business. The Donoghues did not breed, race or sell any of the horses.
- Expertise of advisors. The Donoghues never hired experts nor sought the advice of experts on how to run a profitable horse breeding activity.
- Time and effort devoted to the activity. Mr. and Mrs. Donoghue did not create any contemporaneous documentary evidence to corroborate the hours they spent on the activity.
- Expectation that assets used in the activity may appreciate. The only assets owned as to the activity were the horses themselves. and Mrs. Donoghue were unable to provide any evidence the value of the horses would ever exceed the losses of the activity.
- History of income and losses. The activity never earned a profit in any year.
- Financial status of the taxpayer. Mr. and Mrs. Donoghue received more than $100,000 in each of relevant years, but that income was completely wiped out by the losses of the horse farm.
- Personal pleasure and recreation. Mrs. Donahue loved her horse operations. The Donoghues relied on employees to perform the more grueling aspects of the horse breeding business.
The court also upheld assessment of the Section 6662 substantial understatement penalty. The Donoghues contended they had reasonable cause and acted in good faith because they had a prior audit for 2007 in which the IRS ultimately conceded the hobby loss issue in Tax Court. However, as stated in Transupport, Inc. v. Commissioner, T.C. Memo 2016-216 at 41:
“Petitioner again argues that the methodology was used consistently over years and was therefore correct. Petitioner apparently believes that repeating a fallacy over and over again and ignoring contrary evidence will succeed. It does not. A well established principle is that what was condoned or agreed to for a previous year may be challenged for a subsequent year. Auto Club of Mich. v. Commissioner, 353 U.S. 180 [50 AFTR 1967] (1957); Rose v. Commissioner, 55 T.C. 28 (19709). Thus, the results of a prior audit do not constitute substantial authority.”
V. Bankruptcy Court Refuses to Allow Partnership to Convert to C Corporation Status.
In In Re Schroeder Brothers Farms of Camp Douglas LLP, 123 A.F.T.R. 2d 2019-2080, the U.S. Bankruptcy Court refused to allow the debtor, an entity taxed as a partnership for tax purposes, to convert to C corporation status by making a check the box election on Form 8832. The bankruptcy court held that allowing the partnership to convert to a C corporation was not in the best interests of the debtor, the estate, or its creditors.
VI. IRS Rules S Election was Inadvertently Terminated by Operating Agreement Amendment.
In PLR 201930023, the IRS concluded an LLC’s S election was inadvertently terminated after its members adopted an amendment to the distribution provisions in the LLC operating agreement. The taxpayer was an LLC that elected to be taxed as an S corporation. Thereafter, the LLC and its members amended the agreement to provide liquidating distributions would be made in accordance with positive capital account balances. Later, the operating agreement was amended again to provide for distributions on a pro rata basis.
The IRS ruled the S election was terminated by virtue of the first amendment. However, because all distributions were actually made to the members in proportion to their membership interests, the IRS ruled the termination was inadvertent, and therefore the LLC would continue to be taxed as an S corporation in all periods.
Keith A. Wood is an attorney with Carruthers & Roth, P.A. in Greensboro.