Decisions — The personality of tax benefits

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Image source: Roland Geider (Ogre); of the orignal, Noe [Public domain], via Wikimedia Commons

Image source: Roland Geider (Ogre); of the orignal, Noe [Public domain], via Wikimedia Commons

Federal income tax credits and deductions are not the same, though they do have a few similarities. For example, both reduce the amount of tax you owe. In addition, generally neither are transferable between taxpayers. That nontransferability is an extension of the “fruit of the tree” principle from Lucas v. Earl, a Supreme Court case in 1930, that the fruit must be taxed to the tree on which it grew, meaning income is taxed to the person who earns it.

But what about related taxpayers? Do married couples who file joint returns and “merge” income get to benefit from the credits and deductions of a spouse?

In 146 T.C. No. 12 (Vichich), the question was whether the taxpayer was entitled to offset her individual income tax liability with an alternative minimum tax credit that arose from her deceased husband’s exercise of incentive stock options.

The taxpayer’s deceased husband had reported the transaction that led to an alternative minimum tax credit on a federal income tax return for 1998 that he filed jointly with his first wife. After his divorce and subsequent remarriage to the taxpayer, he and the taxpayer filed joint returns for 2002 and 2003. They attached a form showing the alternative minimum tax carryforward of $304,442 to their 2003 return.

The taxpayer’s husband died in 2004 and she filed a joint return as surviving spouse for that year. She did not include the carryforward from 2003. For tax years 2005 to 2008, the taxpayer filed individual tax returns that did not include the carryforward.

In January 2010, the taxpayer filed an amended income tax return for 2007, claiming an alternative minimum tax credit of $29,172. The IRS issued a refund based on the amended return.

In April 2010, the taxpayer filed an amended income tax return for 2008, claiming an alternative minimum tax credit of $151,928 and requesting a refund.

In October 2010, the taxpayer filed her 2009 tax return, claiming an alternative minimum tax credit of $151,928 and requesting a refund. The IRS issued the refund.

In December 2011, the IRS sent the taxpayer a letter disallowing the refund requested on the 2008 amended return. The letter said the taxpayer had not established her entitlement to the credit for 2008. The IRS also mailed a notice for tax year 2009 disallowing the credit for that year as well.

The court focused on the question of whether the alternative minimum tax credit passed to the taxpayer on the death of her husband. In some similar situations, such as capital losses and net operating losses, only the taxpayer who sustains a loss is entitled to take the deduction (see revenue ruling 74-175). Similarly, the excess charitable contributions of a deceased spouse can’t be deducted by anyone else (see treasury regulation 1.170A-10(d)(4)(iii)).

However, the tax code allowing the alternative minimum tax credit (internal revenue code section 53) does not provide the answer as to whether the taxpayer is entitled to the credit. Nor do the regulations. So the court turned to decisions in other cases.

Case 1Calvin

In this case, the taxpayer incurred net operating losses from her business in the four years before she married. For the first tax year after she married, she and her husband filed separate income tax returns. Her husband reported taxable income on his return, and the taxpayer used part of her net operating losses to reduce the taxable income on her return to zero.

Two years later, the taxpayer and her husband elected to change the separate returns to a joint return. In the joint return, the previous net operating losses incurred by the taxpayer before the marriage were used to offset the joint income of the taxpayer and her husband.

The IRS said the amount of the net operating loss carryover that the taxpayer had sustained when she was single was limited in the joint return to the amount of her income for the year in question, and could not be used to offset her husband’s income.

The taxpayers said that by virtue of filing a joint return, they were entitled to be treated as one taxable unit and that the operating losses incurred by the taxpayer while she was single could be carried over and applied against the joint income of the taxable unit even if some of the unit’s income was that of her husband.

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Case 2Zeeman

In this case (the reverse situation from Calvin), the taxpayer had filed joint returns with her husband for the two years prior to his death and in the year of his death. Her husband was a partner in a stock brokerage firm, and all of the income on the returns had been earned by him alone. Upon his death, the taxpayer became a limited partner in the firm. In the year following her husband’s death, the taxpayer incurred a loss when the brokerage firm became insolvent.

She filed returns to carry the loss back to the joint returns. The IRS disallowed the loss on the prior year returns.

The taxpayer argued that when she sustained the loss she was the same taxpayer she had been in the year in question, notwithstanding the fact that she was no longer a joint taxpayer with her late husband.

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Case 3T.C. Memo. 1973-207 (Rose)

In this case, the taxpayer’s deceased husband had begun a coal mining business. He formed three sole proprietorships, each of which was engaged in a different type of coal mining. The three companies incurred substantial net operating losses, yet continued in operation until the husband’s death.

The taxpayer worked in the three businesses as a billing clerk. She kept the books of the businesses regarding the selling and shipping of coal and was in charge of all the coal sales of the three companies. She never received any monetary compensation for her efforts.

The taxpayer also contributed to the businesses in other ways. She owned a considerable amount of real estate that she repeatedly mortgaged in order to provide funds for the operation of the businesses. She also cosigned numerous notes with her husband to enable him to borrow money to operate the businesses. When her husband died and his estate declared bankruptcy, the taxpayer had to pay off the cosigned loans.

At the bankruptcy sale, the taxpayer purchased various operating assets of the three now-defunct coal mining businesses. She formed a corporation and resumed operation of the businesses. Over the next three years, the corporation realized a net profit from operations and the taxpayer took a substantial salary. On her federal income tax returns for those years, she offset the salary against the losses of the three defunct businesses.

The IRS said she was not entitled to carry over the net operating losses incurred prior to her husband’s death.

The court said the question was to determine if the extent of the taxpayer’s participation in the risk, when the three companies sustained their net operating losses, was enough to let her claim at least a portion of the net operating losses.

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GIVEN THE DECISIONS IN THE ABOVE CASES, WHAT WOULD YOU DECIDE IN THE CURRENT CASE (Vichich)?

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THE COURT’S DECISION

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Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided in the post to read the entire case.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

***

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Sorry, wrong answer :(
Right answer!

For the IRS.

The operating losses were only available to offset the wife’s portion of the income in the joint return.

Congress enacted the provisions of law allowing carryover of losses from one tax year to offset gains in subsequent years to overcome the effect of taxing income strictly on an annual basis. To us, the congressional history of carryover and carryback tax deductions reflects the intent of congress to guard this exception to taxing on a pure annual basis.

The authorities seem to generally agree that in the absence of express statutory language, only the taxpayer who sustained the loss is entitled to take the deduction. To extend the net operating loss to a taxpayer who did not participate in the risk when the loss occurred is to ignore the congressional purpose of allowing such a deduction.

The record before us shows that the taxpayer claiming the benefit of the loss carryover deduction has suffered no losses in his own business but if successful in this litigation would be benefiting solely by reason of the business loss of another taxpayer.

It seems necessary for us to point out that mere filing of a joint return by married taxpayers does not convert a net operating loss of one into the joint loss of both when such loss is sought to be carried to other tax years.

For instance, if a net operating loss is incurred, to carry it back or forward to separate returns necessitates an allocation of the loss to insure that it is only used to offset past or future income of the spouse who incurred it.

To us, deductions should be construed in the same light as exemptions and the same rules of construction should be applied to both. Section 6013(d) of the tax code provides that for the purpose of filing a joint return, the status of husband and wife shall be determined at the close of their taxable year.

By virtue of this, deductions of either spouse before marriage are taken into account in the joint return but only if those deductions were incurred in the year of marriage. Nothing in the language permits transactions occurring in the years prior to marriage to affect joint income taxes.

Sorry, wrong answer :(
Right answer!

For the IRS.

Since it is undisputed that the taxpayer is the person who suffered the loss, the question is rather against whose income it may be carried back.

While net operating losses of one spouse may be carried backward or forward against the combined taxable income of both to years in which they filed or will be able to file joint returns, even if separate returns are filed, the privilege of filing joint tax returns given to married couples is something less than a merger of them into a permanent, single economic unit. The merger of their income for tax purposes is linked between different years for only so long as they are married.

The legal requirements for utilization of loss carrybacks in this area have not remained undefined. As pointed out in Calvin, where the pertinent regulations are analyzed, the presence of the critical requirement for carrying forward a loss against combined income of married taxpayers is dependent on their marital status at the time the loss was sustained.

This case is the other side of the same coin considered in Calvin. There, the right of Mrs. Calvin to carry forward her premarital losses was restricted to that portion of the subsequent jointly reported income which was received by her.

We see no valid reason why the same rule should not apply in the reverse situation here. Unfortunately, however, none of the jointly reported income for the years in question was the taxpayer’s.

The [original] court, in a well-reasoned opinion, ruled that since the taxpayer was not able to file a joint return for the period when the loss was suffered, she could not carry the loss back against income reported in the years when joint returns were filed. We affirm that ruling, but on the narrower ground.

Right answer!
Sorry, wrong answer :(

For the Taxpayer.

We find that the taxpayer was sufficiently involved in the businesses to entitle her to carry forward a portion of the losses and to offset them against income she earned from essentially the same businesses subsequent to her husband’s death.

We agree with the proposition that the determining factor in deciding whether an individual taxpayer is entitled to claim a net operating loss carryover or carryback is the extent to which the taxpayer participated in the risk when the loss occurred. Consequently, our task here is to determine if the extent of the taxpayer’s participation in the risk, when the three companies sustained their net operating losses, was sufficient to entitle her to claim that at least a portion of the net operating losses were her own.

The taxpayer mortgaged substantial amounts of property to raise money for the businesses and she cosigned numerous notes with her husband to provide money for the businesses, many of which she later had to make good with her own funds. Furthermore, as additional evidence of her proprietary interest, she worked full time in the three businesses and received no compensation.

In sum, the taxpayer’s actions with regard to the three companies indicate much more than merely a wife’s interest in the business affairs of her husband. She was, in fact, as much a part of the business as he was. While he was in charge of the mining portion of the business, she handled all of the coal sales and provided much of the venture capital.

The mere filing of a joint return by husband and wife does not convert a net operating loss of one into the joint loss of both when the loss is sought to be carried to other years. As provided in treasury regulation 1.172-7(d), a net operating loss that is incurred in a joint return year and carried forward to a separate return must be allocated to insure that it is used to offset only the income of the spouse who incurred the loss.

On this record we conclude that the losses of the three businesses were incurred equally by the taxpayer and by her husband. It is true that the regulation does not specifically mention a situation in which the transaction from a joint return is caused by the death of one of the marriage partners. However, we think it is applicable to a situation such as this in which a taxpayer goes from a joint to a separate return.

Therefore, in these circumstances, we hold that one-half of the amounts of the net operating losses for each year should be allocated to the taxpayer and that she is entitled to offset such losses against her income.

Sorry, wrong answer :(
Right answer!

For the IRS.

The cases of Calvin, Zeeman, and Rose all interpreted the availability of loss deductions where the deduction or offsetting income originated outside of the duration of the marriage. Calvin and Zeeman stand for the principle that spouses are an economic unit only so long as they are married. Rose and treasury regulation 1.170A-10(d)(4)(iii) both confirm that certain deductions, including net operating losses and excess charitable contributions, are not transferable upon the death of the taxpayer who incurred them.

Further, the ability to offset one spouse’s income with the other’s loss deductions is available only to spouses who elect to file joint returns. See treasury regulation 1.172-7(c), 1.172-3(d). By definition, a taxpayer cannot file a joint return with a deceased spouse except for the year of death. See code sections 6013(c) and (d).

A deceased taxpayer’s unused deductions — capital or net operating loss deductions or deductions for charitable contributions — must be used on the last tax return of the decedent, or they are forever lost.

While we recognize that the purposes of the alternative minimum tax credit and the NOL carryover are not identical, we nonetheless find informative the authorities limiting the transfer of NOL carryovers between spouses. The taxpayer offers us no reason not to extend those authorities to this case.

Therefore, because the taxpayer could not deduct for a postmarital year a net operating loss incurred by her husband even during their marriage, much less before it, we conclude, on the basis of the record and the arguments before us, that she was not entitled to take into account under section 53(b)(1) her husband’s premarital adjusted net minimum tax liability in computing her own minimum tax credit for tax year 2009.

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