Deductions of Charitable Contributions from Income and Death Taxes

Estate of Eileen v. IRS, 144 T.C. 6 (Feb. 19, 2015).

The tax code (income and estate taxes) allows for deductions in the amount of money actually donated to charity or “permanently set aside.”  (Estate taxes: form 1041, line 13; Income Taxes form 1040 Schedule A lines 16-19).

In Eileen, “The issue [was] whether the estate is entitled to a $219,580 charitable contribution deduction for purposes of computing its income tax for the taxable period ending March 31, 2008. The estate contends that during the taxable year ending March 31, 2008, it permanently set aside $219,580 of its gross income for the benefit of the foundation and thus is entitled to a charitable contribution deduction for that amount . . .” Eileen at page 10.  Note the emphasis, this money was set aside, not actually paid to charity at this point.

Merely setting the money aside is not okay for Income tax purposes, but the Court explains that provisions of the Estate Tax code do allow such treatment:  “Charitable contribution deductions from income are allowed under sections 170 and 642(c). Section 170 provides for income tax deductions for charitable contributions by individual taxpayers and corporations; however, section 170 does not apply to charitable contributions made by estates or certain trusts. Sec. 1.170A-1(j)(1), Income Tax Regs.  Under section 642(c)(2) an estate is allowed a current charitable contribution income tax deduction, notwithstanding that the amount will not be paid or used for a charitable purpose until sometime in the future.”  Eileen at pages 11-12.

In this case, Ms. Eileen’s estate was denied the deduction because the Tax Court determined the set-aside was not permanent – it was being used to pay for litigation regarding the estate:  “The facts and circumstances known to the estate when it filed its Form 1041 on July 17, 2008, were sufficient to put the estate on notice that the possibility of an extended and expensive legal fight–and consequently the dissipation of funds set aside for the foundation–was more than ‘so remote as to be negligible’.” Eileen at page 16.

The Tax Court thus sided with the IRS in this one and denied the deduction for this estate’s attempted contribution to charity.  The lesson from the case is that the surest way to properly take charitable deductions from a taxable estate is to actually pay the money to charity.  For income tax purposes, that payment must be made before the deduction can be claimed.

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They Shouldn’t Buckle Under Pressure

Kaminski v. IRS, T.C. Summary Op. 2015-7 (Feb. 3, 2015) demonstrates why the IRS likes to pursue small businesses in audits and before the Tax Court.  That is, small businesses tend to mix personal with business accounts and keep poor records.  Here, Mr. Kaminski kept three calendars, receipts, and other records of his expenditures in his financial planning business.  However, “A close comparison of the three calendars reveals numerous inconsistencies, and the calendars do not uniformly align with petitioner’s other business records.  For example, in several instances, the clients listed on the M&E calendar for a particular day do not match the client names that appear on the client calendar for the same day. Similarly, there are discrepancies between the location and mileage calendar and the receipts petitioner produced identifying the locations of the restaurants where he met with clients for business meals.”  Kaminski at page 4.  In other words, Mr. Kaminski’s records were not very convincing when reviewed under pressure.

Theoretically, “Under section 162(a), a deduction is allowed for ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”  Kaminski at page 9.  In reality, the IRS employee reviewing tax filings, an auditor, and even a Tax Court judge must find the records and testimony demonstrating both the expenses and their business purpose convincing.  Otherwise, the Court may conclude (as it did here) that “Although petitioner’s calendars are comprehensive in scope, they are not consistent with one another, as petitioner acknowledged they should be, and they do not uniformly align with his other business records. For example, in several instances the clients listed on the [meal and entertainment expense] calendar for a particular day do not match the clients listed on the client calendar for the same day. There are similar discrepancies between the location and mileage calendar and the receipts petitioner produced identifying the locations of the restaurants where he met with clients for business meals. In addition to these shortcomings, the Court is left with the strong impression that petitioner was somewhat liberal in treating social visits as business trips. Considering all the facts and circumstances, we conclude that petitioner has not adequately substantiated vehicle expenses in excess of the amount [the IRS] allowed in the notice of deficiency.  Accordingly, [the IRS’s] determination [that Kaminski took too large of deductions] is sustained.”  Kaminski at page 11.

In summary, a small business owner should spend some time keeping reliable records of legitimate business expenses so when the pressure is on, the records hold up.

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Deductibility of Sec. 71 Alimony Payments (Under Sec. 215)

Milbourn v. IRS, T.C. Memo. 2015-13 (Jan 21, 2015).

Yesterday’s Tax Court provided decent analysis on what constitutes a “written separation agreement” to qualify for alimony deductions under Sections 71 and 215 of the IRC.

“Section 71(b)(1) provides:
(1) In general.–The term “alimony or separate maintenance payment” means any payment in cash if–
(A) such payment is received by (or on behalf of) a spouse under a divorce or separation instrument,
(B) the divorce or separation instrument does not designate such payment as a payment which is not includible in
gross income under this section and not allowable as a deduction under section 215,
(C) in the case of an individual legally separated from his spouse under a decree of divorce or of separate maintenance,
the payee spouse and the payor spouse are not members of the same household at the time such payment is made, and
(D) there is no liability to make any such payment for any period after the death of the payee spouse and there is no
liability to make any payment (in cash or property) as a substitute for such payments after the death of the payee
spouse.”

Milbourn at page 8.

Here, the “written separation” element was at issue.  The Tax Court reviewed precedent on what might constitute this element.

“The term “written separation agreement” is not defined in the Code, the applicable regulations, or in the legislative history. Leventhal v. Commissioner, T.C. Memo. 2000-92, 2000 Tax Ct. Memo LEXIS 106, at *19 (citing Jacklin v. Commissioner, 79 T.C. 340, 346 (1982)); Greenfield v. Commissioner, T.C. Memo. 1978-386, 1978 Tax Ct. Memo LEXIS 132, at *4-*5. A written separation agreement has been interpreted to require a clear statement in written form memorializing the terms of support between the parties. Jacklin v. Commissioner, 79 T.C. at 348; Bogard v. Commissioner, 59 T.C. 97, 101 (1972). While an oral agreement does not qualify as a written separation agreement, an oral agreement in court which is recorded in a written, official transcript does qualify. Prince v. Commissioner, 66 T.C. 1058, 1066-1067 (1976). A separation agreement requires mutual assent of the parties. Kronish v. Commissioner, 90 T.C. 684, 693 (1988).  Letters which do not show a meeting of the minds between the parties cannot collectively constitute a written separation agreement. See Grant v. Commissioner, 84 T.C. 809, 822-823 (1985), aff’d without published opinion, 800 F.2d 260 (4th Cir. 1986); Estate of Hill v. Commissioner, 59 T.C. 846, 857 (1973). However, where one spouse assents in writing to a letter proposal of support by the other spouse, a valid written separation agreement has been held to exist. Leventhal v. Commissioner, 2000 Tax Ct. Memo . . . ”

Milbourn at pages 10-11.

So, if you’re planning to deduct alimony payments on this year’s tax filings, review this list of what has been determined to qualify as a “written separation agreement” to make sure a deficiency is not assessed on your 1040.

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Foreign Earned Income Exclusion – Latest from the Tax Court!

Evans v. IRS, T.C. Memo. 2015-12 (Jan. 20, 2015).

The Tax Court issued an MLK-Day gift to the Foreign Service Community with the publication of the Evans v. IRS case. There, the Foreign Earned Income exclusion (IRC Sec. 911) is explained, discussed with other cases, and applied to the facts of Mr. Evans’ case.

“[The Foreign Earned Income exclusion law] provides that a “qualified individual” may elect to exclude from gross income, subject to limitations set forth in subsection (b)(2) [of IRC Sec. 911], his or her “foreign earned income.” To be entitled to this exclusion, a taxpayer must satisfy two distinct requirements. First, he must be an individual “whose tax home is in a foreign country.” Sec. 911(d)(1). Second, he must either be a “bona fide resident” of one or more foreign countries or be physically present in such country or countries during at least 330 days in a 12-month period.”

Evans at page 8.

The Court determined Mr. Evans was not entitled to the exclusion because, in part:

Mr. Evans “was not and could not be joined by his family [abroad in Russia]; slept in employer-provided housing; ate employer-provided meals while on offshore drilling platforms; returned home to the United States during most off-duty periods; had the costs of his travel to and from the United States paid by his employer; and was “essentially commuting on a regular basis from * * * [his] home[] in the United States.”

Evans at page 14 (citing Jones v. IRS, 927 F.2d 849 at 857 (5th Cir. 1991)).

In summary, anyone interested in claiming a Foreign Earned Income exclusion ought to

1) ensure his or her “tax home” is in a foreign country;

2) be either a “bona fide resident” of or at least present in a foreign country over 330 days a year;

3) do as many things as Mr. Jones in Jones v. IRS (see links); and

4) distinguish yourself from the taxpayers in this case, Lemay and Bujol (see links below).

Cases Referenced

Bujol v. IRS, T.C. Memo. 1987-230 (May 5, 1987).

Evans v. IRS, T.C. Memo. 2015-12 (Jan. 20, 2015).

Jones v. IRS, 927 F.2d 849 at 857 (5th Cir. 1991).

Lemay v. IRS, T.C. Memo. 1987-256 (May 19, 1987).

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Continuing with Alimony Deduction Example from the Tax Court

The case of Becker v. IRS (Jan. 13, 2015), perfectly demonstrates the possible consequences of improperly taking a deduction.  Here, much like the example used in Tax Deductions, a Matter of Legislative Grace, the taxpayer improperly claimed is IRC Section 215 (Form 1040 line 31a) alimony payment deductions.  See Becker p. 4.   Mr. Becker’s precise problem was that in 2011, he underpaid his alimony, paid his child support correctly, but failed to reduce his alimony deductions by the amount he had shorted his ex as required by IRC Sec. 71(c)(3).  Consequently, the IRS assess the deficiency and took Mr. Becker to Tax Court when he failed/refused to pay the difference.

The reader might also notice the timing involved with disputes that make it before the Tax Court.  The taxpayer here, Becker, made these alimony payments in 2011, filed in 2012, and did not have this dispute resolved by the Tax Court until 2015.  Proper planning would have helped him avoid a four-year long struggle that followed his divorce litigation.

Becker v. IRS, T.C. Summary Op. 2015-2 (Jan. 13, 2015).

Tax Deductions, a Matter of Legislative Grace (Jan. 13, 2015).

Tax Year 2014 Form 1040.

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Tax Deductions, a “Matter of Legislative Grace”

Tax deductions are one of the most commonly misunderstood legal and accounting topics there is.  The best way to understand them is to first recognize that the internal revenue code presumes that “all income of whatever source derived” should be reported on a 1040 for income tax purposes.  IRC Sec. 61.

Congress

Conversely, a tax deduction is a “matter of legislative grace.”  Interstate Transit Lines v. IRS, 319 U.S. 590 at p. 593 (1943).  So when it comes to federal income taxes, there are no deductions unless Congress has specifically passed a law to allow for a deduction.

Line 31a of Form 1040 for tax year 2014 provides a nice example.  That line allows the taxpayer to subtract the amount paid as alimony to a former spouse under a judgment or separation agreement.  This is subtracted from Line 22, “total income.”  Total income is thereby adjusted for the tax deduction Congress has created with IRC Section 215 “Alimony, etc., payments.”  All of the adjustments on lines 23 through 37 of Form 1040 are similarly created by the grace of our legislative body.  So, resist the urge to deduct expenses because they seem like they should be — only do so where Congress has allowed it.

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