Humpty Dumpty meets the tax code

Hosted by Paul Bonner

In Through the Looking-Glass, a word only might mean, as Humpty Dumpty tells Alice, “just what I choose it to mean.” But in the real world — the world of tax law — words have statutorily set definitions or are interpreted by judges using precedent and reason. In this episode, recorded at the recent AICPA National Tax Conference in Washington, D.C., tax professor and AICPA volunteer tax advocacy leader Annette Nellen, Esq., CPA, CGMA, walks us through four recent decisions by the U.S. Tax Court to show how the precise application of a word or phrase can make a world of difference.

What you’ll learn from this episode:

  • When there may be a difference between saying money is “includable” versus “included” in a taxpayer’s gross income potentially subject to tax.
  • Taxpayers can call their activity a business, but the IRS might classify it as a hobby instead — and deny a net loss deduction.
  • A taxpayer who inherited a partnership interest from his father wasn’t required to consider passed-through interest expense to have the same character as it had in his father’s hands.
  • A common exception from penalties for an early withdrawal from a qualified retirement account can apply in the case of an individual retirement plan but not a qualified retirement plan (the latter also known as a 401(k)).

Play the episode below:

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JofA senior editor, at


Paul Bonner: Hello and welcome to the Journal of Accountancy podcast. I’m Paul Bonner. I’m a senior editor at the Journal of Accountancy and The Tax Adviser, and with me today at the AICPA National Tax Conference is Annette Nellen, who is a professor extraordinaire and director of the master of science in taxation program at San José State University in California. She is also a longtime volunteer member of the AICPA Tax Section panels and committees, including being immediate past chair of the Tax Executive Committee.

We’re going to be drawing from Annette’s presentation to the conference today called “A Baker’s Dozen: Top Rulings of the Past Year.” Rather than 13 cases, we’re going to discuss four of them that were decided by the U.S. Tax Court. And they cover a wide variety of types of taxpayers and problems, but they have one thing in common that I want to call the Humpty Dumpty factor. That’s from Lewis Carroll’s Through the Looking-Glass, in which the character says, “When I use a word, it means just what I choose it to mean, nothing less, nothing more.”

Of course, in real life, the meanings of words, especially those in laws, can’t have only a private meaning. So, although these taxpayers and their problems are vastly different from each other, they all devolve around, or revolve around, the meaning of words.

The first one we’re going to discuss is Mary K. Feigh — that’s F-E-I-G-H — v. the Commissioner of the IRS. This is a reported case, 152 T.C. No. 15, with the opinion issued in May of this year. The word here is “includable,” versus “included.” Is that right, Annette?

Annette Nellen: Right.

Bonner: Some might treat them as synonymous. After all, an item of income has to be includable to be included in income. But what happened here?

Nellen: Well, Paul, it was an interesting case, and it is a regular tax decision. So that means that the judges determined that this is an interpretation of law, whereas most of the Tax Court cases are memorandum decisions, interpretation of fact; then we’ll apply the law to the set of facts that we derive or the actual facts there.

So, the taxpayer’s only income was income from a Medicaid waiver for caring for her adult disabled children, and the IRS had a Notice, 2014-7, where the IRS said that kind of a waiver would be excluded from income. Now, it was questionable if that was a correct interpretation of the law, but since the IRS wasn’t questioning its own notice, the judge decided they weren’t going to raise that particular issue.

What the IRS raised as to why this went to court was, the taxpayer reported the Medicaid waiver income, and then they backed it out, saying, “Well, IRS lets us exclude it under the Notice 2014-7.” But then they used that income to calculate an earned income tax credit and a refundable portion of the child tax credit, and the IRS thought, “Well, that’s not right, because you don’t have any income. How could you possibly have an earned income tax credit? That requires earned income. You don’t have any reported there.”

The court agreed with the taxpayer. This is one of the rare cases where the IRS loses, and why the IRS doesn’t lose very often is that they pick their cases very well before they’re going to court, versus settling with a taxpayer. And the rationale for why they did get the earned income tax credit is that the language in the Code Sec. 32 talks about if the income was includable in income as opposed to included in income. Clearly, it wasn’t included in the income because they excluded it under the notice, but it was includable. The judge seemed to think that probably the notice was wrong, but they weren’t questioning because the IRS didn’t question it. And when the IRS said, “Gee, that’s like a double benefit because you got to exclude the income, but then you used that income to calculate an earned income tax credit.” But the judge said to the IRS, “That’s your doing. That’s not something Congress created on that.”

So, it’s interesting for a few reasons: one, the importance of really looking at exactly what are each of those words in the Code section. And the court did highlight “included” is a different word than “includable,” and the earned income tax credit language is “includable.” Also, I think it’s a good reminder of the ordering of authority of guidance out there. Obviously, the statutes are number one, the Internal Revenue Code, and the judge seemed to think this probably was income under the Internal Revenue Code. And if the IRS decided they wanted to write a favorable rule for taxpayers to back it out, that’s their doing. It was still something includable in income, and they’re entitled to the credit. The IRS cannot take away that statutory credit from them.

Bonner: That’s always nice when someone wins in Tax Court, isn’t it? Nice for them.

Nellen: Nice for the taxpayer, right.

Bonner: And I think, probably, a negative item of income on Line 21 always gets the IRS’s attention.

Nellen: Perhaps. You do wonder what caused the IRS to select that return.

Bonner: Yeah. Well, again, having no income.

Nellen: Yeah, having no income and claiming an earned income tax credit would probably do it.

Bonner: Yeah. Well, that’s a very interesting case, and we’re also going to discuss Charles M. Steiner v. Commissioner. That’s T.C. Memo. opinion 2019-25, issued in April. Now, this was a profit-motive case, as you said earlier, and the Tax Court in this case said, “We give greater weight to objective facts than to the taxpayer’s statement of intent,” a statement involving a yacht named the Triumphant Lady.

Nellen: I’d forgotten about what the name of the yacht was.

Bonner: Well, I noticed.

Nellen: So, I liked this case, because the big dollars involved could have easily been a client of many CPAs, and it begs the question, who was making these decisions to say, “Yes, this is something you can report on your Schedule C,” meaning it was a trade or business. Now Steiner himself actually was, or is, a CPA, but he made lots of money in other business activity, enough money that he had actually purchased a yacht for, I think, just around $5 million, and if that wasn’t enough, then you spend another $11 million to retrofit it to what you need. And he had a full-time crew that operated this yacht, so he was doing pretty well. But then for some reason they weren’t going to be using the yacht as much. It gets to be around 2009, and it’s kind of hard to sell a yacht at the start of the recession, so they want to do something to, I guess, reduce their costs, and somebody comes up with the idea, “Why don’t you go into yacht chartering?” Perhaps it was people who make money off of yacht chartering, because there were a few folks that approached him to say, “You could charter the yacht.”

Now, these folks that had approached him, they were going to make money, because they didn’t have any costs involved. They would just take a cut off the top of what the parties paid to charter the yacht, and over a two-year time period, only one week did they actually get the yacht chartered. They chartered it out for $150,000, so the brokers he was working with, they did OK. But over a two-year period, Steiner had over $800,000 of loss. And again, this is a 155-foot yacht, which, I was trying to figure out — well, how big is that? It’s actually half of a football field, so that’s a big activity here.

Well, starting your yacht chartering business at the start of the recession is also probably a bit of a bad business plan, and the IRS just looked at all of this and said, “This is not an activity engaged in for profit.” They disallowed it as being a hobby, and the court agreed with that. The court went through the nine factors under the regs., under [Regs. Sec.] 1.183-2, to indicate what is an activity engaged in for profit, versus one not engaged in for profit, which we typically call a hobby.

And in going through all of those — I think also good reminders in there of how this is looked at by the courts and the IRS, because you think, “Well, gee, this person made a lot of money in their career from various, obviously successful businesses. Isn’t that enough to show that you must have been operating this yacht chartering in a successful way?” But the court said that doesn’t really tie in there, and looking at the yacht chartering activity just on its own, they didn’t necessarily have separate records on the expenses being paid out of their personal bank account, like they had been before, when this was just a personal-use yacht. Also, they didn’t have a business plan that would lay out how would they actually ever make any money on this, given the expense of operating this yacht with this full-time crew. And just the size of this thing obviously must require a fair amount of work.

So they didn’t win on that one. Additional factors that the court looks at, what’s your expertise? And while they had expertise in just operating your own yacht, that’s not the same as yacht chartering. That’s a whole ’nother activity, which they didn’t really know anything about, but then they were relying on these brokers who really weren’t the best folks to rely on because they had just a vested interest anytime there was someone that was going to charter it, they were just going to get a cut off the top. Those folks didn’t have to advise about, “Well, how do you manage your expenses, and how would you actually make a profit on this?” The broker’s just going to make a profit by anybody. Even if they chartered it for a week for $5,000, the brokers would still make money, and, clearly, Mr. Steiner would not make any money on that.

So going through all the factors, they all indicated hobby. Other than the one, is there any personal pleasure derived from this activity, and there, the court actually said, “Probably not.” While there might have been personal pleasure of just having your own yacht, there’s probably not much pleasure in trying to run a yacht chartering business in the economic downturn, and they said, “Well, that indicates a business.” But, obviously, that wasn’t enough factors to get them to that point.

Every year, there’s probably five to 10 hobby versus business cases that do go through the court. Almost always, the taxpayer does lose, and a couple of years ago, the Treasury inspector general had done one of many studies they do on various IRS activities and had in one report indicated that the IRS should do more to find possible hobbies. And a good indicator that something might be a hobby is where, for a couple of years, there’s losses reported on the Schedule C, but you can tell from page 1 of the return that they’ve got a — now Schedule 1 — that they’ve got other sources of income that they’re clearly living on, so maybe they can survive those losses because they’ve got other income to live on. And, of course, those losses then are reducing their taxes on that other income as well — IRS should take a more careful look to see perhaps they’re really an activity that’s not engaged in for profit.

It’s also an area where I think CPAs can play a good role in helping clients to, if they really are serious this is meant to be a business activity, help your clients get to that point. Help them make the business plan. Make sure they have separate bank accounts, separate credit cards. What are they doing so far as making sure they have some expertise in that business. Also, some cases have indicated, “Gee, you know, you had losses. You should have done something to lessen those losses. Maybe you weren’t charging enough. Maybe you should have….” Like in one case, the judge even said, “You know, the lights are on in your facility all the time, even when it’s closed. That’s not how you operate a business. You would turn off the lights to help reduce your costs.”

So, these are many ways where, obviously, the accounting and business expertise of CPAs can really help. But then, how did this one actually happen? Someone, even Steiner himself, probably should have stopped him from pursuing this, because it was just going to be hard to show there’s this activity engaged in for profit without more being done here. Maybe they just should have found, “Could I cut my losses by selling the yacht?” Or, “This just isn’t going to be the way to go. Something else that I can do with the yacht?” that would have been a better business prospect. But starting a yacht chartering at the start of the recession is not going to be a good start to that activity.

Bonner: And calling it “charter business” — that does not a business make, necessarily.

Nellen: That’s right. That’s what the court was getting at. It’s not what you’re saying your intent was. We want to look at the facts to indicate what was really going on there.

Bonner: Yeah. So, here’s another one that turns upon the definition of a word or a term. William C. Lipnick v. Commissioner of the IRS, and this is another reported case, 153 T.C. No. 1, that came out in August. And the word here is “interest expense,” two words, actually. And it disproves the maxim “like father, like son,” does it not?

Nellen: Right. This is also an interesting case because it deals with a regulation that’s still actually in temporary form, dating back to 1988 at least, never been finalized. And, actually, don’t temporary regs. expire after three years? Only if they were issued after Nov. 20, 1988, when that change was made to Code Sec. 7805. And here, the IRS did modify the reg., but they didn’t do it by issuing a new reg.; they did it by issuing this Notice 89-35.

So, the facts here were that the father was a partner in a pretty large partnership. And the partnership decided they would make a distribution to the partners, but not having cash — I guess, maybe, a real estate partnership that all the money’s tied up in the real estate, but they wanted to get cash out, the partners must have been asking for some cash — so they have a debt-financed distribution. Well, that means that the individual partners need to figure out, “OK, interest expense is going to be separately reported on the [Schedule] K-1 for this borrowing, where the proceeds were used to be distributed to the partners, so then the partners can apply the interest tracing rules at their level.” They’ll have to say, “Well, you got this distribution for the partnership. It represented borrowing by the partnership,” to figure out the category of your interest expense. Is it trade or business, is it investment, is it passive activity, or is it nondeductible personal interest? You apply the tracing rules to that. That’s all laid out in the Notice 89-35.

Now, the notice actually — and if you haven’t read the notice in a while, just let me encourage you to pull it out and take a look, because a lot of good information is in there to help taxpayers. There was actually an alternative way they could have done it. The partnership could have opted instead to say, “It’s as if we used the debt for our own operations,” which would be a good way for the partnership to go if their trade or business expenses were equal to or greater than what they borrowed, because they can say, “Well, it’s all trade or business interest expense.” But they didn’t do that. They instead took the main rule, which was, “Partners, you figure out how you spent this, and every year when you see the interest expense in the K-1, you’ve got to figure out how you treat it on your return.”

Well, the father had actually used his debt-financed distribution from the partnership to buy various investments, so he was treating this as investment interest expense. Well, father passes away, and the son inherits that partnership interest, which is still showing on the K-1 a line for interest expense tied to that debt-financed distribution that was made by the partnership.

Bonner: And the expense is limited to the amount of income from investments, is it not?

Nellen: Yes, so actually the father, you know, under [Sec.] 163(d), you can only deduct whatever interest he had equal to net investment income.

So, when the son inherits the partnership and sees this separate line coming through in the K-1s for interest expense — categorize it based on what you did with the debt proceeds you received — he never received any debt proceeds. So he and, I guess, his tax adviser determined, “Well, I guess we just treat this as if it’s just a normal expense of the partnership.” So let’s say the partnership’s only producing trade or business income. It’s a trade or business expense, and they were just offsetting it all on the Schedule E.

Bonner: And he had minimal investment income.

Nellen: Right, that’s always a challenge. You think, “Oh, investment is an expense.” At least that’s a deductible category, but again, you have to have sufficient net investment income, and the excess carries forward, but, you know, people don’t live forever.

So the IRS challenged that. They said “No, no, no, you have to step in the shoes of your father, and he treated it as investment interest expense. You must do the same thing.”

So they go to court, and the judge holds for the taxpayer. They’re saying, “IRS, where are you getting that rule from? We don’t see it anywhere. We don’t see a lot of logic in it because the son actually did not receive any debt proceeds.” So what else can you do? You might as well just treat it like it was a normal partnership expense. Just throw it in with everything else, the net income coming through from the partnership. So the court agreed with what the son had done.

Now, will the IRS update, modify, finalize the regulation and put a more specific rule in there on what you do with the situation? Because it’s not addressed in the [Temp. Regs. Sec.] 1.163-8T tracing rules or the Notice 89-35 that modifies that for a debt-financed distribution.

And before we leave this, I also want note, if you haven’t read Notice 89-35 in a while, I highly encourage you to do that, particularly regarding another special rule, modifying the reg. that’s in there, is a 30-day-before or -after borrowing and any-account rule, which is often very favorable to individual borrowers, particularly if you’re wondering, “Oh, my client still has a home equity debt.” Home equity debt is no longer considered — at least for eight years — not considered part of qualified residence interest. So I think a lot of people conclude, “Oh, you can’t deduct it.” No, if it’s no longer qualified residence interest, you do what you do for any borrowing: What did you do with the proceeds?

And then we trace it to that, but the 30-day-before and 30-day-after rule that’s in that notice might get a more favorable result for your client than if they borrowed the equity debt to buy a car that traced a personal expense. But if they had something else, like they bought an investment in that 30 days before or after and from any account that, the day they borrowed, they could say, “No, I really am going to pretend I used the debt proceeds to buy that stock or for my trade or Schedule C business.” They know “I will have used the debt proceeds to cover my business expenses in that 61-day period.” So they definitely want to take a look at the notice, and we’ll wait to see, we’ve been waiting for a long time, since 1988, will the IRS ever finalize these rules on interest tracing?

Bonner: Well, 30 years, everybody’s researched it. Go back that far.

Nellen: Well, it’s also a challenge because a lot of practitioners today might not really be aware of it because they haven’t been practicing back to 1989, and while you can find it in the commercial tax tools, it won’t be necessarily obvious because it’s not the normal way you would update a reg., by issuing a notice to say, “We modify the reg. with this notice.”

Bonner: Yeah. Well, let’s look at one more, and this one is Lily Hilda Soltani-Amadi — that’s A-M-A-D-I — v. the Commissioner of the IRS, and this is a summary case, which means it’s a small case and not precedential, No. 2019-19, which came out in August. And here we have a very important distinction between words, a one-word difference between “qualified retirement plans” and “individual retirement plans,” and the penalty for early withdrawal from a retirement savings account under Sec. 72(t), right?

Nellen: Right. And I like this case to remind students, when somebody asks you a question, like you’re at some party or just chatting with friends and family, a good answer, most times, is, “That’s a good question. Let me go just look it up and double-check.”

Somewhere along the way, this person had heard from somebody that if you pulled money out of your retirement account for a first-time home purchase, you would not be subject to the penalty, and they were both under the retirement age, so they said, “OK, I’m not going to owe the penalty.” Well, the IRS tracks this down and determines, “No, that wasn’t the proper withdrawal from your 401(k) for the first-time home purchase, so you do owe the penalty.” And the way the law is written, the exception to the penalty is only if the first-time home purchase is from your IRA, and the court did go into the definition of IRA in the tax law and said “Yeah, IRA’s something different than a 401(k).”

Now, why did Congress only put that penalty exception in for pulling money out of your IRA rather than a 401(k)? Who knows? Would this case be enough to cause Congress to go in and change it?

But, yeah, it’s a reminder that there are these little traps there, but also a reminder we should double-check, even though we might have heard, “Yeah, you can pull money out. There’s some exception to the penalty for a first-time home purchase.” Just about any fact pattern you hear, it’s always good to go double-check what exactly does the law provide here? Are there any special definitions? Is there a special election? Is there a timeframe it has to be done in? There’s just all kinds of little traps in the tax law for us that we avoid by going in and double-checking what it actually says in the law.

But anything like that, its always good to look it up, because there’s these special definitions that are not always the man-on-the-street definition of something, and things can change. Things could leave the Code.

Bonner: They could, and they do.

Well, thank you very much for these select four of the baker’s dozen of recent Tax Court cases, Annette Nellen, and thank you so much for joining us on the podcast.

Nellen: You’re quite welcome. Thank you.