(See "Capital Loss Limits" below)

Tax Tips

Roundup of Important Tax Cases in 2006

By Sidney Kess
New York Law Journal
October 16, 2006


Federal tax law is created by Congress and administered by the Internal
Revenue Service (IRS). This year, much attention has been focused on
legislative developments, including the Tax Increase Prevention and
Reconciliation Act of 2005, signed into law on May 16, 2006, and the Pension
Protection Act of 2006, signed into law on Aug. 16, 2006.
However, judicial decisions interpreting tax rules can have a dramatic
effect on individuals and businesses. Here is a roundup of some key
decisions in 2006 that may impact personal and business returns.

Nonphysical Personal Injury Damages

Section 104(a)(2) of the Tax Code provides that only damages for physical
personal injury or illness are excludable from gross income. Other damages,
including payments for nonphysical personal injury, are taxable. Until now,
this provision has meant that not only damages replacing lost wages were
taxable, but also taxable were damages for defamation and other nonphysical
injuries. However, a whistleblower in the National Guard who recovered
damages for injury to her reputation and emotional distress when she was
forced out of the service successfully challenged this code provision.

Marrita Murphy (then Leveille) told state authorities that her employer, the
New York Air National Guard, had environmental hazards on its air base. She
was effectively forced out of the Guard and, in 1994, filed a complaint with
the U.S. Department of Labor that her former employer violated whistleblower
statutes and "blacklisted" her by giving unfavorable references to potential
employers. The secretary of Labor concluded that she had been unlawfully
discriminated and retaliated against, ordered that adverse employment
references be withdrawn and remanded the case to an administrative law judge
(ALJ) for "findings on compensatory damages." There she gave evidence that
she suffered both mental and physical injuries as of result of the
blacklisting, including "somatic" injuries (e.g., teeth grinding), anxiety
attacks, shortness of breath and dizziness.

She was awarded compensatory damages of $45,000 for emotional distress and
$25,000 for injury to professional reputation. She reported the award on her
return, but later filed for a refund on the grounds that it was not taxable
income.

A three-judge appellate court decided that damages for nonphysical personal
injury are not income under the 16th Amendment of the Constitution, so that
the Code section treating these payments as income is unconstitutional
(Murphy, CA-DC, 2006-2 USTC ¶50,476). The award in this case was neither a
gain nor an accretion to wealth, so it could not be income. Since her mental
health and reputation were not taxable before the injury, damages to
compensate her for injury to them is not income. Damages for lost wages
would have been taxable, but the award in this case was not for lost wages.

Commentators have jumped on this decision as potentially throwing much of
the Tax Code into question and certainly rewarding tax protestors who make
seemingly far-out arguments. The Justice Department is asking the full
appeals court to review the decision in a legal maneuver known as a petition
for "rehearing en banc." The question raised in the case is "one of
exceptional importance to the administration of the nation's tax laws," the
government said. The appeals court panel's decision "represents the first
time in over 85 years that an exercise of Congressional income-taxing power
has been declared unconstitutional."

Long-Distance Service

• Federal excise tax on long-distance service. At the time of the
Spanish-American War, Congress sought to raise revenues by imposing a tax on
long-distance telephone service. Since telephones were still viewed as a
luxury item at the time, it was thought that only wealthy taxpayers and
businesses would owe the fee. Today, there are more than 200 million cell
phones alone in the United States.

A number of large corporations that together paid millions of dollars in
federal excise tax brought separate actions against the federal government,
arguing that the tax was erroneously collected. These corporations
challenged how the tax was being applied, arguing that it was being charged
on elapsed transmission and not on distance, as required by Code
§4252(b)(1). This year, the IRS lost in two key decisions (Fortis, Inc.,
CA-2, April 27, 2006, and Reese Bros., CA-3,May 9, 2006). These cases
conclude that the tax is being wrongly applied and should be refunded, the
same conclusion reached by other courts last year (American Bankers Ins.
Group, CA-11, 408 F3d 1328 (2005); OfficeMax, Inc., CA-6, 428 F3d 583
(2005); and Nat'l R.R. Passenger Corp. (AMTRAK), D.C. Cir., 431 F3d 374
(2005).

As a result of these decisions, the IRS announced that it would cease
application of the tax and grant refunds for tax charged after Feb. 28,
2003, and before Aug. 1, 2006 (Notice 2006-50, IRB 2006-25, 1141). It is
expected to refund about $13 billion. Consumers and Schedule C filers (sole
proprietors and one-member limited liability companies) can claim a refund
for their actual tax payments or rely on a standard refund amount fixed by
the IRS. This amount depends on the number of exemptions claimed in a
household: $30 for one exemption, $40 for two exemptions, $50 for three
exemptions and $60 for four or more exemptions (IR-2006-137, Aug. 31, 2006).
The standard amount includes interest on the overpayment; those claiming a
refund of the actual tax will be entitled to interest (the amount of which
has yet to be announced). The refund must be claimed only on a 2006 tax
return.

Businesses cannot rely on a standard amount; they can only claim a refund
for their actual tax payments. The refund amount is figured on Form 8913,
which is attached to the tax return. Important: Partnerships and S
corporations claim the refund themselves; the owners of these pass-through
entities do not claim their share of the company's refunds on their
individual returns.

Taxpayers claiming a refund of the actual tax paid should amass old
telephone bills. Check for payments covering federal excise tax on
long-distance service. The refund does not apply to federal tax on local
services, federal access charges, and state or local taxes and charges. The
refund is figured on new Form 8913, the amount of which is entered on a new
line of the 2006 tax return.

Capital Loss Limits

The exercise of incentive stock options (ISOs) does not result in any income
for regular tax purposes. However, the spread between the stock's price and
its option price is an adjustment for the alternative minimum tax (AMT).
This means that AMT can be triggered or increased by the exercise of ISOs,
even if the stock price drops after the exercise.

When the stock market tumbled six years ago, the dot.com stocks took a
severe hit. Some individuals holding ISOs got caught in a price squeeze.
They exercised their options and then saw the value of their holdings
plunge. That was the situation that plagued one individual in a case this
past year.

Robert Merlo exercised ISOs in December 2000 to acquire stock worth
$1,070,289; it cost him only $9,225, the option price, to do so. This
created an AMT adjustment of $1,061,064 (the stock price minus the option
price). Including this adjustment in alternative minimum taxable income
(AMTI) produced AMT liability of about $290,000. In September 2001, less
than a year after acquiring the stock, the company filed for bankruptcy and
Mr. Merlo's holdings became worthless. For regular tax purposes, only $3,000
of capital loss in excess of capital gains can be used to offset ordinary
income (Code §1211(b)). The excess loss can be carried forward; there is no
loss carryback. Mr. Merlo's capital loss was $1,076,289 (this $9,225 cost
plus the AMT adjustment of $1,061,064) and he wanted to use this loss as a
carryback to effectively undo his AMT liability.

In Tax Court, Mr. Merlo argued that the capital loss limitation for regular
tax purposes does not apply for AMT purposes (Merlo, 126 TC No. 10 (2006)).
This would allow him to carryback the 2001 loss to 2000 to eliminate AMT
liability in that year. Unfortunately for Mr. Merlo, and many others caught
in the dot.com fiasco, the Tax Court held that the regular capital loss
limits apply for AMT as well. No capital loss carryback is permitted.

In another case, a taxpayer argued that the capital loss limits were
unconstitutional. Ken Perry has capital losses in two consecutive years of
$9,200 and $60,000 and claimed the full amount of the losses on his returns,
disregarding the $3,000 capital loss limitation. Before the Tax Court he
argued that the capital loss limits violated the 16th Amendment of the U.S.
Constitution because Congress' power under this amendment is limited to
imposing tax on "income." He claimed that the capital loss limit, in effect,
taxed him on income he did not receive.

The Tax Court held that the capital loss limit was valid (Perry, TC Memo
2006-77). Congress can choose to treat capital gains and losses differently
from other types of income, and the capital loss limit does not subject a
taxpayer to nonexistent income. The law merely restricts the current use of
losses, something that Congress has the power to do.

Sale of Lottery Winnings

Many states pay their lottery winners in installments over a number of
years. Some winners who prefer a lump sum sell the rights to collect the
remaining payments to receive income now. Does this sale produce ordinary
income or capital gains? That is the question that has been put to several
courts; all have concluded that the resulting income from the sale is
ordinary income and not capital gains.

Take the case of Latteras who won more than $9.5 million in the Pennsylvania
lottery in 1991 with the purchase of a $1 lottery ticket. The winnings were
to be paid in 26 annual installments. In 1999 they sold their remaining 17
installments to a finance company for $3.4 million and reported this as
long-term capital gains on Schedule D of Form 1040. A federal appellate
court upheld the Tax Court in treating the sale proceeds as ordinary income
(Lattera, CA-3, 2006-1 USTC ¶50,165, aff'g TC Memo 2004-216). Applying the
substitute-for-income doctrine (which requires the income received to be
treated the same as the income that would have been received but for the
transaction), the sale results in ordinary income. The lottery proceeds are
ordinary income, so the sale proceeds must be treated the same way. A
taxpayer cannot convert ordinary income into capital gains by selling the
right to receive the income at a set time.

This court reached the same conclusion as the U.S. Court of Appeals for the
Ninth Circuit (Maginnis, CA-9, 2004-1 USTC ¶50,149). That case applied the
assignment of income doctrine under which a taxpayer who earns income cannot
escape tax on it by giving the income away. However, there had been
criticism of this court's approach in various law reviews. The U.S. Court of
Appeals for the Third Circuit's approach is based on a 1941 U.S. Supreme
Court decision (Hort, SCt, 41-1 USTC ¶9354) in which a tenant's lease
cancellation payment to get out of the lease had to be treated as ordinary
income (as would the rent), rather than as capital gain.

Sidney Kess, CPA-attorney, is a consulting editor to CCH Inc., an author and
a lecturer.