Tax Court in Brief | Valentine v. Commissioner | Taxability of Military Pension and Disability Payments and Business Expense Substantiation

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Tax Court in Brief | Valentine v. Commissioner | Taxability of Military Pension and Disability Payments and Business Expense Substantiation

The Tax Court in Brief – April 25th- April 29th, 2022

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Tax Litigation:  The Week of April 25th, 2022, through April 29th, 2022

Valentine v. Comm’r, TC Memo. 2022-42| April 28, 2022 | Gustafson, J. | Dkt. No. 6724-19


Short Summary: Tracy Valentine, a veteran of the U.S. Army, failed to timely file her 2016 Form 1040, and she did not pay any income tax for 2016 beyond the amounts that had been withheld from her wages from and retirement distributions by payors, as reported on Form W-2 and Form 1099-R. The IRS, pursuant to section 6020(b), prepared a substitute for return using information provided by third parties (i.e., those who employed Valentine during the tax year). On February 19, 2019, the IRS issued a statutory notice of deficiency of $11,034 for 2016, as well as additions to tax. On March 25, 2019, Valentine filed a 2016 return on Form 1040, through which Valentine (1) excluded $20,643 of $23,801 she had received in military retirement distributions, (2) claimed itemized business expense deductions on Schedule C, “Profit or Loss From Business,” and (3) she claimed a refund of $2,626.

Key Issues:

  • Whether Valentine may exclude a portion of her retirement distributions from gross income?
  • Whether Valentine is entitled to certain business expense deductions claimed?
  • Whether she is liable for the section 6651(a)(1) and (a)(2) additions to tax determined by the IRS?

Primary Holdings:

  • A retired service member may exclude a portion of retirement distributions in an amount equal to the benefit that the individual “would be entitled to receive as disability compensation from” the Veteran’s Administration, but only if the individual is not currently receiving excludable disability benefits from the VA, as Valentine was receiving. And, Valentine made no showing that she had a “combat-related injury,” which may have permitted Valentine to exclude the retirement distributions from gross income.
  • Valentine failed to keep detailed logs and records of her business travel and expenses as required by the Code and the regulations. Thus, she failed to meet the higher substantiation requirements for deduction of expenses for travel, meals, and lodging.
  • Yes, Valentine was liable for the additions to tax for her failure to timely file. Her testimony that she could not find an accountant was insufficient to establish reasonable cause for failure to file.

Key Points of Law:

  • Burdens of Proof. The taxpayer bears the burden of proving that the Commissioner’s determinations are erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Taxpayers must satisfy the specific requirements for any deduction claimed. INDOPCO, Inc. v. Comm’r, 503 U.S. 79, 84 (1992).
  • Exclusion of Military Retirement Pay from Gross Income. Gross income means “all income from whatever source derived”. 26 U.S.C. § 61(a). Pensions and retirement allowances constitute gross income unless otherwise excluded by law. at § 61(a)(11); Treas. Reg. § 1.61-11(a). Military retirement pay is pension income within the meaning of section 61(a)(11). Wheeler v. Commissioner, 127 T.C. 200, 205 n.11 (2006), aff’d, 521 F.3d 1289 (10th Cir. 2008). Statutory exclusions from income are narrowly construed, and to benefit from an exclusion, taxpayers must “bring themselves within the clear scope of the exclusion.” See Commissioner v. Schleier, 515 U.S. 323, 328 (1995); Dobra v. Commissioner, 111 T.C. 339, 349 n.16 (1998).
  • Generally, amounts received as a pension, annuity, or similar allowance are not included in gross income when they arise from personal injuries or sickness resulting from active service in the armed forces of any country. 26 U.S.C. § 104(a)(4). For example, disability payments from the U.S. Veterans’ Administration are generally excluded from gross income.
  • Military retirement distributions, however, do not usually fit within the statutory exclusion, unless the pension, annuity, or similar allowance is paid by reason of “combat-related injury,” at § 104(b)(2)(C). Also, pursuant to section 104(b)(2)(D), if a taxpayer is entitled to receive combat-related disability payments from the VA,” § 104(b)(2)(D), the amount excludable from gross income is “not . . . less than the maximum amount which such individual, on application therefor, would be entitled to receive as disability compensation” from the VA. See id. at § 104(b)(4) (emphasis added).
  • A retired service member may receive both a disability pension from the VA (which is excludable from income) and retirement distributions (such as a service pension) from the service member’s respective branch of the armed forces. But, payments under retirement plans should generally be included in income regardless of the existence of a VA disability determination, except where certain exceptions may apply. See Lambert v. Commissioner, 49 T.C. 57 (1967); Sidoran v. Commissioner, T.C. Memo. 1979-56, aff’d, 640 F.2d 231 (9th Cir. 1981).
  • Where a petitioner already receives an excludable disability benefit from the VA, “a VA disability determination does not prove that a portion of [additional retirement distributions are] received for injuries sustained during active service” for the purpose of section 104(a)(4). Holt v. Commissioner, T.C. Memo. 1999-348, 78 T.C.M. (CCH) 625, 627.
  • A retired service member who did not receive a disability determination from the VA and who is not currently receiving disability benefits may exclude from gross income a portion of the retired service member’s retirement benefits under section 104 if the service member can prove that he or she would qualify for a disability determination from the VA. A service member who receives a retroactive disability determination by the VA may exclude from gross income a portion of the retirement benefits he or she received during the retroactive period equal to the percentage of his or her disability determination (if he or she did not already exclude them prior to the determination). See, e.g., Strickland v. Commissioner, 540 F.2d 1196 (4th Cir. 1976), rev’gC. Memo. 1974-188; see also Rev. Rul. 78-161, 1978-1 C.B. 31.
  • Deductibility of Schedule C Expenses. A taxpayer may deduct “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business”. 26 U.S.C. § 162(a). A taxpayer may deduct reasonable and necessary travel expenses such as meals and lodging incurred “while away from home in the pursuit of a trade or business.” at § 162(a)(2). Except where specifically enumerated in the Code, no deductions are allowed for personal, living, or family expenses. Id. at § 262(a).
  • The taxpayer must satisfy the specific requirements for any business expense deduction claimed pursuant to section 162(a). See INDOPCO, Inc., 503 U.S. at 84. Taxpayers are required to maintain records sufficient to substantiate items underlying the claimed deductions. See 26 U.S.C. § 6001; Treas. Reg. § 1.6001-1(a), 1.6001-1(e).
  • Section 274(d) establishes higher substantiation requirements for expenses related to travel, meals, and lodging while away from home, entertainment, gifts, and “listed property”, defined in section 280F(d)(4) to include passenger automobiles. For expenses associated with “listed property”, taxpayers must prove: (1) the amount of each separate expenditure with respect to such property; (2) the amount of each business use (such as mileage for automobiles); (3) the date of the expenditure or use with respect to listed property; and (4) the business purpose for an expenditure or use with respect to such property. Treas. Reg. § 1.274- 5T(b)(6), (2)(ii)-(iii) (defining “time” and “place” for these purposes).
  • No deduction is allowed unless the taxpayer substantiates by adequate records or by sufficient and credible evidence corroborating his or her own statement the amount, time and place, and business purpose for each expenditure. See 26 U.S.C. § 274(d) (flush language); Treas. Reg. § 1.274- 5T(b)(2)(ii)-(iii) (defining “time” and “place” for these purposes).
  • Adequate records for this purpose include an account book, log, or similar record and documentary evidence, contemporaneously made with the expense, that together are sufficient to establish each element of the expenditure. See id. at § 1.274-5T(c)(2)(i)-(ii)(C).
  • If a taxpayer’s trip is primarily personal, the traveling expenses are not deductible, even if the taxpayer engages in business activities at the destination. See id. at § 262(a); Treas. Reg. § 1.162-2(b)(1). Expenses paid or incurred at the destination that are properly allocable to the taxpayer’s trade or business are deductible even if the traveling expenses to and from the destination are not deductible. Treas. Reg. § 1.162-2(b)(1).
  • Deductions for most meal and entertainment expenses is limited to “50 percent of the amount of such expense or item which would . . . be allowable as a deduction.” 26 U.S.C. § 274(n); see Reg. § 1.274-5A(h) (providing a per diem method by which taxpayers may elect to use a specific dollar amount for meals while traveling, in lieu of substantiating the actual cost of those meals). The IRS has adopted the “per diem” rates published by the General Services Administration for substantiating the cost of meals, incidental expenses, and lodging for a given period and locality. Rev. Proc. 2011-47, 2011-42 I.R.B. 520.
  • Additions to Tax, Section 6651. Section 6651(a)(1) authorizes the imposition of an addition to tax for failure to file a timely return (unless the taxpayer proves that such failure is due to reasonable cause and is not due to willful neglect). The addition consists of 5% per month (up to a maximum of 25%) of “the amount required to be shown as tax on such return”. 26 U.S.C. § 6651(a)(1).
  • Section 6651(a)(2) provides for an addition to tax for failure to timely pay “the amount shown as tax on any return specified in paragraph (1)” unless the taxpayer establishes that the failure was due to reasonable cause and not willful neglect. The addition consists of 0.5% per month (up to a maximum of 25%) of “the amount shown as tax on such return”. at § 6651(a)(2).
  • The amount of the addition to tax under section 6651(a)(2) reduces the addition to tax under section 6651(a)(1) for any month for which both additions to tax apply. See id. at § 6651(c)(1).
  • The IRS bears the burden of production with respect to additions to tax under section 6651(a)(1) and (2). See at § 7491(c); Higbee v. Commissioner, 116 T.C. 438, 446–47 (2001). To meet this burden, the IRS must produce sufficient evidence that it is appropriate to impose the addition to tax. If that burden is met, the taxpayer then bears the burden of proof as to reasonable cause or other mitigating factors. See Higbee, 116 T.C. at 447. When a taxpayer has not filed a return, the section 6651(a)(2) addition to tax may not be imposed unless the IRS has prepared a substitute for return that meets the requirements of section 6020(b).
  • An substitute for return prepared by the IRS under section 6020(b) is treated as a taxpayer return for purposes of determining the addition to tax under section 6651(a)(2). 26 U.S.C. § 6651(g)(2); see Rader v. Commissioner, 143 T.C. 376, 382 (2014).

Insights: This case provides insight on the taxability or deductibility of military pensions and retirement allowances received by a retired member of the armed forces. Payments under retirement plans are generally included in income regardless of the existence of a Veterans’ Administration disability determination, except where an exception clearly applies. The case also illustrates that the U.S. Tax Court may evaluate claimed itemized business expense deductions on a trip-by-trip, item-by-item, or expense-by-expense basis to determine if a taxpayer has, for each such deduction amount, met the higher substantiation requirements of section 274 and related Treasury Regulations.