Making Sense of a Commonly Misunderstood Tax Deduction, with Policy Recommendations for Lawmakers and the IRS to Provide Additional Relief for American Taxpayer

Working from home has become the new normal for millions of Americans, and is likely to remain a fundamental aspect of American life even after the COVID-19 crisis begins to fade.  In turn, American workers have been required to adapt their circumstances to the unique demands of working from home—setting up home offices, bearing the expense of increased utility bills, and devoting portions of their homes previously used for personal purposes to business use.

In the face of these new circumstances, many workers may wonder whether the costs associated with setting up and operating a home office are tax deductible.  As is common for questions answered by federal tax law, the answers are less than clear and depend on the taxpayer’s particular circumstances.

Home Office Deduction: Background

As a general proposition, ordinary and necessary business expenses are deductible under Internal Revenue Code (IRC) § 162.  Further, expenses incurred in the production of income are generally deductible under IRC § 212, and business-related expenses, such as depreciation, are deductible under different parts of the Internal Revenue Code.  Conversely, expenses incurred in maintaining a personal residence, such as utility bills, general maintenance, and depreciation, are generally not deductible.  However, when a taxpayer works from home, the line between business expenses and personal expense—that is, those expenses which are generally deductible and those which are not—becomes blurred.

In balancing these competing considerations, Congress has created a fairly complex set of rules which start with the presumption that expenses relating to the use of a “dwelling unit,” referred to herein as home office expenses, are not deductible, but which carve out important exceptions designed to prevent abuse while furthering the general policy of permitting deduction of business related expenses.

Before examining the rules governing home office deductions, it is important to note two items of particular relevance.  First, the recently enacted CARES Act, known primarily for providing relief measures to individuals and businesses suffering from the COVID-19 crisis, does not directly affect the rules governing home office deductions. Thus, the pre-crisis rules still govern.

Second, in December 2017, the Tax Cuts and Jobs Act (TCJA) became law.  One aspect of the TCJA was to eliminate miscellaneous itemized deductions for individual taxpayers for tax years beginning after 2017 and ending before 2026.  Home office deductions under § 280A are miscellaneous itemized deductions for individual taxpayers who work as employees.  Thus, under current law, individual employees are not permitted to claim home office deductions, but home office deductions are still available with respect to taxpayers who file a Schedule C with their 1040 to report the income and expenses of a sole-proprietorship.  Similarly, the home office deduction is available to pass-through business entities, such as partnerships and subchapter S corporations. Given the renewed emphasis on at-home work (which in many cases is mandated by employers or State or local ordinances), it may be wise for Congress to revisit this limitation, at least for the 2020 and 2021 tax years.  However, to date it has not done so.

IRC § 280A

Initially, in balancing between the general deductibility of business-related expenses and the non-deductibility of personal-use expenses, courts applied a relatively lax standard and allowed a deduction for business use of a home when the expense was “appropriate and helpful” to a taxpayer performing his job duties.  See Newi v. Comm’r, 432 F.2d 998 (2d Cir. 1970).  Fearing such a standard could lead to abusive behavior, in 1976 Congress passed IRC § 280A.

Section 280A does not itself authorize any deductions—it merely determines when otherwise deductible expenses (for example, those deductible under IRC § 162) may be deducted when those expenses relate to a taxpayer’s home. As noted, the general rule of § 280A is that home office deductions are not allowed.  IRC § 280A(a). However, the statute contains key exceptions.  Specifically, to qualify for the home office deduction under § 280A, a taxpayer’s home (referred to as a “dwelling unit” in the statute) must, on a regular basis, be used exclusively:

1. As the principal place of business for any trade or business of the taxpayer
2. As a place of business which is used to meet patients, clients, customers, etc. in the normal course of the trade or business, or
3. In the case of a separate structure not attached to the taxpayer’s residence, in connection with the taxpayer’s trade or business.

Further, even if these requirements are met, there are limitations on the deductibility of a home office expense. First, only an allocable portion of the applicable expense can be deducted.  After all, even if a taxpayer works from home, some portion of the expense is used for personal purposes and thus not deductible in any circumstance.  Second, § 280A places a ceiling on the overall amount of a home office deduction.  The rules relating to these limitations are discussed in more depth below.

We also acknowledge that there are special rules relating to rental homes and day care facilities operated out of a taxpayer’s residence, but given that both of those activities will be severely limited in the near future, we will focus in this article on the three primary exceptions listed above.

As a threshold matter, § 280A only applies to expenses incurred with respect to a dwelling unit which the taxpayer uses for personal purposes for more than 14 days in the given tax year.  A dwelling unit includes a house, apartment, condo, mobile home, or similar structure, including all structures or other property appurtenant to the dwelling unit.  For this purpose, personal use generally includes personal (non-business) use by the taxpayer, the taxpayer’s family members, or any other individual unless the dwelling unit is rented to that individual for fair value.  Thus if the taxpayer’s home is used as a residence for personal purposes for 14 days or less during the tax year, the deductibility of any associated expenses are determined without reference to § 280A.

Finally, § 280A does not bar deduction of home-related expenses which are otherwise authorized under the Internal Revenue Code notwithstanding the taxpayer’s use of his home in his trade or business.  For instance, the deductibility of mortgage interest is not affected by § 280A.

Home Office Deduction: Elements of Primary Exceptions to § 280A

Before a taxpayer may deduct home office expenses, the taxpayer must satisfy one of the enumerated exceptions to § 280A. The three primary exceptions listed above contain generally applicable requirements and specifically applicable requirements.

1. 1. Generally Applicable Requirements

For each of the primary exceptions under § 280A, the taxpayer’s home must be used in furtherance of a trade or business, and the portion of the taxpayer’s residence used for business purposes must be exclusively used, on a regular basis, for such business purposes.

• To be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and the taxpayer’s primary purpose for engaging in the activity must be for income or profit. Comm’r v. Groetzinger, 480 U.S. 23 (1987).  Note that a taxpayer may engage in multiple trades or businesses at the same time, and the taxpayer’s use of his or her home does not have to occur in connection with the taxpayer’s predominant business activity.
• For this purpose, regular use means frequent and repetitive use. Occasional or incidental use is not sufficient.
• With respect to exclusivity, while de minimis personal use of the allocated portion of the home may be allowed, the allocated space should be used exclusively for business purposes. For instance, if a taxpayer works from his or her dining room table but then later uses the dining room table for family dinner, expenses allocable to the dining room are not deductible.  See Sengpiehl v. Comm’r, C. Memo. 1998-23. However, business-use space need not be clearly partitioned or separated from the residential portion of the property in order to give rise to a deduction, see Hewett v. Comm’r, T.C. Memo. 1996-110, although a clear partition is helpful in proving exclusivity.

As noted earlier, prior to the changes imposed by the TCJA, employees could potentially deduct home office expenses, but only if the home was maintained for the convenience of the employee’s employer.  IRC § 280A(c).  This was a fairly difficult standard to meet.  Home offices which were merely helpful to the employer or employee were insufficient to meet this standard.  Generally, in analyzing this question, courts have looked to whether a home office is required as a condition of employment, is necessary to the proper functioning of the business, or is necessary to allow the employee to perform his duties properly. Given the restrictions placed on businesses determined to be non-essential, it seems likely that many employees working from home due to the COVID-19 would be considered to be doing so at the convenience of their employer, but that issue is not settled.  In the event Congress chooses to relax the limitations imposed by the TCJA and allow employees to claim deductions for home office expenses, this issue would likely be at the forefront of the § 280A issues posed by the COVID-19 crisis.

1. 2. Specifically Applicable Requirements
      1. § 280A(c)(1)(A)

Under § 280A(c)(1)(A), a home office deduction is available when the taxpayer’s residence is the principal place of business.  In some cases, it is obvious that a taxpayer’s home is his or her principal place of business.  For instance, if a taxpayer’s trade or business is operated entirely out of his or her home, the home will be the taxpayer’s principal place of business.  More difficult questions arise when the taxpayer works inside and outside his or her home.  In that circumstance, a taxpayer’s home can qualify as a principal place of businesses so long as the taxpayer uses his or her home to perform administrative or management functions, and there is no other fixed location where substantial management or administrative activities occur.  Thus, if the taxpayer has a home office from which the trade or business is managed, and there is not another location from which substantial management or administrative functions are performed, he or she will be eligible for a home office deduction even if the taxpayer performs services outside the home.  Administrative or management activities include billing, maintenance of books and records, ordering supplies, setting up appointments, and forwarding orders and writing reports.

Further, even if the taxpayer does not engage in substantial administrative or management activities at his or her home, the taxpayer’s home can be the principal place of business based on analysis which looks at the relative importance of the activities performed there and the amount of time spent there.  Comm’r v. Soliman, 506 U.S. 168 (1993).  This analysis requires an objective description of the business in question, and thereafter an analysis of where the business’s goods or services are delivered or rendered. If the business requires a specialized or unique setting outside the taxpayer’s home to complete its business goals, then it is unlikely the taxpayer’s home will be viewed as the principal place of business.

1. 1. 2. § 280A(c)(1)(B)

If a taxpayer meets with clients or customers at the taxpayer’s dwelling, then the taxpayer can qualify for the home office deduction even if the taxpayer’s home is not the principal place of business.  For instance, a doctor who sees patients from a home office could qualify for this exception.  However, to date this provision has been interpreted to require in-person meetings.  Telephone meetings are not sufficient.  There does not appear to be any guidance regarding remote face-to-face meetings (e.g. via Zoom), but in ruling that telephone meetings are not sufficient the Ninth Circuit emphasized the need for clients to actually visit the home office.  Green v. Comm’r, 707 F.2d 404, 407 (9th Cir. 1983).  However, this issue has not been tested in these very unique circumstances in which face-to-face meetings are often prohibited, so the extent to which this exception to the general rule of § 280A will be available to taxpayers meeting their clients and colleagues from home remains an open question.

1. 1. 3. § 280A(c)(1)(C)

Another possible basis to deduct home-office related expenses arises when the taxpayer maintains a separate structure not attached to his or her dwelling unit.  In that circumstance, a home office deduction is allowable if the free-standing structure is used exclusively and on a regular basis in connection with the taxpayer’s trade or business.  What distinguishes this exception from those discussed above is that the free-standing structure need not be the taxpayer’s principal place of business, nor does the taxpayer need to meet customers or clients in person to qualify of this exception.

Home Office Deductions: Limitations on Deductible Amount

In addition to the qualitative prerequisites to the home office deduction, there are two primary limitations on the amount of home-related expenses that may be claimed under § 280A. First, the expense must be allocable to the portion of the home used for qualifying business purposes.  Second, § 280A caps the amount of the home office deduction at the amount of gross income generated by the applicable trade or business.

1. 1. Home Office Deduction Allocation

Taxpayers may use any method that is reasonable under the circumstances to allocate home-office related expenses between business and personal use.  For instance, if the rooms in the taxpayer’s house are approximately equivalent in size, the allocation can be based on the number of rooms that qualify for the deduction under § 280A.  Alternatively, the allocation can be based on the square footage of the home.  The Tax Court has held that only functional space of the home needs to be included in the denominator of the relevant fraction; in other words, unusable portions of an attic or cellar are not included.  Culp v. Comm’r, T.C. Memo. 1993-270.

Direct expenses, i.e. those that benefit only the business-use portion of the home, may be deducted in full.  Conversely, indirect expenses benefit both the business-use and personal-use portions of the home (i.e. utility bills, real estate taxes, insurance, etc.).  Indirect expenses may be deducted to the extent of the percentage of the home allocable to qualifying business use.  For instance, if a taxpayer’s electricity bill amounts to $1,000 per year, and 10 percent of his home is allocable to qualifying business use, $100 is the allowable deduction under § 280A.  Unrelated expenses are those which do not benefit any part of the home used for qualifying business purposes.  For instance, if a taxpayer’s home requires kitchen repairs and the kitchen is not used in the taxpayer’s trade or business, those repair expenses are unrelated expenses. Unrelated expenses may not be deducted.

Alternatively, a safe harbor allocation method is available.  Under the safe harbor method, the allocable square footage of the home (not to exceed 300 square feet) is multiplied by a pre-set rate (currently $5). So, for instance, if 150 square feet of the home is used for qualifying business purposes, the safe-harbor deduction would be $750.

1. 2. Limitations on Amount of Deduction

 Even if a home-office deduction is permitted by IRC § 280A, the deduction is capped by the amount of gross income generated by the business for which the home office is used.  A home office deduction therefore cannot create a net operating loss.  Deduction of expenses relating to a qualifying home office requires several steps, which must be taken in order:

• First, home-related expenses, the deductibility of which is not determined by the existence of a trade or business (i.e. mortgage interest on the taxpayer’s principal residence, property taxes, etc.), must be allocated between business and non-business uses of the home. The amount of such items allocable to the taxpayer’s home office is deducted against the gross income of the qualifying business and reduces the overall gross income limitation.  The balance is deductible in the ordinary course, without regard to § 280A.  Thus, if a taxpayer paid mortgage interest of $5,000, and 10 percent of the taxpayer’s house is used for business purposes which allow for a deduction under § 280A, $500 (that is, 10 percent of $5,000) is deducted against the gross income of the qualifying business, and the applicable gross income limitation must be reduced by $500.  The balance of the mortgage interest amount for that tax year, $4,500 may be deductible irrespective of § 280A.
• Second, expenses attributable to the taxpayer’s business activity but not attributable to the use of the taxpayer’s home are deducted against the business’s gross income, and thereby reduce the overall gross income amount against which home office expenses may be deducted. For instance, if the business spends $1,000 on office supplies during the year, such amounts are deductible business expenses generally but they are not attributable to use of the taxpayer’s home (they would have been purchased regardless of the existence of a home office) and therefore reduce the overall gross income limitation by $1,000.
• Next, expenses that would be have been deductible (for instance under § 162) had the activity giving rise to the expense not been conducted in the taxpayer’s home, but which do not require a basis adjustment (i.e. utilities, insurance, maintenance, etc. that relate to the taxpayer’s residence) may be deducted to the extent of the applicable gross income cap (gross income attributable to the home office business, reduced under steps one and two above).
• Finally, expenses that would be have been deductible had the activity giving rise to the expense not been conducted in the taxpayer’s home, but do require a basis adjustment (i.e. depreciation of the taxpayer’s residence) may be deducted to the extent of the gross income cap remaining after steps one to three, above.
• Remember that § 280A does not itself authorize any deductions—it merely determines when otherwise deductible expenses may be deducted when those expenses relate to a taxpayer’s home. 

Home Office Deduction: Illustrative Example 

Because of the various layers to the home office deduction, we will now use an illustrative example to help shed light on how the home office deduction might play out in the real world.

Suppose Taxpayer operates a consulting business from a home office. Taxpayer previously operated from rented space in an office building, but due to the COVID-19 crisis, by local ordinance his office is closed and he has been forced to work from home since April 1. Today, Taxpayer’s billing, record maintenance, and preparation of policies and related contracts—which were previously performed at his business office—are now performed from his home office. However, due to the COVID-19 crisis, Taxpayer does not meet with clients in his home office. Instead, all client meetings are attended remotely.

Taxpayer reports his income and expenses from his consulting business on a Schedule C attached to his Form 1040 each year.

Taxpayer’s home consists of 10 rooms of various sizes, and totals 3,000 square feet.  Taxpayer’s home office occupies an entire room and comprises 300 square feet.  Since the start of the COVID-19 crisis, Taxpayer’s home office is not used for any purposes other than Taxpayer’s consulting business.  Previously it was used as personal storage space, but since the start of the year it had been empty until the Taxpayer began using it for his home office.

Due to concerns regarding the virus, and factors relating to convenience, the Taxpayer continues to work from his home office the rest of the year.  At the conclusion of the year, gross income from the Taxpayer’s consulting business totals $10,000. Taxpayer also incurred the following home-related expenses during the year:

1. Mortgage interest: $3,000
2. Real estate taxes: $5,000
3. Utilities: $1,000
4. General business supplies: $1,000
5. Homeowner’s insurance: $1,000
6. Lawn care: $500
7. Third-party answering service: $2,000

It is clear that the Taxpayer’s consulting business constitutes a trade or business. Further, his home office should qualify under the generally applicable conditions of §280A. Using a home office during business hours for 9 months of the year—that is, from April to December, should qualify as regular use.  Further, based on these facts, the use will also likely be viewed as exclusive. While his home office space was not used for business purposes from January through March of the tax year, it was not specifically used for any personal purposes either—rather, it was empty.  Had Taxpayer continued to use the space for personal storage purposes, it would be much more difficult to establish entitlement to a home office deduction because the business use of the room would not have been exclusive at all times during the tax year.  See Prop. Reg. § 1.280A-2(g)(1).

The next step is to determine whether the Taxpayer’s business satisfies one of the three primary exceptions provided by § 280A.  Under these facts, the only exception that could apply is the principal place of business exception—Taxpayer does not meet with clients in his home office, and there is no clear authority to date that says remote meetings are sufficient for client-meeting exception.  Moreover, Taxpayer’s office is a room in his house and is not a free-standing structure.  However, since he began utilizing his home office, all administrative and management activities have occurred there, and there is no other fixed location where substantial administrative or management functions occur.  Consequently, the home office should qualify as the Taxpayer’s principal place of business—but only for three-quarters of the year. IRS Pub. 587 (2019) at p. 5 expressly states that partial year use of a residence for a qualifying purpose is sufficient to claim a pro-rata home office deduction.

Taxpayer also properly determines that 10 percent of his home is allocated to an excepted business used under § 280A(c).  Allocating 10 percent of his home to business use is proper because 300 square feet out of a total 3,000 square feet are allocated exclusively for regular use in Taxpayer’s insurance business.

Because the Taxpayer used his home for a qualifying business purposes for only three-quarters of the tax year, the rules of § 280A will only apply to three-quarters of each item.  This example assumes the expense items are evenly allocable to each month during the year (in reality, because expenses often vary month by month, a taxpayer must look to the expenses for each month his home qualifies for the home office deduction).

Of the expenses incurred during the year, mortgage interest and real estate taxes are generally deductible regardless of the business use of the home and thus fall under step 1, outlined above.  However, 10 percent, or $600 (that is 10 percent of $8,000 x 75 percent), still needs to be allocated to the business-use portion of the home. Thus, $600 is deducted from the $10,000 of gross income generated by Taxpayer’s consulting business.  he balance, $7,400, may be deducted by Taxpayer in the normal course, without regard to IRC § 280A.  The overall gross income limitation on home office deductions is reduced by $600 to $9,400.

Next, expenses which are deductible but not related to home use must be taken into account.  Here, that consists of the third party answering service utilized by Taxpayer’s business and the general business supplies.  That $2,250 expense ($3,000 annual total x 75 percent) reduces the overall gross income cap to $7,150.

Next, the home office-related expenses must be allocated between business and non-business use.  Here, those amounts consist of utilities and homeowner’s insurance totaling $2,000.  After application of the allocation percentage, the deductible amount is $200 ($2,000 x 10 percent).  Because Taxpayer’s home was utilized for business purposes during only three-quarters of the year, the deductible amount is reduced by 25 percent, down to $150.  Because the remaining gross income cap ($7,150) exceeds the deductible amount ($150) the full $150 may be deducted against the business’s gross income.

The $500 of lawn care is not allocable to Taxpayer’s business use of his home, and is not otherwise deductible by his consulting business, and is thus not relevant to the analysis.

Policy Considerations

It is clear that § 280A, in its current form, fails to address many of the unique challenges posed by the COVID-19 crisis and the attendant changes to American work life.  There are a number of steps Congress can take through legislation, or the IRS can take through the administrative process, even on a temporary basis, to provide relief to struggling American workers.

First, IRC § 67 can be modified so that the home office deduction is available to employees in tax years before 2026. As explained earlier, under current law the home office deduction is not available to individual employees due to the elimination of itemized deductions in the 2018 to 2025 tax years imposed by the TCJA.  However, more than ever employees are working from their home offices and incurring increased expenses as a result. A temporary change to the deductibility of home office expenses (i.e. by expressly excluding qualifying home office expenses from the definition of “miscellaneous itemized deductions” under IRC § 67(b)) could generate larger refunds for millions of taxpayers and serve as an indirect economic stimulus.

Such a change could be supplemented with IRS guidance that making clear that employees who are required to work at home by their employers or pursuant to a federal, state, or local mandate precipitated by the COVID-19 crisis will be considered to be working at home at the convenience of their employers under § 280A(c)(1).  Thus, taxpayers could be confident in claiming these deductions without the need to wait out the slow process through which tax statutes are interpreted by court decisions.  These changes need not be permanent, and could be effective and provide relief even if implemented solely for the 2020 and 2021 tax years.

Moreover, the IRS could issue guidance clarifying that to the extent taxpayers typically met with clients or customers in a home office prior to the restrictions imposed by the COVID-19 crisis, continuing those meetings remotely (i.e. face to face, even if not physically in the same room) will not bar taxpayers from claiming a home office deduction under IRC § 280A(c)(1)(B), notwithstanding prior precedent that a taxpayer must meet with clients face to face in order to take advantage of the exception provided by § 280A(c)(1)(B).

FIDJ’s tax and tax litigation attorneys have extensive experience handling a wide variety of taxation matters for clients, both in and out of court.  They will continue to monitor developments in this area of the law, and remain vigilant throuthout the Coronavirus public health emergency. If you have any questions, an attorney can be reached by emailing us at contact@fidjlaw.com or by calling 305.350.5690.

 

 

 

In light of the widespread disruption to American life caused by the COVID-19 pandemic, the IRS has promulgated a broad set of deadline extensions, which afford taxpayers substantial relief.  Additionally, under new IRS guidance, the government itself has additional time to take certain actions which may have lasting impacts on taxpayers currently involved in controversy matters with the IRS.  These extensions of time, summarized below, are set forth in IRS Notice 2020-23, which was released on April 9, 2020.

IRS Notice 2020-23 provides relief to taxpayers who face deadlines which would otherwise arise between April 1, 2020 and July 15, 2020.  Specifically, any taxpayer who must file or make payments with respect to certain forms between April 1 and July 15 is granted an automatic extension of time to July 15 to complete the filing or make the payment.  Among the primary forms Notice 2020-23 applies to (a full list is provided in the Notice) are:

• IRS Form 1040 (annual return of individual taxpayers)
• IRS Form 1120, 1120-F, and 1120-S (annual returns of subchapter C, subchapter S, and foreign corporations)
• IRS Form 1065 (annual return of partnerships)
• IRS Form 1041 (annual return of estates and trusts)
• IRS Form 706 (estate and generation-skipping transfer return)
• IRS Form 709 (gift and generation-skipping transfer return)
• IRS Form 990-T or 990-PF (returns of exempt organizations, including those classified as private foundations)
• IRS Form 1040-ES (return related to quarterly estimated tax payments)

Thus if a return was originally due April 15, the deadline has automatically been extended to July 15.  This extension applies to all schedules and attachments that typically must be filed with these forms as well, in addition to any elections that must typically be made on such forms.

In addition to providing relief with respect to form filing and payment deadlines, deadlines to file petitions with the Tax Court, a notice of appeal of a Tax Court decision, filing a claim for refund of tax, or filing a lawsuit seeking a refund of tax that would otherwise fall within April 1, 2020 and July 15, 2020 are also automatically extended to July 15.  For instance, if a taxpayer received an IRS notice of determination dated March 1, typically the Taxpayer would have 90 days—that is, until May 29, 2020—to file a petition to the Tax Court.  Under the Notice, that deadline is extended until July 15, 2020.

Additionally, all of this relief is automatic, meaning that neither the taxpayer nor his tax lawyer or accountant needs to file anything with the IRS to receive this relief. Additionally, the regular extension periods available to taxpayer are still available.  However, if a taxpayer seeks a regularly available extension, the relief provided by Notice 2020-23 does not serve to add additional time to the regularly extended deadline.  For instance, if a calendar year taxpayer files an extension application with respect to his or her 2019 1040 (which would extend the 1040 deadline from April 15, 2020 to October 15, 2020 in normal circumstances), no additional time is provided by reason of Notice 2020-23; the deadline to file the return would still be October 15, 2020.

In addition to providing taxpayers relief, Notice 2020-23 also provides additional time for the government (chiefly the IRS) to take certain actions. Specifically, with respect to any taxpayer (individual or entity) who is under IRS examination or whose case is before the IRS Office of Appeals, the Notice provides the government an additional 30 days to:

• Assess any tax;
• Give or make any notice or demand for the payment of any tax, or with respect to any liability to the United States in respect of any tax;
• Collect, by levy or otherwise, the amount of any liability in respect of any tax;
• Bring suit, by the United States, or any officer on its behalf, in respect of any liability in respect of any tax;
• Allow a credit or refund of any tax; and
• Take any other act specified in a revenue ruling, revenue procedure, notice, or other guidance published in the Internal Revenue Bulletin

The relief provided by IRS Notice 2020-23 is substantial and represents an acknowledgement by the IRS of the seriousness of the challenges posed by the COVID-19 pandemic.  As evidence of this acknowledgement, in normal circumstances extensions to file a return do not concomitantly provide an extension to pay the tax due; even if the deadline to file a return is extended, interest and penalties will accrue unless payment is made by the return’s original due date.  That is not the case under the Notice. Rather, the Notice essentially acts as a waiver by the IRS of three months of penalties and interest associated with an outstanding tax liability.

In addition to extending return filing deadlines, the Notice also carries the potential to substantially affect litigation of federal tax issues.  The Notice provides additional time to make decisions regarding whether to file a petition in Tax Court, whether to appeal a Tax Court decision, or whether to file a refund suit.  Conversely, the Notice also provides the IRS additional time to assess tax and make collection, in addition to other steps.  Consequently, Notice 2020-23 may substantially affect common taxpayer defenses, such as expiration of the applicable statute of limitations.

FIDJ serves as tax counsel for individuals, as well as a wide range of for profit and tax exempt entities. If you or your company are in need of tax counsel related to the Coronavirus or any other issues, feel free to contact us for a free initial consultation.

Under the COVID-19 stimulus package, formally titled the Coronavirus Aid Relief and Economic Security Act (“CARES Act”), which the President signed into law on March 27, 2020, taxpayers who have been unable to carry back net operating losses originating after 2017 based on recent changes to the Internal Revenue Code (“IRC”) have been provided substantial relief.

Specifically, under newly enacted IRC § 172(b)(1)(D), taxpayers may now carry back net operating losses (NOLs) arising in any tax year beginning after December 31, 2017 and ending before January 1, 2021, to each of the 5 preceding tax years. This revision to § 172 expressly (if temporarily) revokes a provision of the Tax Cut and Jobs Act of 2017 (TCJA) which barred NOL carrybacks (instead allowing only NOL carryforwards) for most taxpayers.

Background

Prior to the TCJA, taxpayers were generally permitted to carry back NOLs (that is, the excess of deductible losses over gross income in a given tax year, subject to certain modifications) 2 years from the year of origination, and then carry them forward another 20 years.  The carryback or carryforward of NOLs potentially allowed taxpayers to use a current year loss to generate a refund of tax paid in an earlier or later year.  For a simplified example, assume that in Year 1 a taxpayer has taxable income of $100,000 and pays tax of $35,000 based on a flat tax rate of 35 percent.  In Year 3, the taxpayer generates an NOL of $50,000.  Under the pre-TCJA rules, the taxpayer could apply its $50,000 Year 3 NOL retroactively to Year 1, thereby reducing Year 1 taxable income to $50,000 and generating a refund of $17,500 (that is, half of the tax paid in Year 1).

The policy underlying NOL carrybacks and carryforwards is to smooth out the peaks and valleys of the business cycle and more closely align a taxpayer’s tax obligations with the taxpayer’s economic performance over an extended period of time.  If a taxpayer was very profitable in one year, but suffered losses in succeeding years, the taxpayer could carryback its NOLs to the profitable year and recoup some or all of the tax it had previously paid, thereby creating a truer picture of the taxpayer’s economic performance, and resulting tax obligations, over that period of time.

However, effective for the 2018 tax year and forward, the TCJA eliminated the ability for most taxpayers to carryback NOLs (although it did allow for unlimited NOL carryforwards, as opposed to the 20 year carryforward allowed under prior law).  The effect of the TCJA was especially harsh for taxpayers anticipating the carryback of losses arising in 2018 or 2019 to offset income and generate refunds of tax paid in prior years.  Moreover, in circumstances of a sharp economic decline, like the one the country may be facing, the ability to carry back NOLs is crucial because it is more likely that tax was paid in the immediate past, and it is less likely that tax (or a similar amount of tax) will be paid in the immediate future.  Therefore, the most effective refund-generation efforts will be retrospective rather than prospective.

CARES Act Changes

Under the CARES Act, notwithstanding the limitations of the TCJA, all taxpayers may carry back NOLs arising in tax years beginning after December 31, 2017 and before January 1, 2021 (which therefore includes calendar years 2018, 2019, and 2020) to each of the 5 previous tax years.  For instance, if a taxpayer generated an NOL in 2019, that loss can now be carried back to 2014 and then carried forward through 2015, 2016, etc. until the NOL is fully depleted, whereas under prior law the 2019 loss could only be carried forward to 2020, 2021, etc.  To the extent the taxpayer paid tax in those earlier years, the taxpayer may be able to file a refund claim (most likely through the filing of an amended return for the appropriate year) and recoup some of the tax previously paid.

Alternatively, a taxpayer may waive the five-year carryback with respect to NOLs originating in tax years beginning in 2018 or 2019, and choose instead to use an NOL going forward only.  This approach may be preferred by new businesses, businesses which expect an uptick in income in future years, or taxpayers who haven’t paid a substantial amount of tax during the 5-year lookback window.  The procedures and time limitations for making this election are set forth in IRS Rev. Proc. 2020-24.

Note that the TCJA generally limited NOL deductions to 80 percent of the taxpayer’s taxable income in the carryback or carryforward year with respect to NOLs arising after December 31, 2017.  Under the CARES Act modifications, the 80 percent cap is eliminated for carrybacks or carryforwards to tax years beginning prior to January 1, 2021.  However, the 80 percent cap remains effective for all NOLs carried forward to 2021 or later years, even if the subject NOL originated in 2018, 2019, or 2020.

The changes to IRC § 172 discussed in this blog are reminiscent of Congress’s response to prior economic downturns.  For instance, following the 2008 financial panic and subsequent decline in the U.S. economy, Congress extended the usual 2-year carryback to a period of up to 5 years for losses originating in 2008 or 2009.  One notable difference is that in the 2009 law, taxpayers were given the option of expanding the carryback period to 3, 4, or 5 years, whereas the CARES Act allows only a 5 year carryback period.

Summary

Unfortunately, after years of economic expansion, many individuals and businesses will suffer economically in 2020 due to the COVID-19 pandemic.  In addition to other relief measures passed by Congress, the changes to IRC § 172 outlined in this article will allow taxpayers who suffer economic losses in 2020 (or suffered them in 2018 or 2019) to recover some of the tax they paid in more prosperous times.  If you or your business have incurred net operating losses in 2018 or 2019, or anticipate incurring one 2020, you should discuss this opportunity with your tax professionals to ensure you maximize the benefits made available under the CARES Act.

 

 

 

 

Part III: UCC Excuses for Nonperformance

As the world continues to confront a prolonged battle with the coronavirus pandemic, the long-term impacts on business and contractual relationships become more and more visible. Business owners in countless industries may be faced with labor and supply shortages, as well as government intervention such as quarantines or emergency shelter-in-place orders, which will render non-performance of contractual duties ever the more likely. Despite the pandemic, contracts still remain valid and enforceable, and parties still face liability for breaching duties they owe pursuant to those contracts. However, those faced with the difficult decisions of how to fulfill contractual obligations in these unprecedented conditions may be able to excuse their performance under several doctrines of nonperformance. In this multipart series, the commercial litigation attorneys of FIDJ explore various doctrines which may excuse performance of contractual obligations.

In Part I of our series, we discussed the potential application of force majeure clauses to excuse nonperformance. In Part II, we discussed the common law doctrines of impossibility and frustration of purpose, which, depending upon the circumstances, may excuse contractual nonperformance. Part III of this series explores excuses for nonperformance which may be available to parties under the Uniform Commercial Code Article 2 (“UCC”) for contracts concerning the sale of goods.

Generally, domestic contracts for the sale of goods are governed by the Uniform Commercial Code as codified by the various states. Florida’s version of the UCC has been codified at Chapter 672, Florida Statutes. UCC § 2-615 (codified at Fla. Stat. § 672.615), titled “Excuse by Failure of Presupposed Conditions” codifies the doctrine of commercial impracticability and may provide sellers of goods relief from performance.

As the comments to 672.615 explain, the “section excuses a seller from timely delivery of goods contracted for, where his performance has become commercially impracticable because of unforeseen supervening circumstances not within the contemplation of the parties at the time of contracting.” Fla. Stat. § 672.615, cmt. 1. Section 672.615 provides in pertinent part:

Except so far as a seller may have assumed a greater obligation and subject to the preceding section on substituted performance:

(1) Delay in delivery or nondelivery in whole or in part by a seller who complies with subsections (2) and (3) is not a breach of her or his duty under a contract for sale if performance as agreed has been made impracticable by the occurrence of a contingency the nonoccurrence of which was a basic assumption on which the contract was made or by compliance in good faith with any applicable foreign or domestic governmental regulation or order whether or not it later proves to be invalid.

For Fla. Stat. § 672.615 to apply, the following conditions must be met.

First, the provision can apply to sale of goods contracts “except so far as a seller may have assumed a greater obligation” concerning the risk of loss of the goods. In instances where sellers contractually assumed the risk for loss in all instances, or have done so through the parties’ previous course of dealings, courts will more likely find that 672.615 does not provide an excuse to nonperformance. See Fla. Stat. § 672.615, cmt. 8.

Second, the occurrence of the event which prevented nonperformance must be either: i) “a contingency the nonoccurrence of which was a basic assumption on which the contract was made;” or ii) seller’s compliance with a supervening “applicable foreign or domestic governmental regulation or order.” Fla. Stat. § 672.615(1). In instances where “the contingency in question is sufficiently foreshadowed at the time of contracting,” 672.615 will not provide relief to sellers. Fla. Stat. § 672.615, cmt, 8. Of course, as with the previous doctrines discussed in this series, foreseeability is a fact intensive inquire and will vary depending upon the circumstances.

Third, the seller’s performance must be made “impracticable.” Fla. Stat. § 672.615(1). Sellers should note that the comments recognize the doctrine of “commercial impracticability” as distinct from common law doctrines of impossibility and frustration of purpose. Fla. Stat. § 672.615, cmt. 3. This is because the doctrine does not require impossibility of performance from the seller or buyer. However, while technically the commercial impracticability defense is an easier defense to assert, it is by no means a guaranteed win.

As comment 4 explains, “[i]ncreased cost alone does not excuse performance unless the rise in cost is due to some unforeseen contingency which alters the essential nature of the performance.” However,  “a severe shortage of raw materials or of supplies due to a contingency such as war, embargo, local crop failure, unforeseen shutdown of major sources of supply or the like, which either causes a marked increase in cost or altogether prevents the seller from securing supplies necessary to his performance, is within the contemplation of this section.” Fla. Stat. § 672.615, cmt. 4.

With regard “supervening” changes in the law which render performance impracticable, “governmental interference cannot excuse [nonperformance] unless it truly ‘supervenes’ in such a manner as to be beyond the seller’s assumption of risk.” Fla. Stat. § 672.615, cmt. 10.

We also note that even if a seller satisfies the conditions necessary under subsection one, excuse will only occur if a seller complies with subsections two and three of the statute. Subsection two requires that if a seller’s partial performance is possible, then a seller “must allocate production and deliveries among his or her customers…in any manner which is fair and reasonable.” Fla. Stat. §672.615(2). “An excused seller must fulfill his contract to the extent which the supervening contingency permits, and if the situation is such that is customers are generally affected he must take account of all in supplying one.” Fla. Stat. § 672.615, cmt. 11.

Finally, subsection three requires sellers to “seasonably” notice buyers that there will be delay or nondelivery and, when allocation is required under subsection (2), of the estimated quota made available for the buyer. Fla. Stat. § 672.615(3). The UCC defines seasonable notice as notice “taken at or within the time agreed or, if no time is agreed, at or within a reasonable time.” Fla. Stat. § 671.204(2). However, whether a time is reasonable depends on the nature, purpose, and circumstances of the action. Id. at (1).

Fuerst Ittleman David & Joseph was founded with a focus on serving the legal needs of domestic and international businesses of all shapes and sizes. Our commercial litigation practice group has decades of experience litigating a wide array of business disputes in state and federal courts as well as domestic and international arbitration panels. In addition, our corporate transactional team can assist your company with a full range of corporate legal services which can take you (and your company) from the initiation of your business plan through the daily operation of your now-thriving company. For more information contact us at 305-350-5690 or info@fidjlaw.com.

On March 25, 2020, the Third DCA issued its panel decision in Island Travel & Tours, Ltd. v. MYR Indep., Inc., 3D16-1364, 2020 WL 1451990, at *3 (Fla. 3d DCA Mar. 25, 2020), which reaffirmed application of the independent tort doctrine to bar common law tort claims in business litigation cases where there is already a contract between the parties.

The independent tort doctrine provides that “[w]here a contract exists, a tort action will lie for either intentional or negligent acts considered to be independent from acts that breached the contract.” HTP, Ltd. v. Lineas Aereas Costarricenses, S.A., 685 So. 2d 1238, 1239 (Fla. 1996). “It is only when the breach of contract is attended by some additional conduct which amounts to an independent tort that such breach can constitute [an actionable tort].” Elec. Sec. Sys. Corp. v. S. Bell Tel. & Tel. Co., 482 So. 2d 518, 519 (Fla. 3d DCA 1986).

In 2013, the Florida Supreme Court held that a related doctrine — the economic loss rule — was restricted to products liability cases and could not be used to bar general commercial tort claims. Tiara Condo. Ass’n, Inc. v. Marsh & McLennan Cos., 110 So. 3d 399, 408 (Fla. 2013).

In a concurring opinion, however, Justice Pariente distinguished the independent tort doctrine as still being a valid defense in cases outside the products liability area.

The majority’s conclusion that the economic loss rule is limited to the products liability context does not undermine Florida’s contract law or provide for an expansion in viable tort claims. Basic common law principles already restrict the remedies available to parties who have specifically negotiated for those remedies, and, contrary to the assertions raised in dissent, our clarification of the economic loss rule’s applicability does nothing to alter these common law concepts. For example, in order to bring a valid tort claim, a party still must demonstrate that all of the required elements for the cause of action are satisfied, including that the tort is independent of any breach of contract claim.

Tiara Condo., 110 So. 3d at 408 (Pariente, J., concurring with opinion joined by Lewis and Labarga, JJ.).

Technically, because Justice Pariente’s concurrence was not joined by a majority of the Court, some judges have interpreted the majority ruling in Tiara as having nullified the independent tort doctrine as well as the economic loss rule outside the products liability context. See USI Ins. Services LLC v. Simokonis, 15-CV-24337, 2016 WL 11547701, at *6 (S.D. Fla. Apr. 15) (“There is some disagreement among the district courts in this Circuit on whether the independent tort rule remains intact following the Tiara decision. Some courts have cited to Justice Pariente’s concurrence in determining or at least suggesting that the independent tort rule is still applicable notwithstanding the holding of Tiara.”); report and recommendation adopted, 2016 WL 11547699 (S.D. Fla. May 13, 2016).

It was not until 2017 that the Third District Court of Appeal in Peebles v Puig, 223 So. 3d 1065 (Fla. 3^rd DCA 2017), applied the independent tort doctrine for the first time since Tiara to reverse a jury verdict for commercial fraud (i.e., in a case outside the products liability context).

It is well settled in Florida that, where alleged misrepresentations relate to matters already covered in a written contract, such representations are not actionable in fraud. It is similarly well settled that, for an alleged misrepresentation regarding a contract to be actionable, the damages stemming from that misrepresentation must be independent, separate and distinct from the damages sustained from the contract’s breach. Both of these legal principles are rooted in the notion that, when a contract is breached, the parameters of a plaintiff’s claim are defined by contract law, rather than by tort law.

Peebles, 223 So. 3d at 1068 (citation omitted). The Peebles Court cited Tiara in a footnote, clarifying: “We do not evaluate this case under the economic loss rule.” Id. at 1068 n.4.

The Third DCA’s March 2020 decision in Island Travel reaffirms its commitment to apply the independent tort doctrine that it resuscitated in Peebles to bar tort claims in the commercial litigation context where there is an existing contract between the parties. Island Travel, 2020 WL 1451990, at *3 (“The only properly alleged misrepresentation simply has to do with Island’s failure to perform under the contract. It is a fundamental, long-standing common law principle that a plaintiff may not recover in tort for a contract dispute unless the tort is independent of any breach of contract.”).

The Court in Island Travel further noted that, although fraud in the inducement is generally considered to be an “independent” tort (because the misrepresentation that induces someone to enter into a contract is often unrelated to the obligations under the contract) the Plaintiff’s fraud claim in Island Travel was “clearly duplicative of its breach of contract claim [because Plaintiff] sought the exact same damages for both its fraud claim and its breach of contract claim.” Id. n.7 (emphasis added).

The takeaway: where a contract has been breached, a simultaneous common law tort claim lies only for acts deemed independent of those establishing the contract’s breach or for damages that are attributable to actions other than those that caused the breach of contract.

The litigation and corporate attorneys of Fuerst Ittleman David & Joseph have extensive experience handling complex matters throughout Florida and the United States and can assist with a full range of litigation, transactional, and compliance services from start-up to daily operations of your thriving business enterprise. Please contact us at 305-350-5690 or email us at info@fuerstlaw.com.