NewsNotes

Lesli S. Laffie, J.D., LL.M.

Contingent Attorneys Fees EFTPS HSA Reporting Noncustodial Dependency Exemption Federal Income Tax Liability (Chart)

Court Decisions

Contingent Attorneys Fees

In David Raymond, 2d Cir., 1/13/04, a case of first impression for the Second Circuit, the court reversed a Vermont district court and held that an individual who settled a wrongful termination suit could not exclude from income the portion of the settlement paid directly to his attorneys under a contingency fee arrangement; instead, these amounts had to be included in income and deducted as miscellaneous itemized deductions subject to the 2%-of-adjusted-gross-income floor. Because the taxpayer was subject to the alternative minimum tax, the fees were completely nondeductible.

There is a huge conflict among the circuits on whether a directly paid contingency fee is income to the plaintiff. Courts addressing the issue have generally recognized that state law determines the nature of the legal interests in property, while Federal law determines the tax consequences of the receipt or disposition of property. The Second Circuit now agrees with the First, Third, Fourth, Seventh, Tenth and Federal Circuits and the Tax Court in taxing plaintiffs on contingent fees paid to their attorneys. The Fifth, Sixth and Eleventh Circuits, however, have permitted clients to escape tax on contingent attorney fees. The Ninth Circuit has reached different results depending on state law. For a discussion of Raymond, see Tax Trends, this issue.

From the IRS

EFTPS

According to IR-2004-10, the IRS has launched an initiative, available using the electronic Federal tax payment system (EFTPS), intended to provide businesses with a faster system for paying taxes electronically. EFTPS, a free service, enables taxpayers and tax advisers to make Federal tax payments electronically online, by phone or with batch provider software (for professionals). EFTPS express enrollment for new businesses will affect all businesses receiving a new employer identification number (EIN).

Business taxpayers with a Federal tax obligation will be automatically pre-enrolled in EFTPS to make all Federal tax deposits.

In addition to receiving their EIN, taxpayers will also receive a separate mailing containing an EFTPS personal identification number and instructions for activating their enrollment (by calling a toll-free telephone number, entering banking information and completing an authorization for EFTPS to transfer funds to Treasurys account for tax payments, per their instructions).

Taxpayers can enroll in EFTPS at www.eftps.gov or by calling (800) 555-4477 or 945-8400 to receive forms by mail. Taxpayers can make payments 24 hours a day, 7 days a week from home or office; schedule payments up to 120 days in advance (for businesses) or 365 days in advance (for individuals); and review the last 16 months of tax payment history online or by calling customer service. In addition, taxpayers receive an immediate acknowledgement number for every EFTPS transaction for easy recordkeeping and as proof of the transaction.

HSA Reporting

A new code (Code WEmployers contribution to an employees Health Savings Account (HSA)) to be used in box 12 on the 2004 Form W-2 has been added to the Forms W-2 and W-3 instructions.

The Medicare Prescription Drug Improvement and Modernization Act of 2003 requires reporting of an employers contributions to an employees HSA on Form W-2. The amount that an employer contributes to an employees HSA will be shown in box 12 of Form W-2, using Code W.

Generally, employer contributions to an employees medical savings account are not subject to income, Social Security/Medicare or Railroad Retirement taxes and will not affect amounts otherwise reported in Form W-2 boxes 1, 3 and 5.

Noncustodial Dependency Exemption

The IRS has revised Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents, and Pub. 504, Divorced or Separated Individuals, p. 8, to permit a never-married noncustodial parent to claim a dependency exemption when the custodial parent has waived the exemption. Thus, the IRS now agrees with the Tax Courts holding in Jeffrey R. King, 121 TC No. 12 (2003), that a noncustodial parent was entitled to a dependency exemption because the custodial parent signed Form 8332, waiving the exemption.

Background: Sec. 152(a) generally allows a dependency exemption for parents who provided over half of a childs support during the calendar year. Under Sec. 152(e), the parent with custody for a greater portion of the year is treated as providing more than 50% of a childs support, when the child receives more than half of his or her total support for the year from either or both parents, who (1) are divorced or legally separated, (2) are separated under a written separation agreement or (3) lived apart at all times during the last six months of the calendar year. Sec. 152(e)(2)(A) provides that the custodial parent may release (on Form 8332) the claim to the noncustodial parent.

In King, H and W were never married to each other and did not live together at any time during 1998 or 1999. At issue was whether H or W could claim a dependency exemption for their daughter, D, during the years in question. W executed Form 8332 in Hs favor for 1987 and all later years. H claimed a dependency exemption for D for 19871999 and attached a copy of Form 8332 (executed by W) to his returns for the years in issue. W claimed D, who resided with W at all times, as a dependent in 1998 and 1999. H and W provided support during those years, with W providing over half of Ds support. W never informed H that she intended to revoke the release executed in Form 8332.

H argued he was entitled to the dependency exemptions because H and W lived apart at all times during the years in issue and W signed Form 8332 waiving her dependency claim for 1987 and all future years. The IRS and W contended that Sec. 152(e)(1) does not apply to parents who were never married to each other. The Tax Court held that there is no requirement in the statute that parents be married to each other for the special support test to apply.

Form changes: Form 8332 permits a release of claim to the exemption for a child of divorced or separated parents. The 2003 version of the form, unlike the prior version, does not say that parents have to be married for one to waive the exemption. In its guidance for divorced or separated parents for the 2003 tax year, IRS has also deleted the marriage requirement for Sec. 152(e) to apply; see Pub. 504, p. 8. Under Temp. Regs. Sec. 1.152-4T(a), the release may apply to one year, a set number of years or all future years.