Nebraska Revises Inheritance Tax; and Substantiating Expenses

Overview

There have been several important developments in ag law and tax over the past couple of weeks worth noting.  So, before they pile up even further, I thought I would provide a quick update for you. 

A few recent developments touching ag law and tax – it’s the topic of today’s post.

Nebraska  - “The Good Life” Becomes a Better Place to Die

In 1895, Illinois was the first state to adopt a progressive inheritance tax on collateral heirs (an heir that is not in a direct line from the decedent, but comes from a parallel line.  The law was challenged as a violation of equal protection under the Constitution, but was upheld in 1898 in Magoun v. Illinois Trust and Savings Bank, et al., 170 U.S. 283 (1898).  As a result of the court’s decision, Nebraska adopted a progressive county-level inheritance tax in 1901.  The state’s inheritance tax system has changed little since that time.  Presently, Nebraska is the only state that uses the tax as a local government revenue source. 

But, this session the Nebraska Unicameral has passed (with only one vote in opposition) a bill that the Governor signed into law on February 17 revising the state’s county inheritance tax system (a tax on the privilege to inherit wealth). 

Note:  The lone vote in opposition to the bill was cast by a Senator from a district that has had counties in recent years where the inheritance tax generated zero revenue for the county.  It’s pretty easy to vote against a bill lowering (or eliminating a tax) when it doesn’t affect one’s constituents in the first place.

LB 310 changes the inheritance system for decedent’s dying after 2022.  Amounts passing to a surviving spouse remain exempt, and for “Class I relatives (near relatives – basically those persons up and down the decedent’s line), the 1 percent rate doesn’t change, but the exemption goes to $100,000 from the prior level of $40,000 per person.  For Class II relatives (aunts and uncles, nieces and nephews, and other lineal descendants of these relatives), the tax rate drops from 13 percent to 11 percent and the exemption increases from $15,000 per person to $40,000 per person.  For Class III “relatives” (everyone else), the rate is 15 percent, down from 18 percent, and the exemption will be $25,000 instead of the prior $10,000 amount.  Also included in the revised system is a provision exempting inheritances by persons under age 22 from all tax. 

Note:  Under LB 310, step-relatives are treated in the same manner as blood relatives with respect to the tax rate and exemption amounts based on their classification. 

The new inheritance tax system does require an estate’s personal representative to submit a report regarding inheritance taxes to the county treasurer of a county in which the estate is administered upon the distribution of any estate proceeds.  The Nebraska Department of Revenue must prepare a form for the personal representative’s report which will include information about the amount of the inheritance tax generated and the number of persons receiving property.  The report must also disclose the number of persons who do not reside in Nebraska that receive property that is subject to inheritance tax. 

More Substantiation Cases

In recent days, the U.S. Tax Court has issued a couple of opinions involving the expense substantiation rules of I.R.C. §274.  As we are in the midst of tax season, it is a good reminder that deductions are a matter of legislative “grace.”  If you claim a business deduction, you must substantiate it under the applicable rule(s).  Some types of expenses require more substantiation that do other expenses. 

Business Deductions Properly Denied 

Sonntag v. Comr., T.C. Sum. Op. 2022-3

The petitioners, a married couple, both had sources of income. The husband operated a music studio from a shed in their backyard. They used an electronic application to track their business expenses and receipts. On their joint 2017 return, they reported $247,201 in income from Form W-2. They claimed Schedule C deductions of $47,385, resulting in a business loss of $28,835. The deductions included amounts for travel expenses; air fare; meals and entertainment; bank charges; batteries; books and publications; a briefcase; credit card interest and fees; camera parts; costume cleaning; stage costumes; catering for special events; labor; office supplies; fees for physical training; postage/shipping; personal hygiene products; prop expenses; “research” admission fees; cable fees; Apple Music and Spotify subscriptions; Netflix subscriptions; studio supplies; cell phone expense; tools; and legal services. The IRS disallowed $37,800 of the deductions which included $11,713 of travel expenses; $5,763 of meal and entertainment expenses; and $20,324 of other expenses.

The Tax Court agreed with the IRS. Personal care expenses were properly denied. The credit card and annual fee expenses involved multiple personal transactions and weren’t substantiated as business expenses. The stage costume expense was not deductible because the husband testified that the shoes and clothes could also be worn as personal wear. The catering expenses were not properly substantiated, and the physical training expenses were also determined to be personal in nature as were the hygiene products. The research expenses were determined to be inherently personal. The cell phone expense was properly disallowed - some of the expense had been allowed. Other expenses were also disallowed for lack of substantiation – bank charges; batteries; books and publications; briefcase; camera parts; office supplies; and legal services. The claimed travel expenses were properly disallowed for failure to meet the heightened substantiation requirements of I.R.C. §274(d). Still other expenses were properly disallowed as both personal and unsubstantiated, including costume cleaning; labor; props; studio supplies; tools; and postage/shipping. 

Unreimbursed Employee Expenses Properly Substantiated 

Harwood v. Comr., T.C. Memo. 2022-8

The petitioner was a construction worker that worked for various employers over the tax years in issue. His work required him to leave home for significant “chunks of time.” He sought to deduct unreimbursed expenses for meals and entertainments, lodging, vehicle and other unreimbursed expenses that he incurred during his employment. The IRS disallowed a portion of the claimed deductions. The Tax Court upheld the petitioner’s deductions, noting that he had properly substantiated his travel, meals and lodging while away from home. He corroborated the amount, time, place and business purpose for each expenditure as I.R.C. §274(d) and Treas. Reg. §1.274-5T(b)(2)(ii)-(iii) requires. He also substantiated the auto expenses by documenting the business use and total use by virtue of a contemporaneous log. He also was “away from home” because his employment was more than simply temporary or only for a short period of time. The petitioner also proved that the dd not receive or have the right to receive reimbursement from his employer. 

Conclusion

The Nebraska modification of the county-level inheritance tax is step in the right direction for tax policy that has often ignored the inheritance tax.  On the unreimbursed business expense deduction issue, it’s imperative to maintain good records.  And not all expenses fall under the same substantiation rules.  That’s a key point that was brought out by the Tax Court last year in Chancellor v. Comr., T.C. Memo. 2021-50.  In Chancellor, the Tax Court pointed out that expenses that fall under the I.R.C. §274(d) umbrella cannot be substantiated (estimated) under the Cohan rule.  See Cohan v. Comr., 39 F.2d 540 (2nd Cir. 1930).  So, it’s important to understand which expenses are covered by the rule and those that aren’t, and what it takes to properly substantiate them.  But even if the Cohan rule applies it’s not a certainty that it will be a successful defense to an IRS audit.